A tax-exempt organization that receives income from an activity that is unrelated to the exempt purpose of the organization may have to pay Unrelated Business Income Tax or UBIT.
What is Unrelated Business Income Tax? (26 U.S.C.A. § 512(a))
Unrelated business income tax is a tax on all income earned from an unrelated business activity, minus tax deductions as a result of producing that income. An activity is unrelated business if it meets all three requirements:
- It is a trade or business. This includes any activity carried on for the production of income from selling goods or performing services. For example, an art museum exhibits modern art and operates a gift shop that sells educational books on the development of art and t-shirts featuring the museum’s logo. The museum is selling these goods for a profit and is therefore in a trade or business.
- It is regularly carried on. The activity is performed frequently and continuously, and is operated in a manner similar to comparable commercial activities of nonexempt organizations. If the museum operates the gift shop every weekend, year-round, this activity is regularly carried on. If the gift shop is only in operation for the first week that the museum is open then this activity is not regularly carried on.
- It is not substantially related to furthering the exempt purpose of the organization. The activity does not contribute importantly to accomplishing the organization’s tax-exempt purposes. The sale of educational books on the development of art contributes importantly to the museum’s exempt educational purpose by enhancing the public’s understanding of art, however, the sale of t-shirts has no relationship to art and does not contribute importantly to accomplishing the museum’s exempt educational purposes.
What Organizations are Subject to UBIT? (26 U.S.C.A. § 511(a))
The tax on unrelated business income applies to organizations that are exempt from tax under section 501(a) including charitable, religious, and scientific organizations described in 501(c) and employees' trusts forming part of pension, profit-sharing, and stock bonus plans described in 401(a). This does not include 501(c)(1) organizations. The tax also applies to individual retirement arrangements, state and municipal colleges and universities, qualified state tuition programs, medical savings accounts, and Coverdell savings accounts.
How much is the Tax and what are the Reporting Requirements? (26 U.S.C.A. § 11(b))
All organizations with unrelated business taxable income, except trusts, are subject to taxes at corporate rates on that income. For each taxable year, the tax will be computed under the following rates:
- 15 percent of the taxable income up to $50,000;
- 25 percent of the taxable income over $50,000 and up to $75,000;
- 34 percent of the taxable income over $75,000 and up to $10,000,000; and
- 35 percent of the taxable income over $10,000,000.
For example, if the museum makes $100,000 of unrelated business taxable income from its t-shirt sales, the first $50,000 would be taxed at 15%, the next $25,000 would be taxed at 25%, and the last $25,000 would fall into the third tax bracket and be taxed at 34%.
The tax for trusts is computed under the following rates:
- 15 percent of the taxable income up to $1,500;
- $225, plus 28 percent of the taxable income over $1,500 and up to $3,500;
- $784, plus 31 percent of the taxable income over $3,500 and up to $5,500;
- $1,405 plus 36 percent of the taxable income over $5,500 and up to $7,500; and
- $2,125, plus 39.6 percent of the taxable income over $7,500.
So a tax-exempt trust with $4,000 of unrelated business taxable income would pay 15% on the first $1,500, $225 plus 28% on the next $2,000, and $784 plus 31% on the last $500.
A tax-exempt organization subject to tax on unrelated business income must file Form 990-T if the organization has $1,000 or more of gross income from an unrelated business. The organization must disclose all unrelated business income on the return. The obligation to file Form 990-T is in addition to the obligation to file any other annual returns. Most tax-exempt organizations must file Form 990-T by the 5th day of the 5th month after the end of its tax year.
A tax year is an accounting period, typically 12 months, for keeping records and reporting income and expenses. There are two different tax years: the calendar year and the fiscal year. The calendar year is 12 consecutive months beginning January 1 and ending December 31. The fiscal year is 12 consecutive months ending on the last day of any month except December. If the museum is required to file Form 990-T and is operating under a fiscal tax year beginning December 1 and ending November 30, the museum must file the form by April 5 of the following year.
To file Form 990-T, mail or deliver the completed form to:
Department of the Treasury Internal Revenue Service Center
Ogden, UT 84201-0027
(Form 990-T: https://www.irs.gov/pub/irs-pdf/f990t.pdf)
In addition, a tax-exempt organization must make estimated tax payments if it expects its tax for the year to be $500 or more. These payments are generally due the 5th day of the 4th, 6th, 9th, and 12th months of the tax year and must total 100% of the organization’s total tax liability for that year.
This means that if the museum expects the total tax from its unrelated business income to exceed $500, it must make estimated tax payments on March 5, May 5, August 5, and November 5 assuming that it has the same tax year as in the example above. If the museum does not pay enough of the tax throughout the year it will be subject to a penalty, which is described further in the article.
Use Form 990-W in order to compute the amount of the estimated tax payments.
(Form 990-W: https://www.irs.gov/pub/irs-pdf/f990w.pdf)
What are the Exclusions to UBIT?
Types of Income (26 U.S.C.A. § 512(b))
Generally, unrelated business income is taxable. However, the following income sources are excluded from taxes:
- Certain rental income
- Certain income from research activities
- Gains or losses from the disposition of property
Trade or Business Activities (26 U.S.C.A. § 513)
In addition to exclusions for certain types of income, the following activities are excluded from the definition of an unrelated trade or business:
- Volunteer labor;
- Activities for convenience of members;
- Selling donated merchandise; and
What is Not Excluded from UBIT? (26 U.S.C.A. § 512(b)(13))
If a controlling organization receives specified payments of interest, annuities, royalties, or rent from another organization that it controls (“controlled organization”), those payments are not excluded from unrelated business income tax. The tax still applies whether or not the activity conducted by the controlling organization to earn the income is a trade or business or is regularly carried on. An entity is a controlled organization if the controlling organization owns:
- By vote or value more than 50 percent of a corporation’s stock (for an organization that is a corporation);
- More than 50 percent of a partnership’s profits or capital interests (for an organization that is a partnership); or
- More than 50 percent of the beneficial interest in an organization (for an organization other than a corporation or partnership).
Specified payment means any payment of interest, annuities, royalties, or rents. The payment is included in gross income to the extent that the payment reduces the net unrelated income of the controlled organization. However, if a controlling organization receives any payment of interest, annuities, royalties or rents from a controlled organization after December 31, 2005 and before January 1, 2012, pursuant to a binding written contract, than the payment may be excluded from unrelated business income.
If the same museum from previous examples owns a building close by and leases it to a subsidiary or branch of the museum that deals exclusively with photography. In this case the museum is the controlling organization and the photography center is the controlled organization assuming that the museum owns more than 50% of the photography center’s stock or profits. The rent that the museum receives from the lease is a specified payment and would not be excluded from the museum’s unrelated business income tax. However, if the term of the lease extended from January 1, 2010 to December 31, 2011, the rent payments that the museum received during that time would be excluded from its unrelated business income tax.
Organizations must report specified and qualifying specified payments on Schedule F of Form 990-T.
Who Must Publicly Disclose UBIT?
A 501(c)(3) organization must make Form 990-T available to the public. This includes through Internet postings and in-person or written requests. The form must be made available for a three-year period beginning on the due date of the return. Any schedules, attachments, or supporting documents that relate to the imposition of tax on the organizations unrelated business income must also be made available for public inspection.
What are the Consequences of not Paying the Tax or Reporting the Income?
An exempt organization may be subject to interest and penalty charges if it fails to pay a tax when the tax is due or if it files a late return. Interest is charged on taxes not paid by the due date and on penalties imposed for failure to file, negligence, fraud, substantial valuation misstatements, and substantial understatements of tax from the due date to the date of payment. If an organization fails to file its return when due it is subject to a penalty of 5% of the unpaid tax for each month the return is late, up to a maximum of 25% of the unpaid tax. The penalty for late payment of taxes is typically 5% of the unpaid tax for each month the tax is unpaid, up to a maximum of 25% of the unpaid tax.
An organization is subject to an underpayment penalty if its tax liability for the tax year is $500 or more and it did not make estimated tax payments of at least the smaller of its tax liability for the tax year or 100% of the prior year’s tax. To see if your organization owes a penalty and the amount of the penalty, you may file Form 2220 Underpayment of Estimated Tax by Corporation. The organization may not be required to file the form though because the IRS will typically notify the organization of the penalty.
(Form 2220: https://www.irs.gov/pub/irs-pdf/f2220.pdf)