It is often assumed that all nonprofit organizations are completely tax exempt, but do nonprofit organizations pay taxes? While most nonprofits do have exempt status, they can still be subject to tax if they have unrelated business taxable income (UBTI). UBTI is subject to unrelated business income tax (UBIT). 

Before we can explain two scenarios in which nonprofits have to pay UBIT, let’s review the definitions of UBTI and UBIT.

 What are UBTI and UBIT?

The IRS outlines three requirements that categorize an activity as UBTI and, therefore, subject this activity to UBIT. These requirements are:

1. It is a trade or business
2. It is regularly carried on
3. It is not substantially related to furthering the exempt purpose of the organization

In other words, nonprofits have to pay UBIT if income incurred is not related to the charitable mission of the organization.  

Recently, the IRS has increased its scrutiny of nonprofits’ UBTI and subsequent UBIT. Dividends, interest, rents, annuities and other investment income generally are excluded when calculating UBIT. However, there are two exceptions where this type of income is taxable. Below we’ll detail two scenarios in which nonprofits pay tax on investment income.

1. Debt-financed property

When your nonprofit incurs debt to acquire an income-producing asset, the portion of the income or gain that’s debt-financed is generally UBTI. Such assets are usually real estate, but could also be stocks, tangible personal property or other investments purchased with borrowed funds. Income-producing property is considered debt-financed real estate if, at any time during the tax year, it had outstanding “acquisition indebtedness.”

What is acquisition indebtedness? It is the unpaid amount of debt sustained by a nonprofit on its debt-financed property.

Certain property isn’t considered debt-financed and therefore is exempt from this treatment. Examples include when:

• 85% or more of the property’s use is substantially related to your nonprofit’s exempt purpose or mission
• The property is used in a trade or business that’s excluded from the definition of “unrelated trade or business.” There are several reasons why the business could be excluded from being “unrelated.” These include:
• The property is used in research activities
• The activity has a volunteer workforce
• The activity is conducted for the convenience of members
• The activity consists of selling donated merchandise
• The activity is covered by the neighborhood land rule

What is the neighborhood land rule? If your nonprofit acquires real property intending to use it for exempt purposes within 10 years, the property won’t be treated as debt-financed property as long as it’s in the neighborhood of other property you use for exempt purposes.

2. Income from for-profit subsidiaries or controlled nonprofits

Interest, rents, annuities and other investment income aren’t excluded from UBTI if they are received from a for-profit subsidiary or controlled nonprofit. Such payments are included in the parent organization’s UBTI to the extent that they reduce the subsidiary organization’s net taxable income or UBTI.

What makes a nonprofit organization controlled? If another organization, such as a parent company, owns more than half of the nonprofit’s “beneficial interest” then that nonprofit is controlled by this other organization. Beneficial interest is defined as stock in a for-profit or voting board positions in a nonprofit.

Why does paying UBIT on investment income matter?

Failing to pay UBIT on debt-financed property or income from controlled organizations could have serious consequences, ranging from taxes, penalties and interest to the loss of your tax-exempt status. Jen Solot, a Tax Manager in our Not-For-Profit Group, can help you understand if your nonprofit needs to pay UBIT. Contact her today.

Interested in learning more about our Not-For-Profit Group? Watch our video.