Understanding Unrelated Business Income Tax: A Guide for Colleges and Universities

I woke up at 4:30 this morning thinking about Unrelated Business Income Tax. Yes, you read that right. When you're a tax director who works extensively with nonprofits, particularly colleges and universities, these things tend to occupy your mind at odd hours. But that early morning contemplation helped me crystallize what I want to share with you today about UBIT.

Who Needs to Worry About UBIT? 

First things first: any nonprofit is potentially subject to this tax. If you're working at a college or university, you need to carefully evaluate all your activities and operations to ensure you understand what might fall into this category and what the implications are for your institution. 

The Three Essential Elements of UBI 

Before diving into the complexities, you need to understand that three main factors must be established to determine if an activity generates Unrelated Business Income:

1. Is It a Trade or Business?

This is our first requirement, and interestingly, it's not well-defined within the revenue code or regulations. Instead, it's been defined through court cases over time. The courts have essentially taken a "we'll know it when we see it" approach. 

However, there are some general guidelines we can reference: 

• Profit motive test: Is there a clear drive to make a profit with the activity, or is it just breaking even with revenue and expenses equalizing? 

• Extensive use of resources: How much of your organization's resources are being deployed? 

• Unfair competition test: Are you competing with for-profit entities in a way that gives you an unfair advantage? 

These items have been deemed indicators of trade or business over time by the IRS and the courts.

2. Is It Regularly Carried On?

This distinction is crucial. We often get questions from nonprofits about one-time or infrequent activities: "We've got this activity coming up this year. We've never done it before and don't expect to do it again." 

If something is not regularly carried on, chances are it's not going to meet the fundamental definition of UBI. However, most concerns we encounter involve operations that are routinely carried on, which is why this is one of the main distinctions we have to analyze upfront. 

This is where things get gray. The nature of the activity must be scrutinized to determine: Does this fit the definition or mission of our organization? Is it integral to that mission? 

Obviously, most organizations would want to make the determination that an activity is related, meaning it's not UBI—it's just part of what they do and fits into their overall exempt purpose. 

A Common Misconception 

Here's a question we see all the time: "If we're using the money generated from this activity and spending it toward our main exempt purpose, doesn't that make it related?" 

Unfortunately, it's not that simple. It's not what you do with the money that matters. You must analyze the activity itself in addition to the first two conditions (trade or business, regularly carried on). 

You have to compare the activity to your main exempt purpose and determine with certainty whether it's related to that main purpose or principal activities. If it doesn't meet this test, and it satisfies the other two conditions, you're likely looking at a potential UBI activity. 

Why Does UBIT Exist? 

Understanding the purpose behind UBIT helps clarify why these rules exist. When an organization applies for exempt status, they lay out their business purpose and why they should be exempt. Once that status is granted, the IRS expects you to operate within the parameters of your exempt status. 

If you start operating outside those guardrails into other activities, that's where the UBI category comes into play. The IRS wants to put you on level playing ground with for-profit entities. If you have functions similar to a for-profit organization, they will be taxed accordingly. 

Moving Forward 

These three elements—trade or business, regularly carried on, and not substantially related—form the foundation of any UBIT analysis. In future discussions, we'll explore the modifications and exceptions to UBI, as well as common areas where colleges and universities typically encounter these issues. 

The key is to be proactive in evaluating your activities. Don't wait until you're filing your 990 to discover you have unrelated business income that should have been reported. Regular review of your operations against these three tests will help you stay compliant and avoid surprises. 

Patrick Pittman is a Director at Brown Edwards, specializing in tax compliance for nonprofit organizations, with extensive experience assisting colleges and universities with complex tax matters, including the Employee Retention Credit and unrelated business income tax.