Unrelated Business Income Tax Explained

In order to qualify as a tax-exempt organization under IRC Section 501(c)(3), an organization must be operated primarily for tax-exempt purposes. This parameter allows such nonprofit organizations to engage in a limited amount of business activity unrelated to the organization’s exempt purposes. Although a public charity generally does not pay taxes on income from activities related to its tax-exempt purposes, income generated by unrelated activities may result in the imposition of an unrelated business income tax (UBIT). See IRC Section 511.

When the UBIT rules were enacted, the concern was to eliminate unfair competition by placing a nonprofit’s unrelated activities on the same tax level as a for-profit business engaging in the same activities. The IRS determines whether earned income is related or unrelated using a three-part analysis.

3 Factors

The general rule is that income is treated as unrelated if the activity generating the income is:

  1. A trade or business;
  2. Regularly carried on; and
  3. Not substantially related to the organization’s exempt purpose.

            IRC Section 512(a)(1).

A trade or business. The IRS defines trade or business as “any activity which is carried on for the production of income from sale of goods or the performance of services.” IRC Section 513(c). This definition generally covers any activity that is carried on for the purpose of making a profit. The Regulations suggest that the definition also encompasses the characteristics of a business as defined by federal income tax law, IRC Section 162, relating to deductibility of business expenses.

Regularly carried on. Generally, when an exempt organization carries on a business activity with the same frequency and continuity as a for-profit, the activity is deemed “regularly carried on.” For example, a seasonal activity like a nonprofit’s sale of holiday cards may be subject to UBIT because of the regularity of the holiday season and commercial businesses engaging in the same seasonal activity. On the other hand, engaging in a brief income-producing activity that a for-profit conducts on a regular basis generally will not meet this requirement.

Not substantially related to the organizations exempt purpose. Of the three factors, the third “substantially related” factor generally requires a deeper analysis. Considering all of the facts and circumstances, an activity is related if it contributes importantly to the accomplishment of the tax-exempt purpose (other than through the production of funds and how such produced funds are used). The Regulations indicate that emphasis is placed on the size and extent of the activity in relation to the organization’s overall activities. Therefore, if an activity is conducted on a larger scale than necessary to carry out the exempt purpose, it is more likely to be treated as unrelated. For example, a museum gift shop that sells posters of the famous paintings it displays (for educational purposes) may generate unrelated business taxable income (UBTI) on its sale of souvenirs, which are not being sold to advance its educational purpose. The “fragmentation rule” allows the IRS to examine the sale of each type of item separately and determine if such sales are related or unrelated for the purposes of UBIT.

These general rules are subject to several exceptions and modifications, the most common of which are summarized below:


  • Businesses Conducted by Volunteers – Any trade or business where substantially all of the work is conducted by volunteers without compensation.
    • Example: A church, located near a ballpark, will not generate UBTI when it operates a commercial parking lot on game days when all of the work is performed by volunteers.
  • Convenience Businesses – A business activity or service that is performed for the convenience of members, students, patients, officers, or employees of the organization.
    • Example: A 501(c)(3) museum does not generate UBTI when it operates a cafeteria inside the paid admission area for the convenience of its patrons.
  • Sales of Gift Items
    Any trade or business that consists of selling donated merchandise.
    • Example: A 501(c)(3) organization will not generate UBTI when it operates a thrift store where donated clothes, books and furniture are sold.


Even if a nonprofit regularly operates a business that is unrelated to its exempt purposes, the income generated from the following activities may be reduced or eliminated by modifications specified in IRC Section 512(b):

  • Rents from real property
  • Interest, dividends, and annuities
  • Royalties from intellectual property, minerals
  • Income from the sale of capital assets

Other UBIT Rules

  • Income derived from research conducted by a tax-exempt college, university, or hospital is excluded from UBIT.
  • Certain bingo games not conducted on a commercial basis are excluded from UBIT.
  • A qualified sponsorship payment, or any payment made by a person (or sponsor) engaged in a trade or business where there is no arrangement or expectation that the person will receive any substantial return benefit for the payment, is also excluded from UBIT. See UBIT: Advertisements vs. Qualified Sponsorship Payments

Exceptions to the Exceptions

If an unrelated business activity meets the three UBIT requirements, but also fits into one of the exceptions, the income may still be subject to UBIT if one of the exceptions to the exceptions applies.

  • Interest, rents, and royalties received from a controlled corporation– While an exempt organization can generally avoid UBIT when receiving income from rents, interest, and royalties from another entity, these incomes are taxable when received from an entity that the exempt organization controls.
  • Unrelated debt-financed income– If an exempt organization borrows in order to acquire income-producing property, all or part of that income may be subject to UBIT, even if it otherwise would have been excluded under an exception.


Although the IRS has not provided a bright line percentage rule that specifies precisely how much unrelated business activity a 501(c)(3) organization may engage in without jeopardizing its exempt status, it is important to keep in mind that the organization must be operated primarily for one or more 501(c)(3) exempt purposes. This operational test will be violated if more than an insubstantial part of the organization’s activities is not in furtherance of an exempt purpose. If an organization’s non-exempt business activities run the risk of being characterized as more than insubstantial, one solution may be to form, and move such non-exempt activities into, a taxable subsidiary. Organizations contemplating carrying on significant unrelated business activities are encouraged to contact counsel to determine the most advantageous structure.

Additional Resources

IRS Publication 598 “Tax on Unrelated Business Income of Exempt Organizations” (PDF; online)

Unrelated Business Income Tax: A Primer” by Robert A. Wexler of Adler & Colvin.

Recent Developments

Regularly carried on –