Unrelated business activities can trip up nonprofits

Consider this scenario: You work with a nonprofit organization dedicated to providing educational resources to underserved communities that has an opportunity to open a small bookstore. The bookstore could generate significant revenue to support your mission. However, you soon realize that this new venture might fall under the category of unrelated business activities, subjecting your nonprofit to an unanticipated tax burden. Ouch!

Navigating the intricate rules of unrelated business activities is crucial to ensuring your nonprofit remains compliant while maximizing its potential revenue streams. 

Be careful not to trigger taxes

Unrelated business activities present a nuanced challenge for nonprofits. While activities related to exempt purposes are generally exempt from federal income tax, income generated from unrelated trade or business activities can trigger the unrelated business income tax (UBIT).

For the benefit of their organizations and missions, nonprofit leaders need a basic understanding of what constitutes unrelated business income (UBI) and the intricacies of UBIT. 

Defining unrelated business income

UBI arises from any trade or business activity that is regularly carried on and not substantially related to the nonprofit's exempt purpose. For example, if a nonprofit educational institution runs a bookstore that primarily sells books unrelated to its educational mission, the income may be classified as UBI. However, this rule has numerous exceptions and nuances. Passive income such as dividends is generally exempt from UBIT unless the nonprofit uses borrowed funds to acquire the income-producing asset. 

Adding complexity is the requirement to calculate UBI separately for each unrelated trade or business, a rule that took effect in 2018. Nonprofits must now track and report different unrelated trades or businesses using the first two digits of the NAICS code describing each unrelated trade or business (the IRS uses the North American Industry Classification System to determine separate trades or businesses for tax purposes). This segregation helps mitigate potential tax consequences but requires diligent accounting and reporting practices. 

To navigate these rules effectively, nonprofits might consider restructuring their revenue-generating activities. One common strategy is to transfer these activities to a for-profit subsidiary. This approach can help isolate UBI and potentially reduce the overall tax burden. However, setting up and managing a for-profit subsidiary involves its own legal and administrative challenges. 

The IRS does offer some help. The IRS Technical Guide on Unrelated Business Income Tax, released in late 2023, provides valuable insights into the IRS’s examination techniques. It offers practical guidance on how the IRS approaches UBI and can help nonprofits better prepare for compliance. 

Your role as a nonprofit leader

As a nonprofit leader, stay vigilant about how your organization’s revenue-generating activities are structured and reported. Take proactive steps today. Engage with legal and financial experts to explore alternative structures that might better serve your goals while ensuring compliance with UBIT regulations. The landscape of unrelated business activities is complex, but with careful planning and expert guidance, your nonprofit can effectively manage its obligations and continue to thrive. 

Your mission is too important to be hindered by avoidable tax issues. By understanding and navigating unrelated business activities effectively, you can ensure your nonprofit remains strong and capable of making a lasting impact. 

Does this sound confusing? Yes, tax laws can be. However, the team at Our Community Law is here to help you with the intricacies and put plans in place to protect your tax-exempt status.