Tax-exempt organizations are not completely exempt from federal income tax. When a nonprofit regularly carries on a trade or business that is not substantially related to its exempt purpose, the net income from that activity is subject to unrelated business income tax at the corporate rate of 21%. UBIT exists to prevent tax-exempt organizations from competing unfairly with taxable businesses by leveraging their tax-exempt status in commercial activities. A university that sells commercial insurance to the general public, a hospital that operates a parking garage for the general public, or a church that rents its facilities for commercial events may generate taxable UBIT - even though the organization itself is tax-exempt.
Income is unrelated business taxable income (UBTI) if ALL three elements are present:
1. Trade or business: The activity must involve the sale of goods or services for profit. Investment activities (passive income) generally do not constitute a trade or business for UBIT purposes.
2. Regularly carried on: The activity must be conducted with frequency and continuity similar to comparable commercial activities. An annual fundraising event is not "regularly carried on"; a weekly restaurant operation is.
3. Not substantially related: The income-producing activity must not substantially contribute to the accomplishment of the organization's exempt purpose. The relatedness test examines whether the activity directly serves the exempt purpose - not merely whether the income is used to fund exempt activities.
Many activities that might appear to be unrelated business are specifically excluded from UBIT by statute:
Volunteer labor: A trade or business in which substantially all work is performed by volunteers is excluded from UBIT. A charity thrift shop staffed entirely by volunteers generates no UBIT.
Convenience activities: A trade or business carried on primarily for the convenience of members, students, patients, or employees is excluded. A hospital cafeteria, a university bookstore, or a church gift shop primarily serving members avoids UBIT under this exception.
Passive investment income: Dividends, interest, annuities, royalties, and capital gains are generally excluded from UBIT as passive income. A university endowment earning dividends and capital gains owes no UBIT on those earnings.
Bingo games: Bingo games conducted by a tax-exempt organization are excluded from UBIT if the games are legal under local law and not conducted in a commercial manner.
UBIT is taxed at the corporate rate of 21% on net unrelated business taxable income. The organization may deduct expenses directly connected with the unrelated business activity. An organization with multiple unrelated business activities must track income and expenses separately for each activity - OBBBA codified the "siloing" rule requiring that losses from one unrelated business cannot offset income from another. Each activity stands alone. Form 990-T (Exempt Organization Business Income Tax Return) is filed annually when UBTI exceeds $1,000. Estimated tax payments are required if UBIT liability exceeds $500.