UBIT for Associations in a Nutshell

4 min

Although trade and professional associations are granted a general exemption from federal income tax by the Internal Revenue Code (the "Code") - for income from activities that are substantially related to the purposes for which the association was granted tax-exempt status - they nevertheless are potentially taxable for income derived from unrelated business activities. The Code defines an unrelated trade or business as "any trade or business the conduct of which is not substantially related (aside from the need of such organization for income . . .) to the exercise or performance by such organization of its . . . purpose or function constituting the basis for its exemption . . ."

The tax on unrelated business income first appeared in the Code in 1950. Congress' principal purpose in enacting the unrelated business income tax ("UBIT") was to provide a level competitive playing field for tax-paying business - so that tax-exempt organizations could not use their privileged tax status to unfairly compete with tax-paying businesses in activities unrelated to their purposes. But instead of prohibiting tax-exempt organizations from engaging in any business activities at all (and denying or revoking tax exemption because of such activities), it chose to specifically permit a certain degree of business activity by tax-exempt organizations, but to tax it like any other for-profit business. Thus, such business activities are permissible, so long as the activities are not a "substantial part of its activities." The tax applies to virtually all tax-exempt organizations, including associations and their related foundations.

The imposition of the unrelated business income tax is generally at the federal corporate income tax rates. Deductions are permitted for expenses that are "directly connected" with the carrying on of the unrelated trade or business. If an organization regularly carries on two or more unrelated business activities, its unrelated business taxable income ("UBTI") is the total of gross income from all such activities less the total allowable deductions attributable to such activities.

Three-prong UBIT test. It is important to note that not all business income is subject to taxation or to limitations: only "unrelated business income" as defined in the Code. Unrelated business income will only exist if three conditions are satisfied; if any one of the three is not present, then income from the activity will not be taxable. The income must be:

(1) from a trade or business;
(2) that is regularly carried on; and
(3) that is not substantially related to the purposes for which the organization was granted tax exemption.

Exclusions. Even if all three conditions of the UBIT test are satisfied, there are numerous statutory exclusions (i) from the definition of an unrelated trade or business, and (ii) in the computation of UBTI, which can exempt otherwise taxable income from UBIT. Many such exclusions are potentially applicable to trade associations, while many are not. The most relevant exclusions include:

  • Volunteer labor exception
  • Qualified corporate sponsorship payments
  • Qualified convention or trade show income
  • Dividends, interest and annuities
  • Royalties
  • Rents from real property (non-debt-financed)
  • Certain capital gains

Taxable subsidiaries. If the gross revenue, net income, and/or staff time devoted to unrelated business activities become "substantial" in relation to the tax-exempt functions of an association (thereby jeopardizing its tax-exempt status), the association can "spin off" one or more of the unrelated activities into a separate but affiliated entity, commonly referred to as a "taxable subsidiary." Such a taxable subsidiary will pay corporate income tax on its net income, but can remit the after-tax profits to the parent association as tax-free dividends.

Filing and payment requirements. In computing UBTI, a specific deduction of $1,000 is permitted. If an association has gross UBTI of $1,000 or more during its fiscal year, it must file a completed IRS Form 990-T to report such income and pay any tax due. The Form 990-T is due at the same time as the Form 990, however, if an association expects its annual UBIT (after certain adjustments) to be $500 or more, then it must make estimated tax payments throughout the year. The Form 990-T is not subject to public disclosure like the Form 990.