Unrelated Business Income Tax – Two Common Examples
One of the most confusing compliance issues for churches is Unrelated Business Income Tax (commonly referred to as UBIT). The confusion comes in two main forms. The first is what constitutes Unrelated Business Income. The second is how much Unrelated Business Income is too much, causing your tax-exempt status to be in jeopardy. (SPOILER ALERT: no one knows exactly how much is too much. Frustrating, right?)
Here are two examples that always come my way at the CSBC office.
The Church Coffee Shop (or any other sales)
Ah yes, the church coffee shop and all of the wonderful Christianese names (I’m looking at you, Higher Grounds, HeBrews, or The Well). Many churches have a coffee shop (or bookstore, fireworks stand, etc.) and may not realize that the income derived from this could be not only taxable but could jeopardize the church’s tax-exempt status. Per the IRS Publication 1828, the income will be taxable if these three conditions are met:
- The activity constitutes a trade or business,
- The trade or business is regularly carried on, and
- The trade or business is not substantially related to the organization’s exempt purpose. (The fact that the organization uses the income to further its charitable or religious purposes does not make the activity substantially related to its exempt purposes.)
However, the IRS follows up with some exceptions:
Even if an activity meets the above criteria, the income may not be subject to tax if it meets one of the following exceptions: (a) substantially all the work in operating the trade or business is performed by volunteers, (b) the activity is conducted by the organization primarily for the convenience of its members or (c) the trade or business involves the selling of merchandise substantially all of which was donated.
These IRS guidelines have been heavily debated, contested, and litigated with little clarity given to churches. Is your coffee shop exempt? Maybe. I know it’s not the answer you are looking for, but the ambiguity is the point I’m trying to make. The best defense you probably have to claim an exception to the tax is only to have volunteers working at your coffee shop.
Ok, so maybe you don’t have a coffee shop, but are you renting out a portion of your church property? Be it a school, another church, or some outside business, rental income is typically considered nontaxable if you have no debt on the property. One exception is if a church has a loan on the property they are renting, you may still be able to exclude the rental income if it is land that you’ve financed and intend to use for exempt purposes within 15 years of acquisition.
Will You Lose Tax Exempt Status?
So, your coffee shop is all volunteers, or you have no debt on your church property… guess what? You still have to worry about losing your tax-exempt status. Probably the most confusing and frustrating consideration in UBIT is:
…Regardless of whether or not your income is taxable, you still cannot have too much of your income coming from unrelated business, or you risk losing your exempt status.
How much is too much? Great question. I don’t know. The IRS doesn’t know either. The IRS and the courts go on a case-by-case basis. IRS guidance says your nonprofit can engage in unrelated business activities as long as they are not a substantial part of your organization’s activities. A common conservative threshold (though it has not been “approved” by the IRS) is to not have more than 15% of your church’s total earnings come from unrelated activities. This does not guarantee that the IRS will determine you do not have too much unrelated income. Rather, it is an estimated threshold, a suggestion.
A Final Thought
While I hope to have provided some clarity on this issue, I realize that it still is murky waters. Unfortunately, unless the IRS or the courts give more specifics on how UBIT is determined, we will continue to be in murky waters. What I highly recommend you consider -if you have any concerns about UBIT and your church- is to reach out to a CPA or a lawyer who specializes in nonprofits and taxation. Yes, it’ll cost you some money. But it could ultimately save your ministry.