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One of the benefits of being a nonprofit organization is that the organization is generally exempt from income taxes. As long as the income is generated from activities that are substantially related to its purpose, whether charitable or some other exempt purpose, it will be exempt from tax.

However, no discussion of taxes is simple. Individuals and businesses have a seemingly never ending set exceptions for almost every of rule, and nonprofits suffer from the same circumstances.

Nonprofits are always looking for ways to increase income. If the nonprofit organization engages in a trade or business that is regularly carried on but is not substantially related to its exempt purpose, it will often be subject to tax on those activities as an unrelated trade or business. The Internal Revenue Services requires that a Form 990T be filed for any year in which gross receipts from unrelated sources is $1,000 or more.

What to Consider
To determine if an activity is unrelated, several terms must be understood.

A trade or business is generally an activity that generates income from the sale of goods or the performance of services. This definition holds true for both nonprofit and for profit organizations. Determining whether the activity is related or unrelated to the nonprofit’s purpose relies on several points.

A trade or business must be regularly carried on to be taxable. The activity must occur with frequency and in a continuous fashion. It must be pursued in a manner similar to commercial activities that are used by for profit organizations.

The activity must also not be substantially related to the nonprofit organizations’ exempt purpose. In this case, if the activity does not contribute importantly to the organization’s ability to accomplish its exempt purpose other than the production of income, it will be taxable.

How do you determine what contributes importantly to the accomplishment of your organization? First, look to the extent of the activity involved and to its size in relation to the nature and extent of the exempt function being served. If the activity is of a scale that is greater than is reasonably needed to perform the exempt function, then it does not contribute importantly to the accomplishment of the exempt function. There are several principles that apply.

The first applies to the sale of products of exempt functions. Is the activity the result of the performance of exempt activities? For example, many organizations sell products that have been produced through programs that provide jobs for the disabled. If the product is sold in the condition created through the efforts of the program’s participants, it will not be taxable. However, if a product is then further refined to produce additional products prior to sale, the income generated from these sales would probably be taxable.

Another factor to consider is the dual use of assets or facilities. For example, a school may use its sporting facilities in connection with educational programs during the year. This activity is not taxable. However, if the same facilities are used to provide sports programs to the general public during the summer, that activity would generally be taxable.

The third factor is the exploitation of exempt functions. There are often opportunities to exploit the goodwill or intangibles created by exempt activities in a commercial way. The fact that the income is generated in part by the performance of an exempt activity does not change the commercial nature of the activity generating the income. Unless the income can be shown to contribute importantly to the accomplishment of an exempt purpose, the income will be deemed to be unrelated.

Travel tours can fall in this category. Many organizations arrange travel tours for its members that have essentially the same agenda and programs as commercially run operations. The exempt organization receives many benefits from this arrangement, including income, goodwill and promotional opportunities, but the tour is not an activity that is related to its exempt function.

An environmental organization might offer a study or work tour on the other hand. This tour might provide instructors, educational materials and structured itinerary for the trip. An examination may be given at the end of the tour that allows the participants to obtain credit toward some type of certification. In this case, the tour will mostly likely be considered related to the exempt purpose of the organization.

Excluded Activities
There are activities that are specifically excluded from the definition of a trade or business. For example, if all of the work is performed by volunteers without compensation, then the activity will be excluded. Some of the other excluded activities include:

Activities sponsored by a 501(c)(3) for the convenience of its members.
The processing of qualified scholarships.
Sponsorship income is not taxable if the benefit received by the sponsor is insubstantial and includes only the use or acknowledgement of the business name, logo or product lines in connection with the organization’s activities. However, if the sponsor receives additional benefits, or is advertising a product, the nature of the activity has changed, and a portion of the amount received may be taxable.
Sales of donated merchandise.
The exchange or rental of mailing lists between nonprofit organizations that are eligible to receive charitable contributions.
Qualified convention or trade show activity is not taxable if one of the purposes is to promote and stimulate interest in the products and services of the particular industry or in educating the persons attending with regard to new products, services and regulations affecting the industry. To be exempt, the show must be regularly conducted as one of the substantial exempt purposes of the organization

Other Activities to Note
As noted, the law relating to unrelated business income is complex and cannot be fully covered in an overview. A partial list of other common potentially taxable items follows:

Income generated by debt financed property. The most common example of this is rental income generated through leasing space in a building owned by the organization. If there is a mortgage attached to the building, the income may be taxable. There are exceptions to this rule, and appropriate expenses can be netted against the income.

Royalties are generally not taxable if the payment relates to the use of a valuable right. If the royalty is connected to a payment for personal services, it will be taxable.

Filing Requirements
Unrelated business income is reported on the Internal Revenue Service Form 990T. The form is due on the 15th day of the 5th month after the organization’s fiscal year end. One six month extension is allowed.

If the organization has unrelated business income, the tax is due when the income is earned. Estimated payments should be made on a quarterly basis. The estimates will then be reflected on the Form 990T when it is filed.

Conclusion
No one wants to pay tax. However, the income generated from unrelated sources can provide a much needed source of funds for an exempt organization. Knowing which activities can result in tax will allow informed decisions as to whether to pursue an activity and result in proper filing with the IRS.