Unrelated business income tax explained

A tax-exempt status can be tricky to navigate for religious groups or churches because of shifting tax laws and regulations.

The unrelated business income tax, or UBIT, can trip up well-meaning organizations that tread beyond the confines of tax exemption. The risks of misunderstanding this tax are sizable enough to keep a close eye on the sources of your finances.

Testing for unrelated business income

When the IRS granted tax-exempt status to your church or group, it recognized that the organization's mission wasn't focused on creating profits. Therefore, it agreed not to tax the income your group generates in connection with fulfilling its goals.

That doesn't necessarily mean that every dollar the organization brings in is automatically tax-free. To allow for the fact that some activities will generate revenues that don't directly support the mission, the IRS created an unrelated business income classification. For example, if your church's soup kitchen opens its doors once a week to paying customers or regularly sells parking spots to attendees to a nearby music venue, those revenues don't fall under tax-exempt guidelines.

To help determine whether your organization is generating non-tax-exempt income, ask yourself the following questions, which are based on the IRS's criteria for unrelated business income:

1. Is the activity designed to make a profit?
2. Does it operate on an ongoing basis?
3. Does it fall outside the scope of the organization's core purpose?

If the answer is yes to all three, then it's likely unrelated business income. The soup kitchen that feeds the homeless can't charge diners for weekly dinners and claim the proceeds are tax-exempt. Similarly, the money raised by opening the parking lot to concert-goers isn't treated in the same way as the funds collected during an annual stewardship campaign.

Talking taxes

Not surprisingly, the IRS considers non-core revenues taxable, which is why it implemented UBIT.

UBIT is tax assessed on more than $1,000 of an organization's unrelated business income in a year. The income is charged at a corporate tax rate and may be adjusted for expenses directly related to the unrelated business, such as raw materials and wages.

Additionally, if the organization expects to owe more than $500 in taxes in a year, it must make quarterly estimate payments or it risks additional penalties.

But take care that your organization's unrelated business income isn't substantial. Too much activity unrelated to your organization's primary purpose can cause your organization to lose its tax-exempt status. The IRS doesn't draw a concrete line, but the Foundation Group suggests that unrelated business income should never exceed 20% of the organization's income and typical nonprofits should stay under 10% to avoid unnecessary scrutiny.

Clarifying what's subject to UBIT

Allowing for the sometimes fuzzy line between mission-based fundraising and profit-focused revenues, the IRS has identified a series of UBIT exceptions and exclusions.

For example, income from the following sources may not count as taxable income:

• Dividends and interest
• Funds raised from activities that rely solely on volunteers
• Businesses that exist for the convenience of church members
• Sales of donated items in a thrift shop or bake sale
• Select bingo games

As with any tax matters, consulting with your organization's accountant is essential to ensure any business decisions align with IRS rules and regulations. You'd hate to have a misstep take away a chunk of hard-earned revenue, whether it's tax-exempt or not.