Many tax-exempt not-for-profit organizations that operate under Internal Revenue Code (IRC) §501(c)(3) rely on fundraising, donor gifts, and income-producing activities to sustain themselves. In conducting these activities, an organization may unintentionally generate unrelated business taxable income (UBTI). Any amount of UBTI greater than $1,000 is subject to tax at the normal corporate tax rates under IRC §511(a)(1). Before entering into income-generating activities, organizations should have a clear understanding of any tax-related issues that may arise.


Tax-exempt organizations generate UBTI if the income-producing activity is performed regularly and doesn’t substantially further its overall tax-exempt mission (IRC §513). Modifications, a general term used for exemptions and exclusions, exist within the definition of UBTI. Examples of modifications include royalties, sponsorships, advertising, activities performed by volunteer labor, and gift shops.

Royalty income is defined under IRC §512(b)(2) as “payments for the use of trademarks, trade names, service marks or copyrights, whether or not payment is based on the use made of such property.” Royalties are passive by definition—they can’t include compensation for services performed by an owner of such property.

IRC §152 also excludes sponsorships and activities performed by volunteer labor, provided the sponsorships aren’t contingent on a desired outcome and don’t provide sponsors with commercial or substantial benefit.

But volunteer labor is one area where tax-exempt organizations can unintentionally fall into the “trap” of UBTI if certain criteria aren’t met. Special events, such as dances or concerts, are common ways for tax-exempt organizations to generate income, but they also can be a simple way for organizations to incur UBTI. One way to avoid UBTI is to use volunteer labor to staff income-producing activities. IRC §513(a)(1) excludes from UBTI any income generated by activities “in which substantially all the work in carrying on such trade or business is performed for the organization without compensation.”

Consider the following comparison. Both a local school and a church hold quarterly dances, using the proceeds from admission and concession sales for the benefit of the respective organization. The school uses school faculty and staff, who are paid from the dance proceeds, to chaperone the dances, while the church staffs the dances with unpaid volunteer church members. While the activity is regularly carried out by both organizations, the dances create UBTI for the school but not the church. The use of paid staff rather than volunteers indicates a business-type activity, which creates UBTI.

Another trap area occurs when tax-exempt organizations run gift shops. While some items sold in the gift shops are exempt from income tax, others are not. Consider a church that runs a gift shop in its lobby, selling books by well-known Christian authors. Profits from the sale of the books aren’t subject to tax because their sale furthers the church’s mission. But other items in the gift shop, such as wind chimes or mints, are subject to tax because their sale doesn’t further the church’s overall exempt mission. It may be unclear to the tax-exempt organization which income is UBTI and which is tax-exempt. Additionally, the church must allocate related expenses between tax-exempt income and UBTI.


A recent real-world example can be found in Technical Advice Memorandum 201544025 (October 30, 2015), in which the IRS explained its intent to apply IRC §513 to funds raised by an alumni association on behalf of a public two-year community college.

According to the memorandum, the alumni association raised “substantially all of its revenue” from the operation of a weekly flea market. The association agreed that the flea markets were a regularly performed activity but argued that they were substantially related to its overall tax-exempt purpose of providing civic and financial support to the college. It argued further that the events served the elderly, an exempt civic purpose, but it could provide no evidence that the flea markets actually addressed any specific need of elderly community members. The association argued that, along with generating funds, the flea markets drew potential recruits and donors and “lessened the overall burdens” of the college as a governmental entity. It also argued that the flea markets constituted “events” and not rental of space, or real property, by the vendors.

The IRS stated that the association presented no evidence of a positive correlation between the events and an increase in students or donations. Additionally, sales events don’t “have the characteristics of those public services or facilities that are normally the burden of the government” as neither the state’s laws nor college’s charter required flea markets or similar activities.

Additionally, the IRS stated that fees received from vendors didn’t constitute nontaxable “rents” for real property under IRC §512 (b)(3). Rents are subject to UBTI if they aren’t rents from real property but are instead “payments for the use or occupancy of rooms and other space where services are also rendered to the occupant.” Services are considered rendered if they are provided for the convenience of the occupant and consist of any benefits other than those typically provided when renting out a room or other space. Examples include renting hotel rooms and providing laundry services and rentals of space in parking lots or storage units. Unfortunately for the association, by providing services such as advertising, parking lot shuttles, and ATM machines, the vendor fees were subject to UBTI. The association argued that the services weren’t provided for the benefit of the vendors since there was no contract. The IRS asserted that a vendor would reasonably expect these services in connection with the flea market.

Although the funds were used to further the overall exempt mission of the college by providing scholarships and enhancing facilities, the IRS concluded that the funds were subject to tax based on the facts that: (1) the flea markets were a regularly carried on activity and (2) were not “substantially related” to the overall exempt mission of the association.


Generating much-needed funds while avoiding the trap of UBTI can often be a confusing task for tax-exempt organizations. In each of the examples presented, there was no one single factor that led to tax on funds raised by exempt organizations. Oftentimes, the simplest change, such as using unpaid volunteers instead of paid staff, can help an exempt organization avoid having to pay taxes on UBTI altogether.

Anthony P. Curatola is editor of the Taxes column for Strategic Finance, the Joseph F. Ford Professor of Accounting at Drexel University in Philadelphia, Pa., and a member of IMA’s Greater Philadelphia Chapter. You can reach Tony at (215) 895-1453 or

© 2016 A.P. Curatola

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