Earned income: fees, social enterprise and UBIT

This guide is for charities thinking about earning some of their own money, through program fees, a thrift shop, a café, classes or selling products. Earned income can make a small charity less dependent on grants. It also brings tax rules that surprise many people. After reading, you'll understand the main kinds of earned income, what unrelated business income tax (UBIT) means in plain words, and when you need to file an extra IRS form.

Yes, charities can sell things

A common myth is that charities aren't allowed to charge for anything. That's not true. Many charities earn money:

• Fees for service. A counseling center charges on a sliding scale. A music school charges tuition. A senior center charges a small fee for meals.
• Selling products made through the program. A job-training program sells furniture its trainees build.
• Social enterprise. A business run by a charity to serve its mission or to fund it, such as a café that employs young people leaving foster care.
• Thrift shops selling donated goods.
• Renting out space or equipment when it's not in use.

The question isn't whether you can earn money. It's whether the income is related to your mission, because that decides whether it can be taxed.

Related and unrelated income

A 501(c)(3) charity usually pays no federal income tax on income from activities that are substantially related to its charitable purpose. That's true even if the activity looks like a business.

But if a charity regularly carries on a trade or business that is not substantially related to its purpose, the profit from that business can be taxed. That's unrelated business income tax, or UBIT.

IRS Publication 598 breaks this into three tests. Income is unrelated business income if it comes from:

1. A trade or business: selling goods or services to make money.
2. Regularly carried on: done with the frequency and continuity of a normal business, not a one-off.
3. Not substantially related to your purpose: the activity itself doesn't contribute importantly to your mission. Using the profits for your mission doesn't count. The IRS is clear that using the money for good work doesn't, by itself, make the activity related.

Some examples from the IRS

• A halfway house runs a furniture shop that employs its residents. Publication 598 says that income isn't unrelated, because the shop helps residents transition back to work, which is the mission.
• Selling items made by people in a rehabilitation program as part of their training is usually related, if they are sold in substantially the same state as when they were made.
• A health club program offered on top of an organization's general fitness program was found to be unrelated, where it didn't contribute importantly to the exempt purpose.

Say a literacy charity sells its own reading workbooks to schools. That's probably related. Say the same charity starts a car-washing service every weekend to raise money. That's a business, regularly carried on, and washing cars doesn't advance literacy. Unless an exception applies, the profit could be taxable.

Important exceptions

Publication 598 lists activities that are not treated as unrelated businesses, even if they otherwise would be. Three matter to many small charities:

• Volunteer workforce. A business where substantially all the work is done by unpaid volunteers. The IRS example is a retail store run by an orphanage with volunteers doing almost all the work.
• Selling donated merchandise. A business selling goods that were substantially all given to the charity. A thrift shop selling donated clothes and books is the IRS example.
• Convenience of members. For a 501(c)(3), a business run mainly for the convenience of its members, students, patients, officers or employees.

Other rules cover things like bingo, sponsorship payments, and some kinds of passive income such as interest and dividends. Our guide on corporate partnerships covers sponsorships.

The $1,000 rule and Form 990-T

The IRS says a tax-exempt organization that has $1,000 or more of gross income from an unrelated business must file Form 990-T, the Exempt Organization Business Income Tax Return. This is in addition to your regular annual return (Form 990, 990-EZ or 990-PF).

Note that it's gross income, not profit. Gross income generally means sales minus the cost of goods sold, before other expenses. You could make no profit at all and still need to file.

Other facts from the IRS:

• If your charity has more than one unrelated business, you still file one Form 990-T, with a separate Schedule A for each business.
• When working out the taxable amount, a specific deduction of $1,000 is generally allowed.
• An organization that is taxed as a corporation (most charities formed as nonprofit corporations) pays tax at 21% of its unrelated business taxable income, according to the Form 990-T instructions.
• You must pay estimated tax during the year if you expect your tax to be $500 or more.
• Form 990-T is generally due by the 15th day of the 5th month after your tax year ends. For a calendar-year charity, that's May 15. You can request an automatic extension using Form 8868.
• A 501(c)(3) that files Form 990-T because it has $1,000 or more in unrelated business gross income must make the form available for public inspection.

Too much unrelated business

Paying some UBIT is normal and not a problem. But if unrelated business becomes a large part of what a charity does, it can raise questions about whether the charity is still mainly charitable. If a business activity grows big, get professional advice. Some charities put large businesses in a separate company that they own, but that needs a lawyer and an accountant.

Pricing with care

Fees can make services harder to reach for the people you exist to help. Many charities use a sliding scale, offer free places, or ask those who can afford it to pay a little more. Decide your pricing approach with your board and write it down.

Running an earned income activity well

• Write a simple business plan, even one page: what you'll sell, to whom, at what price, and what it costs.
• Keep separate records for each activity's income and costs. That's how you'll know if it's working, and how your accountant can fill in Form 990-T.
• Check local licenses, sales tax and health rules. Being a charity doesn't exempt you from all of them.
• Review after six months. Is it making money? Is it serving the mission? Is it worth the volunteer time?

Earned income checklist

• We can explain how the activity itself advances our mission
• We checked whether any exception applies, and its conditions
• Income and costs are tracked separately for each activity
• We know if gross unrelated income will reach $1,000
• We have a calendar reminder for the Form 990-T due date
• We checked local licenses and sales tax rules
• An accountant reviewed our plan

If you want someone with business experience to look at your plan, ask a member charity for help through the Exchange.