How the IRS Decides Whether Income from Your Nonprofit is Unrelated

By Stan Hutton, Frances N. Phillips

Running a nonprofit organization requires paying special attention to IRS rules. The IRS definition of unrelated business income is based on three questions: Does the income come from a trade or business? Is it regularly carried on? Is it not substantially related to the organization’s exempt purpose?

To better understand what these questions mean, consider an extreme example. The Juniper Avenue Young People’s Club, a 501(c)(3) nonprofit with the mission of providing recreational opportunities, mentoring, and job-skills training to adolescents, decides to open a shoe-repair business. It rents a storefront space, purchases equipment, hires employees, and begins soliciting business. The shoe-repair shop does very well.

In fact, in the first year of operation, income exceeds expenses by $10,000. The club uses the money to pay some costs incurred in working with young people in the neighborhood. The problem is that the shoe-repair shop has no relationship to the club’s charitable purpose. In this case, the club is required to file Form 990-T and pay appropriate taxes on the $10,000. That’s okay, however, because the club still realizes a profit that can be applied to some of its program costs.

However, what if the club opens the shoe-repair shop with the purpose of providing training in the shoe-repair trade to adolescents in the neighborhood? In that case, chances are good that any income from the business will be considered “substantially related to the organization’s exempt purpose,” and the unrelated business income tax (known as UBIT) won’t be due on any proceeds.