What Taxes Do Nonprofits Pay?

With some exceptions, all nonprofits are subject to the same federal tax rules. The details of what taxes nonprofits pay lie in Unrelated Business Taxable Income (UBTI).

So, what exactly does tax-exempt mean?

If you’re part of a nonprofit, you may ask questions like: What taxes are nonprofits exempt from? When do nonprofits pay taxes and when do they not? In this article, we have tried to provide you with the best possible answer.

Your organization has a “tax-exempt purpose.” All income generated from activities “substantially related” to that purpose are tax exempt. You’re permitted to raise a reasonable amount of funds from “unrelated activities,” but that income – UBTI – is taxable.

Before we cover UBTI, Standard federal tax exemptions cover:

• Federal income taxes
• Donations are tax-deductible for donors
• Federal unemployment tax
• Taxes on financing
• Reduced postal rates

State tax exempt benefits vary by state, but most include: state and local property taxes, state income tax, and sales tax on purchases.

So the first umbrella, income related to your exempt purpose, is relatively simple. 

Under the second umbrella, Unrelated Business Taxable Income (UBTI), there is a long set of rules used to determine what income is taxable and what is tax exempt. These rules have been buried deep within the Internal Revenue Code and other IRS publications. Until now. 

The IRS’s main source of this information is its Publication 598, which in turn is largely an explanation of section 512 of the Internal Revenue Code. We hope this article will be an even more accessible source of this information.

With no further ado, here is your comprehensive reference tool for nonprofit taxes and UBTI.

Unrelated Business Taxable Income (UBTI) 

Rules of Tax Exempt Status

[TABLE OF CONTENTS]

—General Information—

• Tax Exempt Status
• Unrelated Business Taxable Income (UBTI)

—Specific Rules on Unrelated Business Taxable Income (UBTI)—

• Membership-based Income
• Fundraising Events
• Merchandise
• Advertising and Sponsorships
• Rental Income
• Other Facilities and Property-based Income
• Miscellaneous UBTI Rules

—Considerations by Type of Tax Exempt Organization—

*(e.g., 501(c)(1), 501(c)(3), etc.)

General Information

Tax Exempt Status

• Exempt Purpose: In order for your nonprofit to become tax exempt, it must be registered with the IRS under a specified exempt purpose (or “organized for charitable purposes” – usually your mission statement).
  • Standard exempt purposes for 501(c)(3) include: educational, religional, scientific, literary, testing for public safety, fostering national or international sports competition, and preventing cruelty to animals or children.
  • Tax exempt purposes for other 501(c) designations include the organizing of groups around common goals, activities, and benefits related to recreation, professions, shared resources (e.g. financial or utilities), and more.
• 501(c)(1): These organizations, established by acts of Congress, are not subject to these rules and pay very few taxes at all.
• Employees Pay Taxes: Though an organization is tax exempt, its employees must pay most federal income tax from their paychecks, including Social Security and Medicare (though, in most cases, not federal Unemployment tax).

Key Terms:

• “Substantially Related Activities”: Or, in this article, “related activities.” All income generated by activities deemed “substantially related” to your organization’s exempt purpose benefit from the federal tax exemptions listed above.
• “Unrelated Activities”: In IRS tax exempt language, and in this article, “unrelated activities” refer to all those not “substantially related” to your tax exempt purpose.
• Unrelated Business Taxable Income: All UBTI is subject to federal taxation, according to the rules detailed below.

Unrelated Business Taxable Income

• Fundraising ≠ “Related Activity”; Just because funds raised from an activity go toward your exempt purpose, doesn’t mean the activity itself is related and tax exempt. (However, the income may be tax exempt if the activity is run entirely by unpaid volunteers.)
  • • Ex: If your organization’s exempt purpose is to prevent cruelty to animals, and you make extra income to support that cause by providing pet grooming, then that income will be taxable as UBTI.
• UBTI Activities are Ongoing: Generally, UBTI rules apply to unrelated activities that are ongoing, or on a regular recurring basis (weekly, monthly, or annual). One-time fundraisers are usually tax exempt.
• Prohibited Unrelated Activities: Some unrelated activities, such as involvement in a political campaign, are banned and will result in a loss of tax exempt status.
• Excessive UBTI: If unrelated business income is an excessive portion of a nonprofit’s total income, it could result in the loss of tax exempt status. There is no set percentage defined as “excessive,” and this is assessed on a case-by-case basis.
• Tax Filing: UBTI is reported on a separate tax form, Form 990-T. 
  • Annual tax returns on UBTI are due on May 15th (except for 401(a) organizations, which file by April 15th)
  • At certain levels, UBTI must be reported quarterly.
• Separate IRS Forms: If your organization has multiple forms of unrelated business income, each amount must be calculated separately on your Form 990-T. The sum is your organization’s total UBTI.
• Deductions: For the most part, deductions are allowable for UBTI reported on Form 990-T, as they would be allowed for income of a for-profit business.
  • UBTI losses are not deductions: However, if one source of unrelated business income yields a loss, that loss is not subtracted from the total UBTI from all unrelated income sources.
• Purpose of UBTI: The UBTI rule was established by the US Congress in 1950 (and modified several times since) to eliminate abuse of nonprofit tax advantages.

Specific UBTI Rules

Membership-Based Income

• Membership Dues – Several types of 501(c) organizations are membership-based, with those members paying dues. If those members are actively involved in the organization’s exempt purpose, then the organization pays no taxes on the income derived from dues. However, if those members are not active participants but receive insurance and benefits (usually for 501(c)(5) and 501(c)(6) organizations), then the income is likely considered UBTI and is taxable.
• The convenience of Members – Tax Exempt – According to the IRS, “A trade or business conducted by a 501(c)(3) organization or by a state college or university primarily for the convenience of its members, students, patients, officers, or employees isn’t an unrelated trade or business.” So income from such activities is not taxable.

• • • Ex: A laundry room in a college dormitory provides convenience to its students, so any income from use of the machines is tax exempt.
• Exchange of Member Lists – Tax Exempt – Profit from the sharing of member lists, for the purpose of soliciting donations, is not considered UBTI and is therefore tax exempt.
• 501(c)(12) – Tax exempt – Income from memberships to 501(c)(12) co-op utility providers is not considered UBTI and is tax exempt.
• Services to General Public – Taxable – If your organization’s exempt purpose is to serve its members in some way and you make the same services available to the general public for a profit, then those profits are generally taxable as UBTI.

Fundraising Events

• Volunteer-Run Fundraisers – Tax Exempt – See above, “Fundraising ≠ Related Activity”. An exception to this rule exists when a fundraising event is run entirely by volunteers. Income from such events is likely tax exempt. Unrelated fundraisers are subject to taxation if they are run in part by paid employees.
• Trade Shows – Tax exempt situation – Most income from trade shows (e.g. attendance fees) is tax exempt for 501(c)(3), 501(c)(4), 501(c)(5), and 501(c)(6) organizations, if trade shows are a regular activity of your organization (typically at least annual) and the event is substantially related to the organization’s exempt purpose.
  • Display Space– Taxable – However, income from exhibitors’ rental of display space is considered taxable UBTI.
  • Live Streaming of Trade Shows – These rules are extended to any live information disseminated or streamed online as part of a trade show event, as long as it takes place on its own segmented section of your organization’s website.
• Fairs and Exhibitions – Rules applying to fairs and exhibitions are similar to those for trade shows.
  • Public Entertainment Activity – Tax Exempt – Games and entertainment activities at fairs and exhibitions are not considered unrelated business, because they are designed to attract more people to the event, so income they generate is not considered UBTI and is likely tax exempt.
• Bingo Games – Tax exempt – This one is interesting. Income raised through bingo games is generally considered tax exempt, regardless of your organization’s exempt purpose, as long as they aren’t illegal under a state’s gambling laws or take place in a jurisdiction where bingo is regularly conducted by for-profit organizations.

Merchandise and Sales of Items

• • Merchandise – Taxable – Income derived from the sale of small items is considered UBTI (taxable) unless:
    • Production is related to exempt purpose – Tax Exempt – The sale of any product that is produced through your organization’s exempt purpose is tax exempt as long as it is not altered after the fact (see example 2 below).
      • Ex 1: If knitting hats is part of a rehabilitation program, any income from sales of those hats is tax exempt; but if there are sales of additional hats made by the general public (not by individuals in the rehab program), then that income is likely considered UBTI  and is taxable.
      • Ex 2: If a tax-exempt organization does research on dairy cows, then sale of the milk produced through the regular course of operation is tax exempt. But if that milk is made into butter or ice cream, and that activity does nothing to further the organization’s mission, then those sales are likely taxable as UBTI.
    • Donated Merchandise – Tax Exempt – Income from the sale of donated items, such as clothes at a thrift store, is typically tax exempt and not considered UBTI.
    • Gift Shops – Consider an art museum gift shop, or similar vendor

 

• Taxable if – All related items (e.g. post card with museum art on it) are tax exempt)

 

• • • Tax Exempt if – All unrelated items (e.g., snacks and drinks)
  • “Minimum Suggested Donation” items
    • Taxable if – Income from any item given in exchange for a donation that costs the organization (not the customer) more than a certain amount to obtain (based on $5 in 1987; the amount was $11.10 in 2019) is taxable. 
    • Tax Exempt if – Revenue from items that cost less than this amount are tax exempt, so long as they are allocated toward the organization’s stated purpose.
  • Food Courts and Concessions Stands – Tax Exempt – Generally, the provision of food, especially in large facilities like theatres, hospitals, and museums, is considered related to an exempt purpose (and tax exempt) if it helps patrons and employees stay on site for a longer time and therefore furthers the organization’s impact.

Advertising and Sponsorships

• Advertising  –Taxable – In most cases, income related to advertising is considered unrelated to an organization’s exempt purpose and taxable as UBTI, unless the advertisement advances the organization’s mission.
  • • Ex: If your organization’s exempt purpose surrounds legal advocacy and you publish a quarterly pamphlet, then income from advertisements in the pamphlet is not tax exempt solely because the pamphlet furthers your mission. If the advertisement itself furthers your mission, such as promotion of an educational event on legal professions, then income from that one advertisement is likely considered related and therefore tax exempt.
  • Sponsorships – Tax exempt – An exception to this rule exists for sponsorships, when the only publicity given is the sponsor’s name and/or logo (without information about products or services).
    • At Trade Shows – Taxable – If a sponsorship takes place at a trade show (see below), it is considered an advertisement, and income it creates is taxable as UBTI.
    • In Periodicals – Taxable – If a sponsorship is placed in a periodical (regular publication, e.g. monthly or quarterly), it is considered an advertisement and income it creates is taxable as UBTI.
    • Segmenting Ads and Sponsorships – A supporter may place a taxable sponsorship and a tax exempt advertisement, as defined above, in two separate instances with your organization as long as the two amounts are paid separately, in reasonable proportion to their respective value.
  • Endorsements: – Taxable. – Endorsements are distinguished from sponsorships, considered advertisements, and are generally taxable as UBTI. If your organization enjoys a high reputation, and uses that reputation to sell endorsements (even if to companies related to your cause), then income derived from them is likely taxable as UBTI.

Rental Income

If income is derived from rent on real property, then taxation depends on the renter’s relatability to your organization’s tax exempt purpose. Some considerations are:

• Above Threshold – Tax exempt – If 85% or more of the property is used directly for exempt purposes, then all the income generated from the property is excluded from the UBTI rule and is tax exempt.
• Below Threshold – Taxable – If less than 85% of the property is used for the exempt purpose, then income relative to the portion used for unrelated purposes is taxable (e.g., if 20% of the property is used for unrelated business, 20% of the property’s income is taxable).
• Rental Business as an Exception to Other Rules – Tax Exempt – A related activity can be deemed unrelated if it is made available to the general public (not only members or usual beneficiaries). However if that same activity, available to the public, is performed by another party who rents or leases your facility, the income may remain tax exempt because it is considered related rental income.

• • • Ex: A college operates tennis courts for its student teams, an activity related to its exempt purpose. During the summer, the college’s employees run a tennis camp, open to the general public, for a fee. Income from this camp is likely taxable as UBTI because it doesn’t serve the college’s students. However, if the same camp, open to the public, is run by another party who rents the facility, it is tax exempt because teaching tennis is a related activity and rental income doesn’t have to come from serving members or students.
• Income from Financed Property – Taxable – If the ownership of the property is debt-financed (such as through a mortgage) and its use isn’t directly related to the exempt purpose, any income is taxable as UBTI (see below).
• Renting Personal Property – Taxable – Income from the rent of personal property (assets), as opposed to real property (facilities) is taxable as UBTI, unless it furthers your organization’s exempt purpose.
  • Above High Threshold – Taxable – If more than 50% of a single rent payment is for personal property, as opposed to real property, then the entire amount is taxable as UBTI unless it furthers your organization’s exempt purpose.
  • Below Low Threshold – Tax exempt – If less than 10% of a rent payment is attributable to personal property, then the entire amount is treated as real property, not considered UBTI, and is tax exempt.
  • Between Thresholds – If more than 10% but less than 50% of a rent payment is attributable to personal property, then the percentage that is considered to be for personal property is taxable as UBTI and the rest is tax exempt.
• Service provided – Taxable – If substantial personal service is provided to lessees (sufficient to consider that their payments are not only for rent) then the income is generally taxable as UBTI.
  • • Ex: Taxable – In the above tennis camp example, income is tax exempt when facilities are rented to an outside group to run the camp. However, if you provide services, such as paying employees to assist in the camp, then income is considered more than merely rental, and therefore doesn’t enjoy this exception to UBTI (i.e., income is taxable).
    • Ex: Tax exempt – Your organization is a rehabilitative boarding home, and residents with the financial means pay rent to stay in your facilities. Services you provide, such as food and rehabilitative programming, are directly related to your exempt purpose, and therefore this rental income is tax exempt.
• Exceptions for Certain Exempt Statuses – Tax Exempt – See below, special rules for 501(c)(7), 501(c)(9), or 501(c)(17).

 

Other Facilities and Property-Based Income

• Unrelated Use of Assets or Facilities – Taxable – Income from use of facilities is likely taxable as UBTI if it does not relate to your organization’s exempt purpose.
  • • Ex: Taxable – If you operate a nonprofit theater and acting company, then proceeds from all plays is likely tax exempt. If you show a movie in your theater once a week and sell tickets to the general public, then income from those tickets is likely considered unrelated to your purpose and taxable as UBTI.
      • Tax Exempt Exceptions – However, income might remain tax exempt if the event is: run entirely by volunteers (see above “Employee- vs. Volunteer Run”) or available only to members of the theater.
• Sale of Property – Tax Exempt – Income from the “disposition” (or sale) of property is generally excluded from UBTI and is tax exempt.
  • Property acquired to be sold – Taxable – The above rule does not apply if property is bought and held with the primary intent of being sold for a profit. Such activity is usually considered an unrelated business, and its income is taxable as UBTI.
  • Debt Financed Property – Taxable – Income from the sale of property is taxable if it was owned under a mortgage or other debt (see below).

Income from Financed Property or Assets

 

• Debt Financed Income – Taxable – Any income from a source that is controlled under debt – such as property with a mortgage, assets bought on a payment plan, etc. – is considered UBTI and is taxable. 
  • Taxes Relative to Unpaid Portion – This pertains to the extent that the debt is paid off. For example, if half of a mortgage is paid on a property, then half of the rental income from the property is taxable as UBTI and the other half is tax exempt.
  • Include Financed Renovations – This includes property for which a loan was taken out to do renovations.
  • Exceptions to this rule include:
    • Exception for Property Acquired as a Gift – Tax Exempt – If the property was received as a gift or part of a will, it is taxed (or not) as if wholly owned. This rule applies for 10 years from the date the property was gifted, as long as: 1) the mortgage had been in place for at least 5 years prior to gifting, and 2) the previous owner owned the property for at least 5 years.
    • Exception for 501(c)(12) organizations – Tax Exempt – These organizations may treat debt financed property, for tax purposes, as if it is wholly owned.
    • Property Substantially Related to Exempt Purpose – Tax Exempt – If 85% or more of any property’s activity is substantially related to an organization’s exempt purpose, then its income is tax exempt.
    • Additional Exceptions – Tax exempt – Income from debt financed property may be tax exempt if it is run entirely by volunteers, it exists for the convenience and benefit of its members (see “Membership-Based Income” above), or it exists for the sale of donated merchandise (such as a GoodWill store).

Miscellaneous UBTI Rules

• Gaining Tax Exempt Status – Taxable – If a taxable corporation obtains tax exempt status, all of its assets are taxed one time as if they are being sold. This rule doesn’t apply if tax exempt status is obtained within three years of the organization’s formation, or within three years of previously losing tax exempt status.
  • If a portion of assets is going to be used for an unrelated trade or business, that portion is not subject to this one-time tax, but it continues to be taxed ongoing according to the rules of UBTI.

• Travel and Tour Programs: If your nonprofit organization generates income by providing travel, tours, or similar services to its members, that income is taxable, unless the services directly further the mission of the organization (e.g., they are designed as educational programming).
• Investment Income – Tax Exempt – Income from dividends, interest, annuities, payments on security loans, and other income from your organization’s “ordinary and routine investments” is not considered UBTI and therefore is tax exempt.
  • Debt Financed – Taxable – Any investment income that is financed by a loan or other debt is considered taxable as UBTI.
• Research – Tax Exempt – Income from conducting research, if done by a college, university, or hospital, or done for the United States government, is generally not considered UBTI and is tax exempt.
• Royalties – Tax exempt – Income from royalties is generally not considered UBTI and therefore is tax exempt.
• Special rules for 501(c)(7), 501(c)(9), and 501(c)(17) – These organizations are respectively described as Social Clubs, Voluntary Employees’ Beneficiary Associations (VEBAs), and Supplemental Unemployment Compensation Benefit Trusts (SUBs). Generally, their tax situation is derived from section 512(a)(6) or the Internal Revenue Code.
  • Non-exemptions: In general, all income that is not related to these organizations’ exempt purpose is taxable as UBTI, without considering any of the above exceptions to UBTI rules. This means the rental income, investment income, and many other forms of income that would be tax exempt for other organizations are not tax exempt for 501(c)(7), (9), and (17) organizations unless the income is derived from activities substantially related to the exempt purpose.