Unrelated business income (UBI) occurs when a nonprofit organization engages in a trade or business that is regularly carried out that is not substantially related to that organization’s exempt purposes.  Charities must pay taxes on this UBI in a manner similar to their for-profit counterparts.  In addition to taxes, however, the charities are not permitted to carry on too much unrelated business without endangering their tax-exemption.  The rules for determining firstly what constitutes unrelated business and secondly whether there is excessive UBI are generally acknowledged to be murky areas of the law.

Issue 1:  What is Unrelated Business?

Commerciality doctrine.  The first issue of determining whether the activity of a tax-exempt organization is considered unrelated business is controlled by what has come to be known as the “commerciality doctrine.”  Because this judge-made doctrine has taken on varying definitions and interpretations, it currently lacks uniform application and consequently requires a separate article from this one to depict its evolution in the courts.  But in short, it is described by nonprofit expert Bruce R. Hopkins this way:  “A tax-exempt organization is considered to be engaged in a nonexempt activity when that activity is engaged in a manner that is classified as commercial in nature.  An activity is a commercial one if it has a direct counterpart in, or is conducted in the same manner as is the case in, the realm of for-profit organizations.”  Once the charity’s activity is determined to be unrelated business, the second issue must be considered.

Issue 2:  How much UBI will be considered “excessive UBI” and consequently jeopardize the charity’s tax exempt status?

As mentioned above, the unrelated business income tax (UBIT) on a charity’s UBI might not be the only consequence.  Too much unrelated business can jeopardize the tax exempt status of a charity.

Case Law.  Public charities establish and keep their tax exempt status by being organized and operated exclusively for exempt purposes as specified in IRC § 501(c)(3).  Although courts sometimes substitute the word “primarily” in place of “exclusively” the latter is still the correct term of art.  According to Stevens Bros. Foundation, Inc. v. Commissioner, 324 F.2d 633, its definition is no longer open for debate. The Court of Manning Association v. Commissioner, 93 T.C. 596 explains:

“The word ‘exclusively’ has not been literally construed to mean ‘solely’ or ‘absolutely without exception,’ Church in Boston v. Commissioner, 71 T.C. 102, 107 (1978), and we have recognized that ‘a nonexempt purpose even perhaps somewhat beyond a de minimis level has been permitted without loss of exemption,’ Copyright Clearance Center v. Commissioner, 79 T.C. 793, 805 (1982).  Nevertheless, there is a limit beyond which the statute may not be stretched. That limit was set forth by the Supreme Court in Better Business Bureau v. United States, 326 U.S. 279, 283 (1945), as follows:

‘[T]he presence of a single [nonexempt] * * * purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt] * * * purposes.’”

The case of Goldsboro Art League v. Commissioner 75 T.C. 337 puts it like this:

“A substantial nonexempt purpose will disqualify an organization from tax exemption despite the number or the importance of its exempt purposes. * * * Whether an organization satisfies the operational test is a question of fact.”

Therefore, a nonexempt purpose cannot be “substantial” or it will jeopardize the tax exempt status.  This determination is based on the specific facts of each situation.

In reality, neither case law nor the IRS has given any kind of formula for determining the parameters of “insubstantial” UBI.  Rarely are the actual numbers in these cases recorded for our analysis.  In the case of New Faith, Inc. v. Commissioner, T.C. Memo 1992-601, the charity’s commercial activity accounted for approximately 80% of its gross expenditures and nearly 100% of its gross revenues; the charity’s tax exemption was lost in this case.   The case of Church in Boston v. Commissioner, 71 T.C. 102, involved a situation where 20% UBI was found to be too substantial, also resulting in the lost of tax exemption.  That Court stated:

“These facts demonstrate that petitioner’s * * * nonexempt activities * * * are more than incidental or a ‘slight and comparatively unimportant deviation from the narrow furrow of tax approved activity.’ St. Louis Union Trust Co., 374 F.2d 427 at 432-433.”

The court of Manning actually refutes the notion of any safe harbor and stresses again that each case is decided on its individual facts.  In Manning, the charitable organization was erroneously interpreting previous case law to mean that it could safely devote up to 10% of its activities to UBI:

“Petitioner calls attention to World Family Corp. v. Commissioner, 81 T.C. 958 (1983), as suggesting, in petitioner’s words, that ‘where a nonexempt function represents less than ten percent of total efforts, the doctrine of ‘exclusively’ will not be contravened.’ It then treats that suggestion as a ‘rule of law’ establishing a ‘10-percent safe harbor’ limitation, and undertakes to show that only about 10 percent of the time was expended by its officers and others on its behalf on matters relating to genealogy while some 90 percent of efforts were devoted to other matters such as negotiating the lease, etc.  * * * [C]ontrary to petitioner’s position, World Family Corp. v. Commissioner establishes no such 10-percent safe harbor rule.” [Emphasis added]

In fact, the Court in World Family Corp. v. Commissioner (81 T.C. at 967 n. 10) stated:

“We establish no general rule for future cases in finding 10 percent to be insubstantial. We noted a similar caveat in Church in Boston in which we found approximately 20 percent of expenditures to constitute more than an insubstantial activity: ‘We hasten to point out that while the facts in the instant case merit a denial of exempt status to petitioner, we do not set forth a percentage test which can be relied upon for future reference with respect to nonexempt activities of an organization. Each case must be decided upon its own unique facts and circumstances.’ Church in Boston v. Commissioner, 71 T.C. 102, 108 (1978). [Emphasis added]

Before harkening back to the test iterated in the Better Business Bureau case, supra, the Manning Court went on to say, simply:

“This case must also be decided upon its own unique facts and circumstances. It is unnecessary for us to ‘make a determination based upon some economical and moral calculus * * *. It is sufficient only to find, as we do, that ‘more than an insubstantial part of its activities is not in furtherance of an exempt purpose.’’  Christian Stewardship Assistance, Inc. v. Commissioner, 70 T.C. 1037, 1042 (1978).”

Therefore case law gives no clear guidelines and even explicitly rejects “safe harbors” for this area, though the cases show that at least 20% can be too much.  But the courts refuse to be pinned down on to a particular ratio and reserve the right to examine the facts and circumstances of each case before making a determination of excessive UBI.

Expert Opinion: 15% to 30% borders excessive UBI.  Below are the general impressions from different attorneys and nonprofit experts regarding what constitutes excessive UBI.  Most feel that 15% to 30% is as far as an exempt organization should push the limit.

Mosher & Associates is a firm out of Chicago that specializes in nonprofit legal issues.  In an article entitled “Learning to Recognize and Manage Unrelated Business Income Tax” found in their first quarterly report of their Nonprofit Update in 2007, they write:

“[T]oo much unrelated business activity can jeopardize an organization’s tax-exempt status. While no set limit exists, as a general rule, organizations generating more than 20% of their gross revenues should consider setting up a subsidiary to conduct such business activities.”

In an article on UBI from the Ann Arbor law firm Magill & Rumsey, P.C.,

“Organization leaders must also be attentive to excessive unrelated business income. A large proportion of unrelated business income could indicate that the organization is not organized and operated primarily for its tax-exempt purposes. While there appears to be no hard and fast rule, many authorities believe that a safe level of gross unrelated business income is 20 to 30% of the organization’s total income depending upon the specific organization and the nature of activities involved.”

On the other hand, Wendell Bird, a nonprofit expert out of Atlanta, wrote the following in his 1999 article “Publishing Activities of Exempt Organizations” appearing in Tax Exempt Organizations.  Although it is geared to address publishing activities, the case seems to suggest that there are circumstances where UBI that exceeds 50% is permissible.

“In more recent technical advice, the Service ruled that a religious college and school that operated a publishing division that ‘amounted to more than one-half of the organization’s total receipts,’ and was well beyond the textbook needs of the college and school, generated UBI but did not revoke the exemption.  This was so even though the pricing was ‘probably comparable to ordinary commercial prices,’ and the sales methods were ‘indistinguishable from ordinary commercial sales practices.’”

Commensurate-in-scope doctrine. Lastly this doctrine, built from a 1964 Revenue Ruling and a 1971 General Counsel Memorandum, seems to allow some organizations to maintain very high levels of UBI in relation to their total revenue if the UBI goes directly to further the charitable purposes.  This is sometimes called “destination of income” test.  This test looks to see if there is “real, bona fide, or genuine charitable purposes, as manifested by the charitable accomplishments of the organization, and not a mathematical measuring of business purpose as opposed to charitable purpose.”  Gen. Couns. Mem. 32869 (Oct. 9, 1963).   The case involved in the 1964 Rev. Rul. involved a charity that had was earning substantial amounts of rental income from its property and giving it to charitable purposes.

But this doctrine cannot be safely relied upon by charities as there are many cases that clearly state that just because an organization uses its profits for charitable purposes does not mean that the excessive UBI is excused.  According to Fishman & Schwarz’s Nonprofit Organizations, a distinction may be drawn between these seemingly contradictory cases.  The founding cases for the commensurate-in-scope doctrine all involved situations of passive income sources such as rental income.  Passive sources of income such as dividends, interest, and royalties often do not even qualify for UBIT, based upon the rational that they are not as disruptive to the for-profit market.  Ultimately, Fishman & Schwarz do not recommend placing heavy reliance upon this doctrine, as it is in great need of more clarification.

For Profit Entities to avoid Excessive UBI.  In light of the difficulty involved in drawing clear lines around excessive UBI, many charitable organizations choose to spin their commercial activities off into a for-profit organization.  Although it comes with downsides, this format can prevent the charity from jeopardizing its vital tax exempt status.