How Much Unrelated Earned Income Can a Nonprofit Receive?

An example of earned income for a nonprofi is the San Francisco Museum of Modern Art gift shop.
Is the income from a museum gift shop unrelated or related business activity? The answer can be complex. Lonely Planet Images/Getty Images

Question: How much unrelated earned income can a nonprofit receive?

A reader asked:

"Several years ago, 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:

I asked Emily Chan of The Nonprofit Law Blog for her opinion. Here's what she said:

Nonprofit organizations are generally limited in the amount of unrelated business activities they can conduct.

But the Internal Revenue Service (IRS) has not been specific about how much permissible earned income can be generated by unrelated sources.

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

  1. First, unrelated business income is taxable at the corporate tax rate (i.e., subject to the unrelated business income tax (UBIT).
  2. 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 a trade or business that is regularly carried on, and not for the most part related to the exempt purpose of the organization.

A related business means that the income-generating activity supports the organization's exempt purposes, and does not just produce income.

Whether or not the activity produces income is not the most important fact. But what does matter is if that activity supports the organization’s mission.

The analysis of related vs. unrelated business activities can become quite complex. For instance, individual items sold in a museum gift shop could be classified either way.

There are also exceptions to the rule under Internal Revenue Code section 513(a) for certain activities.

These exceptions include:

  • Activities run by a volunteer workforce
  • Activities carried on for the convenience of its members, students, patients, officers, or employees
  • Selling of donated merchandise. (Passive income, such as interest, dividends, rents, and royalties is also generally excluded from unrelated business income.

Serious issues would likely exist under the unrelated business income rules for an organization with over 50% of its total gross income produced from unrelated business activity.

However, regulations are imprecise about where to draw the line below that 50% mark.

Without a fixed percentage limitation from the IRS, legal advisers often use various rules of thumb, although 20% is common.

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 how it engages in such activities without triggering any penalties.

Resources: 

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

Does My Nonprofit Need to Pay Tax? Understanding Unrelated Business Income Tax, NPQ, 12/25/2011

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) 

 

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