Two Lawline CLE Programs for Attorneys Helping California Nonprofits

We are presenting two Continuing Legal Education (CLE) programs for Lawline on Friday, January 13, 2016 that we hope California attorneys will find helpful in their representation of nonprofits:

 Forming a California Nonprofit (Erin)

This program will discuss the process of forming a California nonprofit entity, going through the legal considerations involved in each step in detail. We will start with a discussion of some of the appropriate things to consider before beginning the formation process and then turn to the mechanics of formation, including drafting Articles of Incorporation, Bylaws, and a Conflict of Interest Policy. We will also cover other legal considerations that apply to California nonprofits, including registration requirements at the state level.

Most nonprofits are required to separately seek recognition of tax-exemption at the state and federal levels, so we will take a close look at the requirements for exemption and the application process, focusing primarily on 501(c)(3) organizations. Finally, we’ll briefly touch on some alternatives to forming a California nonprofit that may be attractive in certain circumstances.

Throughout the session, Erin Bradrick, Senior Counsel at NEO Law Group, will illustrate concepts through examples and will provide information on how to access additional resources.

Earned Income Issues and Guidance for California Nonprofits (Gene)

Many people are surprised to learn that over 70% of the revenues from reporting public charities comes from the sale of goods and services. And charities are increasingly engaging in earned income (and social enterprise) ventures as they face the simultaneous challenges of uncertainty in public fundraising and the tax benefits associated with charitable giving, undependable philanthropic funding, and increased competition for limited resources. But earned income is an area wrought with misconceptions and misunderstandings.

The rules governing unrelated business taxable income (UBTI) are complex. As a result, many non-profits simply fail to properly report and pay taxes on their UBTI or preclude themselves from starting an earned income venture. As the differences in the activities of non-profit and for-profit organizations continue to blur with the increasing commercialization of charities and the growth of socially-purposed taxable entities (like the benefit corporation), the associated tax issues will only get more complicated. Subsidiaries, joint ventures, and commercial co-ventures may be useful options for some non-profits if entered into with sufficient knowledge and consideration.

This audio-only course, taught by Gene Takagi, the managing attorney of NEO Law Group, a firm specializing in non-profit law, reviews the legal issues that should be considered when reviewing a non-profit’s earned income venture and offers practical guidance on best practices for both in-house and outside counsel.

Best of the Nonprofit Law Blog 2014

Best of 2014 - The year in reviewHere are some selected highlights from NEO Law Group over the past year that we hope you’ll find helpful. 2014 was also highlighted by an addition to Erin’s family and Michele’s graduation and passage of the bar exam! Amazing year for all of us.

Blog Posts


What Issues Should a Nonprofit Board Consider Annually?

Executive Succession: 10 Tips for Boards

Executive Committees: Why You Should Limit Their Authority


Nonprofit Advocacy is More Than Lobbying

Charities and Issue Advocacy: Doing it Right – Part One

5 Things Nonprofits Should Know About Ballot Measure Advocacy in California

Fiscal Sponsorship

Fiscal Sponsor Due Diligence

Fiscal Sponsorship: A Valuable Option for Grantmakers and Grantees

Arts Projects: Charitable or Not?

Proposed Laws

12 Things Nonprofits Should Know About Proposed Tax Reform

California Bill to Strengthen Enforcement of Charity Registration and Reporting

Proposed Rules Affecting California Charities – Comment Period Ends Today!

UBIT / Social Enterprises

UBIT: Advertisements vs. Qualified Sponsorship Payments

Nonprofit Limited Liability Company

Nonprofit Crowdfunding Risks


Nonprofit Laws for Human Resources Managers to Be Aware Of

Retroactive Reinstatement Procedures: Simplified

Dissolution and Transfer of Remaining Assets: An Alternative to Merger


Fair or Foul: A Review of Federal Tax Laws Governing Unfair Competition, The Nonprofit Quarterly (2014)

12 Reasons Why You Should Gracefully Resign from a Nonprofit Board, The Nonprofit Quarterly (2014)

10 Issues To Address In Your Nonprofit’s Social Media Policy, The Nonprofit Times (2014)


Tips on Starting a Nonprofit: Initial Board of Directors

Tips on Starting a Nonprofit: Fundraising Before Exemption

Tips on Starting a Nonprofit: Initial Bylaws

Nonprofit Radio

Advocacy, Net Neutrality, & The Bright Lines Project

Your Board’s Role in Executive Hiring


Speaking Engagements


Profit for Good: How Social Enterprise Policy Affects You, Independent Sector Public Policy Action Institute

Hot Topics in Nonprofit Law, CalNonprofits Policy Convention

Small Charities – Problems and Solutions, American Bar Association, Tax Section Mid-Year Meeting


Earned Income 101 for Nonprofits, Lawline

Understanding UBIT: What Does It Mean for Your Shared Space? Nonprofit Centers Network

Navigating Legal and Ethical Issues, New Grantmakers Institute, Northern California Grantmakers

UBIT – Issues for Shared Spaces



I will be speaking this week for The Nonprofit Centers Network on unrelated business income tax (“UBIT”) related issues faced by nonprofits providing shared space with other individuals or entities (you can register for the webinar here).  As we’ve discussed in previous posts on UBIT, generally, net income from unrelated business activities will be subject to UBIT if the activity constitutes (1) a trade or business, (2) that is regularly carried on, and (3) is not substantially related to the furtherance of the organization’s exempt purpose.

Most nonprofits that share space with other entities presumably rent that space out for a return payment.  Because renting space for a prolonged period would be considered a trade or business and is likely regularly carried on, whether the income from such rentals constitutes unrelated business income potentially subject to UBIT will turn on whether providing the rentals is substantially related to furthering the organization’s exempt purpose.  If a nonprofit is formed with the purpose of strengthening the nonprofit sector by fostering collaboration, inspiring and nurturing nonprofits, reducing duplication, and increasing nonprofit efficiency, and rents space solely to other nonprofits exempt under Section 501(c)(3) of the Internal Revenue Code, then such rentals are likely to be considered substantially related.  However, this remains somewhat of an unsettled area and whether the activities are substantially related may turn on how commercial in nature they are.  If the same nonprofit were to begin renting some of its space to for-profits, the income from such rentals would likely be subject to UBIT and may even cause the organization’s activities to be viewed as too commercial in nature to qualify as exempt.  Similarly, if an exempt organization with a completely unrelated purpose had extra space in its building and decided to rent it to other nonprofits or to for-profits, those rentals would unlikely be considered substantially related and the rental income may be subject to UBIT.

As we’ve previously discussed on this blog, though, there are exceptions, exclusions, and modifications that apply to the UBIT rules.  One such exclusion is that income that is earned passively, including from some rentals of real property or personal property rented with real property, is not subject to UBIT.  However, the rents exclusion does not apply (and thus the rental income may be subject to UBIT) if any of the following is true:

  1. The nonprofit renting the property out also provides services not typically provided with such a rental as part of the rental (e.g., administrative or technology support services);
  2. The value of the personal property rented out with the real property equals more than 50% of the total rent amount; or
  3. The amount of rent is determined based on the income or profits derived by the renter from the leased property, other than an amount based on a fixed percentage of receipts or sales.

Also, if property is acquired by a nonprofit as an investment to produce income and the nonprofit has debt on the property, then only a portion (based on the debt/basis percentage) of the rental income may be excluded from UBIT.

A nonprofit that shares space may potentially have multiple lines of unrelated business activities (such as if it runs a coffee cart or café for the benefit of its tenants or provides administrative support services for a separate fee) and each line of business will need to be analyzed separately for potential UBIT. There may also be other exclusions (such as if substantially all of the work related to the unrelated business is carried on by uncompensated volunteers or is for the convenience of the nonprofit’s members) or modifications (such as the reasonable allocation of expenses attributable to both related business activities and unrelated business activities) that may also impact the amount of UBIT that a nonprofit owes on any unrelated business income.

Any nonprofit that receives income from sharing space with other individuals or entities and is not absolutely certain that such rentals are substantially related to furthering its exempt purpose, or that engages in any other unrelated business activities, would be well-advised to consult with a nonprofit attorney or accountant to determine whether it has any income subject to UBIT.

UBIT: Advertisements vs. Qualified Sponsorship Payments

Retro TV Commercial


Generally, net income from unrelated business activities will be subject to the unrelated business income tax (”UBIT”) if the activity constitutes (1) a trade or business, (2) that is regularly carried on, and (3) is not substantially related to the furtherance of the organization’s exempt purpose.  The IRS considers soliciting, selling, and publishing commercial advertising to constitute a trade or business that, if regularly carried on and not substantially related to the organization’s exempt purpose, may produce income subject to UBIT.  In contrast to advertising, however, qualified sponsorship payments (“QSPs”) are specifically excluded from the definition of unrelated trade or business.  Accordingly, income generated from QSPs is not subject to UBIT.  So what’s the difference between advertising and QSPs and how can your organization plan accordingly?


Advertising includes endorsements; inducements to use, sell, or purchase certain products or services; and messages that contain qualitative or comparative language, indications of value, or price information.  For example, if a nonprofit issues a monthly newsletter in which it sells space to companies to use to describe and encourage readers to purchase their goods or services, this will constitute advertising and such sales will likely generate unrelated business income potentially subject to UBIT.  Moreover, the fact that commercial advertising is included in a publication, such as a journal, that otherwise contains material related to the publishing organization’s exempt purpose will not lead to the advertising itself being considered related and income generated from such advertising will likely be considered unrelated business income.  However, keep in mind that advertisements that are contained in a publication related to a one-time event, such as a program at a fundraising gala, are not likely to be considered regularly carried on.  Therefore, the income generated from such advertising activities will not be subject to UBIT.

Qualified Sponsorship Payments

In contrast to advertising, a qualified sponsorship payment is any payment made to a nonprofit by an individual or company without an arrangement or expectation that the payer will receive a benefit in return.  The nonprofit may provide minor benefits in connection with a QSP without turning the QSP into advertising.  These minor benefits may include acknowledgement of the sponsorship through use of the donor’s name or logo, or goods or services of an insubstantial value.  If the nonprofit does provide the use or acknowledgment of a donor’s sponsorship, it should not include qualitative statements regarding or endorsements of the donor’s goods or services in the acknowledgment.  However, a use or acknowledgment may include a list of the donor’s locations, contact numbers, or website; a logo or established slogan; and value-neutral descriptions, displays, or depictions of products or services.  In general, the content of the use or acknowledgment should be controlled by the nonprofit and not by the entity making the payment.

For example, let’s assume that a local pizza chain agrees to sponsor an amateur soccer team organized by a local nonprofit and the nonprofit in exchange agrees to acknowledge the sponsorship by placing the pizza chain’s name and logo (and no other qualitative or comparative statements) on the back of the team jerseys.  In this example, the payment provided by the pizza chain will be a QSP and will not be subject to UBIT.  However, one additional separate exception to be aware of is that a payment for the use or acknowledgment of a business name, logo, or product in a nonprofit’s periodical (which generally includes any regularly scheduled and printed material published by or on behalf of a nonprofit) will be treated under the rules that apply to income derived from advertising activities, even if the payment otherwise seems to qualify as a QSP.

Payments that are Both for Advertising and Qualified Sponsorship Payments

Sometimes, a payment to a nonprofit can constitute both a payment for advertising and a qualified sponsorship payment.  Using the example above, this may be the case if the pizza chain agrees to make a payment to the local nonprofit in exchange for both having its name and logo placed on the back of the team jerseys and for running an ad of the pizza chain’s design on the nonprofit’s website on a regular basis.  In this case, the IRS will treat the payment as two separate payments and UBIT will only be applied to the part of the payment that represents the fair market value of the website advertising that the pizza chain is receiving in return.  However, in instances in which a nonprofit is accepting a payment that is both for advertising and constitutes a qualified sponsorship payment, it may be wise for the organization to separate out the payments into two separate transactions and to document them separately in order to more clearly establish whether and to what extent any portion of the payment is subject to UBIT.

For more information, see IRS Publication 598.

Social Enterprises: Nonprofits vs. For-Profit



I'm honored to be speaking tomorrow at the 2013 BoardSource Leadership Forum on Social Enterprises: Nonprofit vs. For-Profit. Here's the description in the program:

As the activities of nonprofit and for-profit organizations continue to blur with the commercialization of charities and the growth of socially purposed taxable entities, we’re going to see stronger push back from regulators and critics. The IRS will place greater scrutiny on unrelated business taxable income; nonprofits will respond with increased use of taxable subsidiaries; critics of the “hybrid” entitles (such as  the benefit corporation) will be increasingly vocal, warning legislators not to give preferential treatment to such entities because of the ease of green/charity-washing and encouraging attorney general oversight. Within this context, Gene Takagi will explore the issues you should consider in launching a social enterprise and the different legal structures that may be involved.  He’ll also address the board’s role and duties in making these investments and understanding the changing playing field.

Slides available at BLF site here.

Download Erin Bradrick's BLF 2013 Handout accompanying my presentation and read Erin's article for the BLF blog Exceptional Boards.

Unrelated Business Taxable Income – What Doesn’t Count?


Revenues created by business ventures of nonprofits can result in unrelated business taxable income (“UBTI”) subject to the unrelated business income tax (“UBIT”), but it’s important to understand that not all revenues generated by unrelated businesses are subject to UBIT.  And to be clear, if you have no UBTI, you owe no UBIT.  We have included a few examples below of unrelated business revenues that are not likely to be subject to UBIT.

General rule

Net income from unrelated business activities will generally be subject to UBIT if the activity constitutes (1) a trade or business, (2) that is regularly carried on, and (3) is not substantially related to the furtherance of the organization’s exempt purpose.

Activity not regularly carried on

Activities that are carried on for only a limited duration or on an infrequent basis are unlikely to be considered regularly carried on and therefore are not likely to generate UBTI.  For example, if a charity sells ads to be included in a program of its annual gala or holds a fundraising concert a few times each year, the net income from such activities would not be subject to UBIT.

Activities for the convenience of an organization’s members

Income generated by a trade or business carried on by a 501(c)(3) organization or a state college primarily for the convenience of its members, students, patients, officers, or employees is excepted from UBTI and is not subject to UBIT.  For instance, if a charity generates revenues from vending machines intended for use by its employees and certain beneficiaries of the charity’s services, the net income from such vending machines would not likely be subject to UBIT.

Rental Income from Real Property

Generally, income derived from the rental of real property and incidental personal property is not subject to UBIT unless there is an outstanding debt on the property at issue (such as a mortgage note).  This may not be the case, however, if personal services are rendered in connection with the rental.  Take for example, a parking lot owned by a charity and acquired without debt-financing.  If the charity regularly operates the lot for the use of the general public in exchange for parking fees, such parking fees would not be treated as rent from real property and would likely be subject to UBIT.  If, however, the organization leases the lot to a vendor who operates the lot as a parking lot, the lease payments to the charity would constitute rent on real property and would not be subject to UBIT.  Take as another example an exempt organization that regularly rents out its hall to be used for weddings.  If the building’s mortgage has been paid in full and no services (such as bartending or catering) are provided by the organization in connection with the rental, the rental income for the hall would not be subject to UBIT.


By statute, certain bingo games do not constitute unrelated trade or business and the income from such games is therefore not subject to UBIT.  In order to be excluded, the bingo game must meet the legal definition of bingo, be legal where it is played (be careful to be aware of and comply with any state and local laws governing bingo and other gambling activities, including any registration requirements), and be played in a jurisdiction where bingo games are not regularly conducted by for-profit organizations.  Assuming a bingo game meets these requirements, income generated from the game will not be subject to UBIT.

Closing Thoughts

We’ve done a fair amount of writing about UBTI and UBIT here at the Nonprofit Law Blog (see, for example, our prior posts on UBIT explained, earned income and UBIT, and unrelated business income and the commerciality doctrine).  Nonetheless, we think it’s an important topic that warrants further discussion.  The current movement towards social enterprises is reshaping both the nonprofit and for-profit sectors and we believe that UBIT issues will remain at the forefront of federal tax concerns for exempt organizations for the foreseeable future.  As the differences in the activities of nonprofit and for-profit organizations continue to blur with the increasing commercialization of charities and the growth of socially-purposed taxable entities, the nonprofit sector will see stronger pushback from regulators and critics, and the Internal Revenue Service will likely place greater scrutiny on UBTI.  The IRS’s increasing focus on UBTI was recently demonstrated by its Colleges and Universities Compliance Project, a multi-year project evaluating tax-exempt colleges and universities for compliance in the areas of UBTI and executive compensation, which resulted in the IRS identifying approximately $90 million worth of additional UBTI that had been underreported by the 34 colleges and universities it examined.

For more examples and more information, see IRS Publication 598.

Independent Sector Public Policy Action Institute 2013: Key Issues in Tax Reform



Day Two of the Independent Sector Public Policy Action Institute kicked off with a session on tax reform moderated by Kyle Caldwell, Charles Stewart Mott Foundation, and divided into five hot topics.

Charitable Deduction. Richard Schmalbeck, Duke University School of Law, discussed the availability of a charitable contribution deduction only to itemized filers and the 28 percent cap for high-income taxpayers proposed by President Obama, which he supported as a possible solution.  Sue Nelson, America Heart Association, began by stating that she did not expect major tax reform in the next five years and noted that the sector has diverse levels of interest on the issue of the charitable deduction. 

Non-cash Contributions. Victoria Bjorklund, Simpson Thacher & Bartlett LLP, discussed policy issues surrounding the general 30 percent deduction rule but startled the audience by noting that the IRS has a 100 percent win rate on the denial of deduction cases involving noncash contributions and defective substantiating paperwork (Forms 8283 and 8282). Seth Turner, Goodwill Industries International, Inc., discussed the potential adverse impact on Goodwill of policies that would diminish the incentive of noncash contributions.

UBIT/Commercial Activity. Jill Manny, National Center on Philanthropy & the Law, NYU School of Law, discussed basics of UBIT and the commerciality doctrine and noted the unlikelihood of reform hitting these areas. Exactly how much unrelated business activities are permissible to a charity remains vague, but a bright line test doesn't seem practicable. Angela Williams, YMCA of the USA, emphasized the need for nonprofits to be part of the conversations on tax reform because they are the starting point of conversations for years to come. She mentioned the Business Coalition for Fair Competition's advocacy against earned income activities of nonprofits, reminding the audience of the need for a counterpoint. 

Community and Private Foundation Issues. David Shevlin, Simpson Thacher & Bartlett LLP, discussed the equivalency determination repository; differing conflicts of interest rules for public charities, private foundations, and donor-advised funds (can they be harmonized?); the wide spectrum of investments that don't all fit into legally defined categories; and donor-advised funds (will the still-forthcoming IRS regulations treat them like private foundations?).  Sue Santa, Council on Foundations, echoed the need for strong advocacy by the sector, the importance of drawing a line in the sand to protect against a chipping away of the charitable deduction, and the work of Charitable Giving Coalition. She also noted the proposed tiering of the charitable sector, dividing charities into different classes subject to different tax treatments.

Nonprofit Advocacy and Political Activity. Nina Ozlu Tunceli, Americans for the Arts Action Fund, discussed proposals limiting 501(c)(4) political activity following the recent IRS controversy that range from 0 to 49 percent. Greg Colvin, Adler & Colvin, started by calling on foundations to remove the prohibition against lobbying from their grant agreements. He then noted the problems with the lack of guidance on political intervention (what it is and how much is permitted) and the solution proposed by the Bright Lines Project

Unrelated Business Income and the Commerciality Doctrine


As is clearly determined (and as we’ve discussed several times on the Nonprofit Law Blog), in order to establish and maintain tax exemption under Section 501(c)(3), an organization must be primarily operated for an exempt purpose.  What is less clearly determined, however, is when a 501(c)(3)’s tax exempt status may be at jeopardy by operation of the “Commerciality Doctrine.”  The Commerciality Doctrine, a product of the courts, looks at whether a nonprofit organization is operating in a manner that is too commercial for purposes of determining whether the organization is operating primarily in furtherance of an exempt purpose.

In applying the Commerciality Doctrine, the IRS or the courts will generally look to whether a nonprofit is engaging in activities that are in direct competition with those of for-profits.  It will consider factors such as whether the organization is:

  • adopting pricing in order to maximize profits
  • engaging in commercial marketing methods
  • generating and accumulating unreasonable reserves
  • using paid staff rather than volunteers
  • discontinuing unprofitable programs
  • selling to the general public as opposed to a discrete charitable class
  • receiving substantial public charitable contributions

An interesting (and not yet clearly answered) question associated with the Commerciality Doctrine is how an activity related to an organization’s exempt purpose may become an unrelated activity due to the organization’s operation of the activity in an excessively commercial manner.  Income generated from an unrelated activity may be subject to the unrelated business income tax (“UBIT”) and, if too substantial, may impact whether an organization satisfies the operational test set forth above.

For example, it is fairly typical for a 501(c)(3) nonprofit university to charge its students tuition of $40,000 per year.  The activities associated with such tuition are related to the university’s educational purpose and do not result in unrelated business income.  However, if the same nonprofit university decides to charge $400,000 per year in tuition while offering the same curriculum, but with courses taught by the most respected professors in the world to much smaller classes, would the Commerciality Doctrine apply to make the university’s educational activities unrelated to its educational purpose?  In looking at the Commerciality Doctrine factors, we must consider whether the university is adopting pricing in order to maximize profits, engaging in commercial marketing methods, generating and accumulating unreasonably substantial reserves, and/or selling to the general public who can afford such tuition as opposed to a discrete charitable class.  If the Commerciality Doctrine applies, the university’s high-priced educational activities may threaten its exempt status and, at the very least, expose it to substantial UBIT.

As another example, Professor Thomas A. Kelley posted on the Nonprofit Law Prof Blog several years ago that a client of the Community Development Law Clinic he was supervising indicated in its application for 501(c)(3) exempt status that it would be operating a fast-food restaurant to serve as a classroom for its public health and nutrition-related educational activities in its community.  The IRS responded that it considered the restaurant to be too commercial of an activity to qualify the organization as exempt and instead suggested that the restaurant be operated as a soup kitchen.  According to Professor Kelley, it was ultimately agreed to that the restaurant would, among other things, post suggested donations for its food items, rather than fixed prices.  This example illustrates the way in which an activity related to an organization’s exempt purpose may quickly switch by operation of the Commerciality Doctrine to an unrelated activity, thereby potentially endangering the exempt status of the organization.

In short, whether engaging in an activity that is related to a 501(c)(3) organization’s exempt purpose in too commercial of a manner can subject the organization to UBIT or, worse, threaten the organization’s exempt status, is not an easily answered question.  Nonetheless, it is an issue of which 501(c)(3) organizations should be aware, particularly as they design and develop plans to market their revenue-generating activities.

Unrelated Business Income Tax Explained

In order to qualify as a tax-exempt organization under IRC Section 501(c)(3), an organization must be operated primarily for tax-exempt purposes. This parameter allows such nonprofit organizations to engage in a limited amount of business activity unrelated to the organization’s exempt purposes. Although a public charity generally does not pay taxes on income from activities related to its tax-exempt purposes, income generated by unrelated activities may result in the imposition of an unrelated business income tax (UBIT). See IRC Section 511.

When the UBIT rules were enacted, the concern was to eliminate unfair competition by placing a nonprofit’s unrelated activities on the same tax level as a for-profit business engaging in the same activities. The IRS determines whether earned income is related or unrelated using a three-part analysis.

3 Factors.

The general rule is that income is treated as unrelated if the activity generating the income is:

  1. A trade or business;
  2. Regularly carried on; and
  3. Not substantially related to the organization’s exempt purpose.

            IRC Section 512(a)(1).

A trade or business. The IRS defines trade or business as “any activity which is carried on for the production of income from sale of goods or the performance of services.” IRC Section 513(c). This definition generally covers any activity that is carried on for the purpose of making a profit. The Regulations suggest that the definition also encompasses the characteristics of a business as defined by federal income tax law, IRC Section 162, relating to deductibility of business expenses.

Regularly carried on. Generally, when an exempt organization carries on a business activity with the same frequency and continuity as a for-profit, the activity is deemed “regularly carried on.” For example, a seasonal activity like a nonprofit’s sale of holiday cards may be subject to UBIT because of the regularity of the holiday season and commercial businesses engaging in the same seasonal activity. On the other hand, engaging in a brief income-producing activity that a for-profit conducts on a regular basis generally will not meet this requirement.

Not substantially related to the organizations exempt purpose. Of the three factors, the third “substantially related” factor generally requires a deeper analysis. Considering all of the facts and circumstances, an activity is related if it contributes importantly to the accomplishment of the tax-exempt purpose. The Regulations indicate that emphasis is placed on the size and extent of the activity in relation to the organization’s overall activities. Therefore, if an activity is conducted on a larger scale than necessary to carry out the exempt purpose, it is more likely to be treated as unrelated. For example, a museum gift shop that sells posters of the famous paintings it displays (for educational purposes) may generate unrelated business taxable income (UBTI) on its sale of souvenirs, which are not being sold to advance its educational purpose. The “fragmentation rule” allows the IRS to examine the sale of each type of item separately and determine if such sales are related or unrelated for the purposes of UBIT.

These general rules are subject to several exceptions and modifications, the most common of which are summarized below:


  • Businesses Conducted by Volunteers – Any trade or business where substantially all of the work is conducted by volunteers without compensation.
    • Example: A church, located near a ballpark, will not generate UBTI when it operates a commercial parking lot on game days when all of the work is performed by volunteers.
  • Convenience Businesses – A business activity or service that is performed for the convenience of members, students, patients, officers, or employees of the organization.
    • Example: A 501(c)(3) museum does not generate UBTI when it operates a cafeteria inside the paid admission area for the convenience of its patrons.
  • Sales of Gift Items
    Any trade or business that consists of selling donated merchandise.
    • Example: A 501(c)(3) organization will not generate UBTI when it operates a thrift store where donated clothes, books and furniture are sold.


Even if a nonprofit regularly operates a business that is unrelated to its exempt purposes, the income generated from the following activities may be reduced or eliminated by modifications specified in IRC Section 512(b):

  • Rents from real property
  • Interest, dividends, and annuities
  • Royalties from intellectual property, minerals
  • Income from the sale of capital assets

Other UBIT Rules.

  • Income derived from research conducted by a tax-exempt college, university, or hospital is excluded from UBIT.
  • Certain bingo games not conducted on a commercial basis are excluded from UBIT.
  • A qualified sponsorship payment, or any payment made by a person (or sponsor) engaged in a trade or business where there is no arrangement or expectation that the person will receive any substantial return benefit for the payment, is also excluded from UBIT. See Adler & Colvin’s Corporate Sponsorship: Frequently Asked Questions.

Exceptions to the Exceptions.

If an unrelated business activity fulfills the three UBIT factors, but then fits into one of the exceptions, the income may still be subject to UBIT if one of the exceptions to the exceptions applies.

  • Interest, rents, and royalties received from a controlled corporation– While an exempt organization can generally avoid UBIT when receiving income from rents, interest, and royalties from another entity, these incomes are taxable when received from an entity that the exempt organization controls.
  • Unrelated debt-financed income– If an exempt organization borrows in order to acquire income-producing property, all or part of that income may be subject to UBIT, even if it otherwise would have been excluded under an exception.


Although the IRS has not provided a bright line percentage rule that dictates how much unrelated business activity a 501(c)(3) organization may engage in, it is important to keep in mind that the core activity of the organization must be exempt in nature. Remember, a tax exempt organization must be operated primarily for tax-exempt purposes. If an organization’s business activities begin to overshadow their exempt activities, one solution may be to form a subsidiary. Organizations contemplating carrying on significant unrelated business activities are encouraged to contact counsel to determine the most advantageous structure.

Additional Resources:

IRS Publication 598 “Tax on Unrelated Business Income of Exempt Organizations” (PDF; online)

Unrelated Business Income Tax: A Primer” by Robert A. Wexler of Adler & Colvin.

Alliance for Community Media National Conference (Part Three)




Our final post of resources referenced in our session at the 2013 Alliance for Community Media National Conference, Nuts and Bolts of Nonprofits and Their People, with Syvia Strobel (ACM) and Deborah Vinsel(Thurston Community Television).

Timely Nonprofit Issues

Unrelated Business Activities: IRS Examination Area

The underreporting of unrelated business taxable income (UBTI) was the first mentioned highlight of the IRS Colleges and Universities Compliance Project Final Report released on April 25, 2013. 90% of the examined institutions underreported UBTI! The primary reaons for such underreporting:

  • Reporting losses as connected to unrelated business activities when they were not (recurrent losses from activities indicated no profit motive, causing them to fail to meet the trade or business requirement);
  • Misallocating expenses that were used to carry out both exempt and unrelated business activities and then applying an excessive proportion to offset unrelated business income;
  • Miscalculating net operating losses; and
  • Reporting unrelated business activities as exempt activities, thereby not properly reporting the income from such activities as unrelated business income.

The Report reveals an enormous compliance problem and rare area in which the Exempt Organizations (EO) division of the IRS can generate additional tax revenues. EO Division Director Lois Lerner (before her recent suspension) noted: “Because these issues may well be present elsewhere across the tax-exempt sector, all exempt organizations need to be aware of the importance of accurately reporting unrelated business income ….” If you have earned income generated from activities that do not contribute importantly to accomplishing your charitable mission, disregarding how the profits from such activities are used, you need to look at these issues carefully. And note that net income from advertising is almost always UBTI subject to the unrelated business income tax.


  • For unrelated business activities generating recurrent losses, determine whether there is a profit-motive and document such determination, including the business rationale for continuing such activities despite the recurrent losses;
  • Determine and document a fair and reasonable basis for allocating shared expenses among exempt and unrelated business activities;
  • Document the underlying detail for determining net operating losses;
  • Use reasonable care (which may or may not require the assistance of legal counsel) in determining whether a business activity is exempt or unrelated.

See our earlier post on the Report here.

See also Tax on Unrelated Business Income of Exempt Organizations, IRS Publication 598 here.


Lobbying and Political Activities: Hitting the Fan

Lost amidst the politicization of the recent IRS scandal is the fact that 501(c)(3) nonprofit organizations can, and often should, lobby and engage in other forms of permissible advocacy in order to effectively and efficiently advance their respective missions. But these organizations need to understand the limitations and rules of the game. And they should protect their rights to engage in such advocacy, which might include advocating for greater clarity in the laws and stronger enforcement against those organizations that abuse the laws.


  • For any charity with less than a $20 million annual budget, strongly consider making the 501(h) election that enables you to measure your lobbying activities on lobbying expenditures – see Maximize Your Lobbying Limit (Bolder Advocacy - AFJ);
  • Consider whether a change in the laws could be of great advantage to advancing your charitable mission, and what your organization could do to effect such change;
  • Get help in understanding the federal and state lobbing and election laws that may require registration and reporting for certain activities;
  • Understand and strictly enforce the absolute ban on electioneering (including the prohibition against endorsing political candidates); and
  • Develop policies and train your employees and volunteers to help ensure your compliance with respect to the applicable laws (this may not be so difficult) and the First Amendment rights of individuals to express their views.

Also see Part One and Part Two of this series of posts.