What is the difference between a ‘related’ and ‘unrelated’ business activity?
You want to bring in more revenue and you’re thinking about your options. Before you begin, you’ll need to understand how your business activities are perceived from a tax perspective.
When a nonprofit charges a fee for a service or sells a product as an ongoing activity, the law considers whether the activity or product is “related” to the organization’s mission. If the business is “related” to your exempt purposes, then you will not incur corporate income taxes on the net proceeds of that business activity (though you may need to pay sales and other taxes).
Taking care to ensure that your business activity is “related” significantly reduces the risk that your organization will lose its tax exemption for carrying on too much activity that does not further the mission.
An example of “related” business would be a health clinic that charges patients a reduced price for health services. This furthers its mission to provide affordable health care services.
If the business is not related to the organization’s exempt purposes, then it is considered “unrelated” and net income from the business is subject to Unrelated Business Income Tax (UBIT). UBIT is applied when gross income from the unrelated business is $1,000 or more. These are reported and paid by filing a Form 990-T, which is required in addition to any other tax reporting forms required of the exempt organization. Individual states may also have their own filing and tax requirements. For example, in California, the Franchise Tax Board requires a Form 109 to calculate and pay tax on unrelated business.
Keep in mind, there are limitations on the amount of unrelated business activity in which a nonprofit can engage. Under IRS regulations, a nonprofit risks losing its tax exemption if an unrelated business constitutes a “substantial” portion of the organization’s total activities. While the word “substantial” is subject to interpretation, if the unrelated business activity grows to 25 percent of your nonprofit organization’s activity, you should seek legal counsel. One option for continuing to engage in a substantial amount of unrelated business activity is to form a subsidiary corporation or limited liability company to carry on the business.
Still not sure if your activity is related?
Know that the IRS considers an activity to be “unrelated” if all three of the following are present:
- It is a trade or business (i.e., selling of goods or services).
- It is regularly carried on (as distinct from the occasional car wash or bake sale).
- It is not substantially related to furthering the exempt purpose of the organization.
This is a brief description of an area that is complex. If your organization is carrying on or planning to start a business venture, the advice of legal counsel familiar with these complicated tax rules is strongly advised.