How Do Businesses Determine Whether a Worker Should Be Classified as a 1099 Contractor or W-2 Employee?
Nonprofits increasingly look beyond donations, grants and program fees to diversify revenue, but a successful side business can create a federal tax obligation.
The Tax Cuts and Jobs Act of 2017 changed how organizations with multiple unrelated businesses calculate taxable income, and final IRS regulations under Section 512(a)(6) were published on December 2, 2020.
Understanding where mission-related revenue ends and taxable commercial activity begins can help organizations expand thoughtfully without creating avoidable compliance problems.
Unrelated Business Income Tax, or UBIT, applies when a tax exempt organization earns income from a trade or business that is regularly carried on and is not substantially related to its exempt purpose. All three elements generally must be present. The fact that profits are used to support the organization’s mission does not, by itself, make the activity related. UBIT exists to prevent exempt organizations from gaining a tax advantage when competing with taxable businesses. A museum operating a restaurant, for example, may have taxable income even though museum admissions remain exempt. Paying UBIT does not automatically jeopardize exempt status.
Common UBIT-producing activities include advertising, public-facing restaurants, event-space rentals, retail sales of merchandise unrelated to the mission, and certain income flowing through partnerships or alternative investments. The facts matter. A museum café serving only visitors may qualify for the convenience exception, while a street-access restaurant serving the general public may look more like a commercial business. Advertising usually differs from qualified sponsorship payments because advertising promotes or encourages purchases. Venue rentals can also change character when substantial services are provided. A useful Nonprofit vs For-Profit question is whether the activity resembles a commercial business operating regularly in the same market.
Several statutory exclusions and exceptions can keep side-activity revenue outside UBIT. The Internal Revenue Code generally excludes dividends, interest, certain royalties, qualifying rents from real property, certain research income, and gains from selling property. It also excludes businesses in which substantially all work is performed by unpaid volunteers, activities conducted primarily for the convenience of members, students, patients, officers or employees, and sales of merchandise substantially all of which was donated. Qualified sponsorship payments can also be excluded when the sponsor receives permitted acknowledgment rather than advertising. These rules matter because modest operational changes can affect a nonprofit’s tax result.
A nonprofit generally starts with gross income from each unrelated trade or business and subtracts deductions directly connected with producing that income. Deductible costs may include expenses, depreciation and other items that have a proximate and primary relationship to the activity. Reasonable allocations of shared or indirect expenses may also be deductible when properly allocated. Section 512(a)(6) generally requires organizations with multiple unrelated businesses to calculate UBTI separately for each business. A $1,000 specific deduction is generally available in computing total UBTI. If gross income from all unrelated businesses reaches $1,000 or more, the organization generally must file Form 990-T. Organizations taxable as corporations generally apply a 21% tax rate, while certain exempt trusts use trust tax rates. Estimated tax payments generally are required when expected annual tax reaches $500 or more.
Address UBIT before a new revenue stream launches whenever possible. Organizations should document how the activity supports the exempt mission, identify available exceptions, separate related and unrelated revenue and expenses, and establish reasonable cost-allocation methods. Contracts should distinguish qualified sponsorship from advertising, and venue, retail and food-service operations should be reviewed for public access, services provided and mission connection. Strong nonprofit compliance also means maintaining records that support classifications and deductions. The IRS Assessment Statute Expiration Date (ASED) can affect how long a filed return remains open to assessment, so filing and record-retention decisions should be coordinated with tax advisers.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Alana Mueller, partner of Bennett Thrasher’s nonprofit accounting practice, or call us at 770.396.2200.
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