What it means
Charities, universities, hospitals and many associations are exempt from US income tax because of the work they do. That exemption covers income from the exempt purpose, such as donations and fees for the core mission, but it does not automatically cover every dollar they earn.
An activity triggers UBIT when three conditions are met. It must be a trade or business, it must be regularly carried on, and it must not be substantially related to the organisation's exempt purpose.
A university selling tickets to a general-public concert series could qualify as unrelated, while its tuition fees would not. Several types of income are generally excluded, including most dividends, interest, royalties and certain rents.
Income from property bought with borrowed money, known as debt-financed income, can be pulled back into the tax net, which surprises many organisations with investment portfolios. The taxable amount is the gross income from the unrelated activity less the expenses directly connected with earning it.
The rate follows the corporate rate for exempt organisations structured as corporations, and the trust rates for those structured as trusts, and both are set by tax legislation rather than by the organisation. Organisations usually report the income on a specific annual return and may need to make estimated payments during the year.
Many also use a separate taxable subsidiary to hold commercial activities, which keeps the charity's exempt status safer if the commercial work grows large. Management should also keep good records that separate exempt and commercial activity.
Time sheets, shared cost allocations and clear contracts all help show which income is related to the mission and which is not, and weak records are a common reason for disputes during an examination.
In practice
Real-world examples
Example 1
A hospital foundation rents its building to an outside laboratory that serves private patients with no link to the hospital. The rent is substantial and the activity is a regular commercial one. The foundation reports the net income and pays tax on it.
Example 2
A trade association sells advertising space in its monthly magazine to companies outside its sector. The advertising income is regularly earned and not tied to member education. After deducting the direct costs of selling the space, the association pays tax on the profit.
Example 3
A college runs a cafe that serves students and staff as part of campus life. Because the cafe supports the school's educational setting and mainly serves its own community, the income is generally treated as related and is not taxed.
Think of it
Imagine a church running a weekend soup kitchen for the homeless, which is its core mission and pays no tax. If that same church opens a commercial car wash on the side to make extra cash, it has to pay tax on the car wash profits just like any other local business.
Formula
Calculation
Unrelated business taxable income = Gross unrelated income - Directly connected expenses
UBIT = Unrelated business taxable income x Applicable tax rate
A museum runs a paid parking lot that is open to the public for events unrelated to its exhibitions. Gross income from the lot is $300,000 and directly connected expenses, such as staff, insurance and maintenance, are $180,000. Unrelated business taxable income = 300,000 - 180,000 = $120,000. Assuming a tax rate of 20% for illustration, the tax = 120,000 x 20% = $24,000. This ignores the small statutory deduction that organisations are usually allowed, which would reduce the figure slightly.Case study
Seen in the real world
Greenacre Arts Trust is an illustrative, fictional charity that runs a theatre and, to raise extra money, hires out its main hall for corporate conferences. Conference hire brought in $450,000 a year, with $270,000 of direct costs, and the trustees assumed the income was sheltered by the trust's exempt status.
The trust's accountant explained that conference hire was a regular commercial activity unrelated to the performing arts mission. The taxable profit was 450,000 - 270,000 = $180,000, and at an assumed 20% rate the trust owed $36,000, which had never been budgeted.
In the illustrative sequel, the trustees moved the conference business into a taxable subsidiary that donated its profit back to the trust. That arrangement made the tax position clearer and reduced the risk of the main charity losing its exempt status as the hire business grew.
Watch out
Common mistakes
- Assuming that tax-exempt status means all income is tax free, when income from unrelated regular business is taxable.
- Forgetting that debt-financed income can be taxable even when it comes from normally excluded sources such as rent or dividends.
- Allocating shared costs without a reasonable method, which can lead the tax authority to challenge the deductions against unrelated income.
Questions
People also ask
Does UBIT mean the organisation loses its exempt status?
Not usually, but if unrelated business becomes a substantial part of its activity the exempt status itself can be put at risk.
Which income is usually left out of UBIT?
Most interest, dividends, royalties and certain rents, although exceptions apply, especially where borrowed money was used.
Why would a charity use a subsidiary for commercial work?
A taxable subsidiary pays its own tax and keeps commercial activity separate from the charity, which helps protect the charity's exempt position.