Besides conducting related business activity and earning income through passive strategies, nonprofits can simply earn income through unrelated business activity. Unrelated business activity is exactly what it sounds like: activity a nonprofit conducts that has nothing to do with its charitable purposes. More accurately unrelated business income is income generated from activity that is:
- A trade or business (the IRS defines any activity designed to raise income from the sale of goods or performance of services as a trade or business);
- Regularly carried on (isolated sales or even sporadic activity may not be considered “regularly carried on”); and
- Not substantially related to furthering the exempt purpose of the organization.
Some examples of unrelated businesses are below:
- A folk-art museum selling scientific literature and memorabilia associated with the surrounding community in its gift shop engages in unrelated business.
- An organization set up to prevent cruelty to animals engages in unrelated business when it owns and operates a pet grooming and boarding business.
- A youth welfare organization engages in unrelated business when it owns and operates a miniature golf course that is open to the public.
All unrelated business income will be taxed at normal income rates for any organization who receives income in this way. Therefore, an organization must think carefully about whether engaging in such business activity makes financial sense.
The key here to a tax-exempt organization running an unrelated business is that the unrelated business must not be a substantial part of the organization’s operations or else its tax exempt status may be at risk. Unfortunately, the IRS has never defined what “substantial” means. Many legal experts tend to advise no more than 20% of an organization’s income come from unrelated business. But in no circumstance should an organization raise more than 50% of its income from unrelated business.
While unrelated business income may not sound appealing to those looking to make high impact social change outside the boundaries of the high pressure competitive atmosphere of the for-profit arena, unrelated business income may actually be a great opportunity for an organization to dip its toes into a competitive field while drawing potential customers and stakeholders to the social impact of its exempt activities. It may also prove to be another form of valuable income that an organization can then channel into its operations.