What is UBIT, and when does a nonprofit owe it?

Case law and IRS pronouncements have provided a three-pronged test


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Section 513(e) of the Internal Revenue Code imposes a tax at normal corporate rates on unrelated business taxable income of most tax-exempt organizations. In general, that is the net income earned by a nonprofit organization from activities that are unrelated to the entity’s tax-exempt purpose. The tax imposed is often referred to as UBIT (unrelated business income tax).

It is sometimes questionable whether this tax is really owed as there is no bright line rule for determining its applicability. Case law and IRS pronouncements have provided a three-pronged test.

Income or loss of an exempt organization is subject to UBIT if

 • The activity constitutes a trade or business

 • Such trade or business is regularly carried on by the organization

 • The activity is not substantially related to the taxpayer’s tax-exempt purpose

If an activity fails to satisfy any one of the above criteria, it is not subject to UBIT.

The first two prongs of the UBIT test are fairly straightforward and are usually conceded by taxpayers that regularly engaged in a business activity under scrutiny by the IRS.

The term “trade or business” generally includes any activity carried on for the production of income from the sale of goods or the performance of services. However, one should note that an activity will not be considered an unrelated trade or business unless the organization’s primary motive for engaging in the activity is to earn a profit.

One example that clarifies this distinction is that of a museum cafeteria. Museums often run an eating facility on the premises, and such facilities can be profitable. However, because the purpose of the eating facility is to help attract visitors and allow them to spend more time viewing the museum’s exhibits, the museum’s operation of an eating facility is not primarily profit-driven.

 

Not substantially related

 

The aspect of the UBIT test that generates the most controversy is the third prong.

Gross income is considered generated by an unrelated trade or business and subject to UBIT only if the trade or business that produces the income is not substantially related to the purposes for which the exemption is granted. The issue is essentially one of fact, and the result depends on the particular circumstances of each case.

Generally, a useful starting point for determining whether an activity is substantially related to the exempt purpose is the organization’s statement of purpose. If it is unclear whether the statement of purpose includes the activity at issue, then one should consider whether the activity “contributes importantly” to the exempt purpose.

Both Treasury regulations and case law state that an activity is substantially related to an exempt purpose, if it “contributes importantly” to the accomplishment of such purpose. In determining whether activities contribute importantly, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function they purport to serve.

An example of this factor occurred in St. Luke’s Hospital of Kansas City v. U.S. In that case, the court held that certain pathology tests, the specimens for which were obtained from outside physicians, were substantially related to the hospital’s tax-exempt status because the tests contributed to the hospital’s teaching function. Although the test program produced a high volume of specimen, the large number was necessary in order to have sufficient positive tests for teaching purposes.

The courts have enumerated several additional factors to consider, including:

 • Whether the fees charged by the organization are directly proportional to the benefits received

 • Whether the service provided is commonly provided by for-profit entities

 • Whether the activity is unique to the organization’s tax-exempt purpose

 • Whether the manner in which the trade or business is conducted suggests a profit-driven motive

 • Whether the activity benefits the members as a group rather than as individuals

Overall, one should ask honestly from a common-sense standpoint – does this activity serve a private interest, or does the activity benefit a class of people within the ambit of the organization’s charitable, religious, educational, scientific or literary purpose? If the answer is the latter, the organization should consider seeking a private letter ruling from the IRS that the tax is not owed.

Nicole B. Jacobson is of counsel and works in the Manchester office of Primmer Piper Eggleston & Cramer. She can be reached at 603-626-3337 or njacobson@primmer.com.


 

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