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How Much Unrelated Earned Income Can a Nonprofit Receive?

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San Francisco Museum of Modern Art gift shop.
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Question: How Much Unrelated Earned Income Can a Nonprofit Receive?

A reader asked:

"Several years ago, in the context of social entrepreneurship, I read something to the following effect: 'nonprofit organizations are, by law, limited to a certain percentage of unrelated sources of earned income to total income received.' Do you know what that percentage is?”

 

Answer:

Emily Chan of The Nonprofit Law Blog provided this answer:

Nonprofit organizations are generally limited in the amount of unrelated business activities they can conduct, but the Internal Revenue Service (IRS) has not articulated an exact threshold in terms of a fixed percentage limitation on the amount of permissible earned income generated by unrelated sources.

Although no fixed percentage limitation exists, there are generally two main reasons why unrelated business income raises concern for public charities and most other exempt organizations under Internal Revenue Code section 501(c) engaged in unrelated business activities.

First, unrelated business income is taxable at the corporate tax rate (i.e., subject to the unrelated business income tax (UBIT)). Second, an exempt organization cannot engage in more than an insubstantial amount of unrelated business activity without risk of losing its tax-exempt status.

An "unrelated business" is defined by the IRS as: (1) a trade or business, (2) regularly carried on, and (3) not substantially related to furthering the exempt purpose of the organization. All three elements must be met and the third element is usually the most difficult to analyze.

"Substantially related" is a highly fact-sensitive inquiry that requires that the income-generating activity itself contribute importantly to the accomplishment of the organization's exempt purposes, other than through the production of income. In other words, regardless of whether or not the activities generated net revenues, the goods produced or services provided would contribute importantly to advancing the organization's mission. This facts and circumstances analysis can be very specific and detailed depending on the situation (e.g., each item sold in a museum gift shop may need to be categorized as either related or unrelated for determining its taxable business income).

There are also exceptions to the rule under Internal Revenue Code section 513(a) for certain activities that could otherwise be considered unrelated business activity. These exceptions include activities run by a volunteer workforce; activities carried on for the convenience of its members, students, patients, officers, or employees; or the selling of donated merchandise. Passive income (e.g., interest, dividends, rents, royalties) is also generally excluded from unrelated business income.

Thus, the unrelated business income analysis can be quite nuanced and complex depending on the given facts and circumstances of the activity and organization. It may be reasonable to assume serious issues would exist under the unrelated business income rules for an organization with over 50% of its total gross income produced from unrelated business activity, but does not leave much insight for an organization about the appropriate levels of unrelated business activity below 50%.

Without a fixed percentage limitation from the IRS, practitioners turn to illustrative Treasury Regulations and guidance from various Revenue Rulings and court opinions, meaning that rules of thumb can vary among practitioners (though 20% is common).

In addition, it may be more accurate to analyze the amount of relative resources dedicated to producing the unrelated business income rather than the percentage of income generated by unrelated business activities. Accordingly, organizations should seek appropriate counsel or expertise when engaging in business activities. If the activities do not meet the definition of an unrelated business or fall under an exception or exclusion, the organization may have much more flexibility in determining how it can optimally engage in such activities without triggering any penalties.

Resource: IRS Publication 598 -- Tax on Unrelated Business Income of Exempt Organizations

This communication was not written or intended to be used, and may not be used, by any taxpayer for the purpose of (i) avoiding any tax-related penalty under the Internal Revenue Code, or (ii) promoting, marketing or recommending a tax-related transaction described herein.

Related:

 

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  3. Nonprofit Charitable Orgs
  4. Starting a Nonprofit
  5. Managing a Nonprofit
  6. Nonprofit Finances
  7. How Much Unrelated Earned Income Can a Nonprofit Receive?

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