Overview

"Unrelated business income" is defined as gross income derived by an organization, less certain deductions, from an activity which satisfies all of the following criteria:

• the activity must be a trade or business;
• the trade or business must not be substantially related to the organization's exempt purpose; and
• the trade or business must be carried on regularly.

A federal tax, and in some instances state tax, is imposed on an organization's unrelated business income; this tax is referred to as the "unrelated business income tax" (i.e., UBIT).

The treasury regulations indicate that "trade or business" means any activity which is carried on for the production of income and which presents a sufficient likelihood for unfair competition with for-profit business endeavors of a comparable nature. Actual competition need not be present for taxation of unrelated business income.

As a general rule, income received by an exempt organization from regularly carrying on a trade or business is not subject to UBIT if the business activity contributes importantly to the accomplishment of the organization's exempt purposes. This is known as the "substantially related test."

Another general rule provides that UBIT is only imposed on income from a trade or business (including activities carried on through a partnership) if the business is frequent, continuous, and pursued in a manner similar to commercial businesses. This is known as the "regularly carried on test."

The three criteria outlined above are applied on a collective basis. If a taxpayer can demonstrate that any one of the three does not apply to a particular activity, no UBIT will be assessed on that activity.

UBIT is not imposed in connection with income from activities that meet the following exceptions provided by statute:

1. the volunteer work exception, in which substantially all the work is performed without compensation;
2. the donated goods exception, in which the income is from the sale of merchandise substantially all of which was donated to the organization;
3. the convenience exception, in which the trade or business is conducted by the organization primarily for the convenience of its students, faculty, patients, officers, or employees; the convenience exception can be challenged by the IRS if sales appear to be substantially beyond "the convenience" of students, faculty, patients, officers, employees;

In addition, specific additional exclusions from UBIT are provided for certain types of income. The excluded items primarily involve passive income sources and include royalties, dividends, interest, annuities, rents from real property, certain rents from personal property, securities loans, and capital gains. Passive income (except dividends) may still be subject to UBIT if received from a controlled organization, or if the income is received from debt-financed property.