When Income Earned by Tax-Exempt Organizations Is Not Exempt
An entity can be a nonprofit organization without being a tax-exempt organization. Further, tax-exempt organizations are not always exempt from all tax.
Tax-exempt organizations are nonprofit organizations that apply for and are awarded tax-exempt status by the IRS. Some organizations choose to be a nonprofit but not seek tax-exempt status, and some simply do not qualify.
In general, tax-exempt organizations do not have to pay any federal or Illinois income tax. However, there are situations in which tax-exempt organizations must pay tax. Further, at some point, pushing the envelope too far can result in the tax-exempt organization losing its tax-exempt status altogether.
1. Unrelated Business Income Tax (UBIT)
Briefly, a tax-exempt organization is subject to income tax to federal and Illinois income tax on unrelated business taxable income (UBTI). This tax is called unrelated business income tax.
2. Related Versus Unrelated Income
Trade and business activities (and thus the income earned thereon) in the tax-exempt world is broken into two basic categories: “related” and “unrelated” to the tax-exempt mission.
Related: Income that is “related” is generally revenue that is earned through trade or business activities that are substantially related to the performance of its exempt mission. For example, XYZ College is a tax-exempt organization with a mission of education. Teaching is at the core of supporting its tax-exempt mission. Teaching for money is a related trade or business and so tuition paid by students to XYZ College to attend classes would be related business income. Accordingly, the income from teaching classes would be related income (i.e., not UBTI) and not subject to UBIT.
Unrelated: Income that is “unrelated” is generally revenue that is earned through trade or business activities that substantially relate to the performance of its exempt mission other than simply to raise money. For example, XYZ College is a tax-exempt organization with a mission of education. Let’s say that XYZ College decides to purchase bicycles from a bicycle manufacturer and open a retail store selling the bicycles. The store is completely staffed and operated by nonstudent employees (i.e., no education-related mission to the operation of the store). The operation of the retail store would be an unrelated trade or business. Accordingly, the income from the retail store would be UBI subject to UBIT.
3. So What?
Reporting and Payment of Tax: If a tax-exempt organization earns more than $1,000 of UBTI in any fiscal year, it must file IRS Form 990-T and pay UBIT. If the tax-exempt organization operates more than one unrelated trade or business, it must prepare and attach a separate Schedule M form reporting separately each of such trades or businesses.
Lose Tax-Exempt Status: If a tax-exempt organization pushes the UBTI envelope too far, it can suffer more than having to pay UBIT. It may even lose its tax-exempt status.
Below are three illustrations that help clarify the difference, as well as some applicable rules that are in the federal income tax laws:
If, in the bicycle store example above, the people who operate the store are students enrolled in a class designed to teach students how to operate a retail store, then the operation of the store would likely be classified as “related.”
If a tax-exempt organization, with the mission to prevent cruelty to animals, boards and grooms people’s pets for money, it would be considered an unrelated business activity even though the mission relates to the prevention of cruelty to animals.
If a tax-exempt vocational school operates a shop that sells items made by students while participating in a vocational class also also sells items made by nonstudents in the same shop, the sale activity is bifurcated so that the income earned by the sale of student-made items is not UBTI and the income earned by the sale of nonstudent-made items is UBTI.
5. Specific Activities
There are specific activities that are, by statute, excluded from the definition of an “unrelated trade or business” even if they are completely unrelated to the organization’s mission:
Under many certain circumstances, bingo games are excluded from the definition of an “unrelated trade or business.”
Gambling activities operated by a tax-exempt organization in North Dakota are excluded from the definition of an “unrelated trade or business” if otherwise legal under North Dakota and local laws.
For more information about tax law, see STATE AND LOCAL TAXATION — 2017 EDITION. Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.