June 30, 2025

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Executive Summary

• Generally, an organization that has received recognition of tax-exempt status under Internal Revenue Code (“IRC”) § 501(c)(3) will not be subject to federal income tax on the organization’s income.  

• However, with some significant exceptions, income generated from an activity unrelated to the 501(c)(3) organization’s exempt purpose(s) may be taxed at regular federal corporate income tax rates as unrelated business income (“UBI”).  

• In addition to being subject to these taxes, 501(c)(3) organizations that engage in too much unrelated business risk losing their tax-exempt status.  

• Key exceptions include passive income from assets that are not financed by debt and certain volunteer-led activities.  

• Leaders of 501(c)(3) organizations should know when the Internal Revenue Service (“IRS”) will characterize the organization’s income as UBI, how to pay any Unrelated Business Income Tax (“UBIT”) owed, how UBIT practically impacts an exempt organization, and when UBIT may put an organization’s exempt status at risk.

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Qualifying for Tax-Exempt Status

To qualify for 501(c)(3) tax-exempt status, an organization must continually pass both the organizational and operational tests. This means that the organization must be explicitly organized in its founding documents for one or more of the tax-exempt purposes (religious, charitable, educational, etc.) and that the organization must in fact operate for these purposes. For more on the organizational and operational tests, see Napa Legal’s blog post on the Four Things To Know About The 501(c)(3) Organizational and Operational Tests.

Disclaimer: This whitepaper will focus on the applications of UBIT at the federal level.¹ However, each state’s tax regime will also address the taxation of the unrelated business activity of nonprofits, which may impose further tax liability. This whitepaper, therefore, should not be treated as legal advice or an all-inclusive guide to everything a nonprofit should know about UBIT. Nonprofit leaders should consult with a tax professional for more information on UBIT.

The Operational Test and Business Activity

As part of the operational test, the IRS applies the commerciality doctrine², which involves an analysis of whether a nonprofit has engaged in any business activities that are unrelated to its exempt purpose.  

If so, the IRS takes a closer look to determine whether the organization has engaged in such unrelated commercial activity to a “substantial degree.” In most cases, if the IRS finds there is substantial commercial activity, the IRS may conclude that the organization has failed to qualify for continued tax-exempt status.³  

There is no precise definition for “substantial” in the Tax Code. However, the IRS has principally relied on two tests to analyze whether unrelated commercial activity is substantial: the commensurate in scope and the primary purpose tests.⁴

Understanding and complying with these tests is crucial, because losing 501(c)(3) status can have serious consequences for your organization’s ability to fundraise and operate. To learn more about the impact of losing tax-exempt status and the process of reapplying, see Napa Legal’s whitepaper on the subject here.

Commensurate in Scope Test

Under the “commensurate in scope” test, the IRS compares money spent on the exempt organization’s exempt activities to the resources applied toward the organization’s commercial activities.⁵ If the effort expended in carrying out the exempt activity is proportional to the income made from the unrelated activity, the IRS may find the organization does continue to qualify for tax exemption.⁶  

For example, an inner-city after-school tutoring program may sell hot chocolate each holiday season to help defray program expenses. If the hot chocolate sales only occur once per year, do not require extensive staff time⁷, and do not divert money away from the tutoring activities, the IRS may find that this fundraiser is “commensurate in scope” with the organization’s exempt purpose.  

Commensurate in Scope: A Case Study

This test was applied when an online flower salesman attempted to qualify for tax-exempt status by donating a percentage of each sale to charity.⁸ The salesman argued his organization qualified for an exemption because the profits from the sale were “commensurate in scope” with the donations to charity, as he donated about 20% of each sale to charity.⁹ The court was not persuaded by this argument. The court ruled that, under the commensurate in scope test, an organization cannot claim tax exemption simply by giving money to charity when the organization’s actual primary activity is selling goods at market price.¹⁰  

The annual sale of hot chocolate in the above example was infrequent and involved a minimal amount of the organization’s time and resources, so the activity would be commensurate in scope to the organization’s exempt purpose. Conversely, the case study involving the sale of flowers involved a substantial amount of the organization’s time and resources to a commercial activity unrelated to the organization’s exempt purpose and so would not be commensurate in scope.

Primary Purpose Test

The IRS also uses a second test to determine whether an exempt organization has engaged in a substantial amount of business activity: the “primary purpose” test.  

According to the primary purpose test, organizations cannot be tax-exempt when a substantial portion of their activities are related to a business unrelated to an exempt purpose.¹¹ The reasoning behind the test is that offering tax exemption to an organization that operates essentially as a for-profit entity would be unfair.¹²  

Courts look at the following factors under this test to determine whether an organization operates like a for-profit: (1) the competition with for-profit businesses; (2) the extent of low-cost services offered; (3) the pricing plan; and (4) the reasonableness of income generated.¹³

Primary Purpose Test: A Case Study

This test was applied to determine whether a religious organization could continue to qualify for tax-exemption after opening several health food stores.¹⁴ The organization claimed vegetarianism was part of its religious beliefs and, thus, not an unrelated business.¹⁵ The court disagreed, concluding that the stores operated like a for-profit by (1) engaging in direct competition with local restaurants, (2) pricing its food similar to a for-profit restaurant, (3) advertising extensively, and (4) not being supported by charitable donations.¹⁶

What this Means for Your Faith-Based Nonprofit:  

Before engaging in an unrelated commercial activity, the organization should conduct a written analysis of the facts that will determine whether the organization passes the two tests.¹⁷

What do the two tests mean for your faith-based nonprofit?  

When exploring fundraising opportunities involving commercial activity—for example, sales of spirit wear at a faith-based elementary school—the board and organization leadership should make sure the activity is small relative to overall operations. Ideally, the board minutes or an executive memorandum should note the analysis that takes place and the basis for the leadership’s decision that the unrelated commercial activity does not jeopardize the organization’s tax-exempt status.  

Based on the factors listed in the two tests, the organization may want to begin by evaluating the following:  

Primary Purpose Test:  

1. competition with for-profits;  

2. the extent of low-cost services offered;  

3. the pricing plan; and  

4. the reasonableness of income generated.

Commensurate in Scope Test:  

5. the volume of sales relative to the organization’s overall budget;  

6. the amount of time spent administering the sales compared to time spent on other operations, etc.; and

7. the amount of advertising efforts spent promoting the sales compared to the organization’s core mission.¹⁸  

It also might be worth considering whether your organization can fundraise without triggering UBIT. For example, if on the one hand your organization receives a majority of its funding from private donors and revenue from a program that furthers an exempt purpose, having an occasional sale that covers a small part of the organization’s costs will likely not run afoul of the primary purpose or commensurate in scope tests. On the other hand, if your organization would not be able to cover its current expenses without a commercial activity that it currently engages in, it is more likely that this commercial activity jeopardizes your organization’s tax-exempt status.

Tax Code Provisions on UBIT

IRC § 511 provides the authority to tax UBIT. For example, if a nonprofit regularly carries on a commercial activity (such as selling goods or services as a way of generating funds) and that activity is not related to its exempt purpose (such as if a religious and educational organization sold religious books at cost to spread its message) but is primarily for the purpose of generating revenue, the commercial activity will often be subject to UBIT

This section lays out which organizations are subject to UBIT and which are excluded.¹⁹ Under this section, 501(c)(3) religious organizations are expressly subject to the tax.

IRC §§ 512 and 513 lay out the applicability and functioning of UBIT. IRC § 512 specifically lays out the general rules of the UBIT test.²⁰ IRC § 513 provides exceptions to the definition of an “unrelated trade or business.”²¹

Why Tax UBIT?

Before discussing how UBIT applies in practice, it may be helpful to discuss the purpose of the tax through a real-life example.  

In 1946, New York University Law School (“NYU”), a 501(c)(3), bought C.F. Mueller Co., a macaroni manufacturer, so that all profits of macaroni sales went to the law school.²² NYU assumed that the profits made from the macaroni sales would not be taxed because the profits were being used to further the educational purpose of the law school.²³ The court disagreed and its primary concern was unfair competition. As Congress stated a year earlier, “[t]he tax-free status of [nonprofits] enables them to use their profits tax free to expand operations, while their competitors can expand only with the profits remaining after taxes.”²⁴ In short, courts will not consider that the profits ultimately serve an exempt purpose if local businesses would be harmed by the unfair advantage granted by the tax exemption.  

This case, therefore, illustrates the underlying purpose of UBIT: elimination of unfair competition with local for-profit entities.  

UBIT in Practice

As stated above, generally the IRC imposes a tax on an otherwise exempt organization’s unrelated business income. The IRS applies a three-part test to define “unrelated business.” Under the test, an organization (1) must be engaged in a trade or business, (2) that is regularly carried on, and (3) is not substantially related to an exempt purpose.²⁵ The IRS, as noted above, additionally provides exceptions to UBIT where the three-part test is satisfied. For more on exceptions to UBIT, see the ”Exceptions” section below.

Three-Part Test

1: Trade or Business

First, to be an unrelated business activity, the activity must first fit the applicable definition of a “trade or business.” The IRC lays out an expansive definition, including “any activity carried on for the production of income from the sale of goods or performance of services.”²⁶ This definition is meant to cover anything meant to create a profit, even if no profit is actually made.  

The IRS directly addressed the scope of this definition when a 501(c)(3) rehabilitation center claimed it should not fall under the definition of a “trade or business” when it provided employment to disabled persons in its custody.²⁷ The IRS ruled that this activity was not a “trade or business” because the purpose of the employment was to rehabilitate the disabled persons in their care, not to generate a profit from their work.²⁸

2. Regularly Carried On  

Second, the activity must be “regularly carried on.” The IRC provides a facts-and-circumstances analysis here, looking at the frequency and continuity of the activity as compared to similar for-profit entities.²⁹ This definition is met whenever an organization operates like a for-profit entity engaged in similar activity.  

This analysis was tested when a nonprofit veteran organization sought to avoid UBIT through its yearly sale of Christmas cards.³⁰ The organization argued that the sale of cards was not “regularly carried on” because it did not occur outside the Christmas season.³¹ The court was not persuaded by this argument. The court said that activities are “not regularly carried on” if they are incidental to another event, like a fundraiser for an annual dance.³² However, activities are regularly carried on when they are a large source of revenue and consistently carried out.³³ Because the organization conducted the sale every year and made a large profit, it was regularly carried out.  

3. Not Substantially Related to an Exempt Purpose

Third, the activity which produces, or seeks to produce, the income must be substantially unrelated to the exempt purpose. Here, “substantially unrelated” means the income-generating activity does not contribute importantly to furthering an exempt purpose.³⁴ The specific facts and circumstances weigh heavily on the outcome of this analysis.  

The “substantially unrelated” analysis often arises when nonprofits engage in advertising sales. In one case, for example, a nonprofit sought to avoid UBIT tax liability for advertising in its medical journal.³⁵ The organization argued that the advertising income was substantially related to its exempt medical purpose.³⁶ The Supreme Court, looking at the specific facts and circumstances, did not agree. The Court said that advertisements can only be substantially related if they are used to provide information relevant to the exempt purpose.³⁷ But, as in this case, advertisements are not substantially related if they are used solely to make a profit, with no relation to the exempt purpose.³⁸

Exceptions

The following activities will not trigger UBIT even where the three-part test is satisfied:

1. Work done by Volunteers

Activity where substantially all the work done in carrying out the trade or business is performed by volunteers, without compensation, is exempted from UBIT.³⁹  

For example, this exception would apply if a religious order operated a commercial farm.⁴⁰ The farm could be commercial business, regularly carried on, and substantially unrelated to the religious order.⁴¹ However, if the members of the order are the only workers on the farm and are not compensated for their work, the business activity will likely fall under this exception.

An issue could arise if they are compensated by receiving free room and board. In this situation, the exception will only apply if they would have received the room and board even if they refused to work.⁴²

2. Work done for the Convenience of the Members

Activity that is carried out primarily for the convenience of members of the organization will not trigger UBIT.⁴³

Consider the case of a museum, operated for an exempt purpose, which also has a cafeteria for customers and employees.⁴⁴ The museum could claim that the cafeteria is there, at least in part, for the convenience of the customers and employees. Under this exception, any sales to customers and employees are not taxable under UBIT.⁴⁵ However, the museum can still be taxed under UBIT for sales to the public because members of the public are neither customers nor employees of the museum.⁴⁶

3. Distribution of Low-Cost Articles

The distribution of low-cost articles in connection with the solicitation of charitable donations is exempted from UBIT.⁴⁷  

This exception would apply, for example, if an organization sent out a greeting card to initiate communications with potential donors.⁴⁸ For this exception, courts are mainly focused on whether there is unfair competition with local businesses.⁴⁹ Thus, in this example, the distribution of the greeting cards will not be considered a business activity, taxable under UBIT, so long as the organization is not in competition with local greeting card businesses. The organization will not be considered to be in competition with local taxpaying businesses, where the donations are not used to reinvest in greeting card distribution, but rather are used for the exempt purpose of the organization.⁵⁰  

4. Corporate Sponsorship Payments

Payments made to certain corporate sponsors are not subject to UBIT.⁵¹ For this exception, a qualified sponsorship payment is one where the corporation expects no substantial benefit in return.⁵² A “substantial return benefit” does not include use or acknowledgement of the corporation’s payment or donation to the nonprofit.⁵³ Use or acknowledgement of the corporation may be placement of a logo or slogan without description of the corporation’s services, the corporation’s contact information, or value-neutral descriptions.⁵⁴ Advertisements for the corporation are not mere use or acknowledgments. Advertisements are defined as messaging which “promotes or markets” the corporation.⁵⁵  

For example, consider a nonprofit that holds an event for which a corporate sponsor provides goods, like refreshments and prizes, free of charge.⁵⁶ In exchange, the nonprofit may place the corporate sponsor’s name on fliers or even change the name of the event to include the corporation’s name as mere acknowledgment of the sponsorship. These actions likely would not rise to the level of advertisements because they were “value-neutral” statements about the corporation.⁵⁷ Thus, the refreshments and prizes given to the nonprofit are qualified sponsorship payments, not taxable under UBIT.⁵⁸  

5. Bingo Games

Profits made from conducting bingo games will not trigger UBIT.⁵⁹ However, note that the game must: (1) have wagers placed, winners determined, and prizes distributed in the presence of all attendees; (2) not compete with local for-profit bingo games; and (3) not violate any law.⁶⁰  

In addition to the above requirements, if a nonprofit operates a variation of a traditional game of bingo, they will not fit the definition for this exception. For example, UBIT would apply to profits made from “instant bingo.”⁶¹ In this game, participants are given scratch-off cards that resemble a bingo board, which they scratch-off to reveal whether their card is a winner. Because this is not the traditional game of bingo, where a person calls out random numbers to participants, the exception would not apply.⁶²  

6. Other Relevant Exceptions

Other relevant exceptions to UBIT include the “thrift shop exception,” where the organization sells items that were received as a gift,⁶³ and the exchange of donor information with other organizations for the purpose of soliciting donations.⁶⁴  

Additionally, in many cases the IRC excludes from UBIT all dividends, interests, payments with respect to secured loans, deductions related to such payments, and many rents received for real or personal property,⁶⁵ as well as certain income from debt-financed property if substantially all the use of the property is substantially related to the exempt purpose(s) of the organization.⁶⁶

This whitepaper covers only the exceptions most likely to be directly relevant to religious nonprofits. For a list of all the exceptions to UBIT, see page 3 of the Form 990-T instruction sheet at: https://www.irs.gov/pub/irs-pdf/i990t.pdf.  

Filing Obligations

Religious nonprofits must file Form 990-T to pay tax on the net income of unrelated business activity, where the organization receives over $1,000 from the activity, by the 15th day of the 5th month after the end of the tax year.⁶⁷ Note that any religious organization that receives unrelated business income is required to file Form 990-T regardless of whether that organization has to file a Form 990. This includes churches or other organizations ordinarily exempt from filing Form 990. Note also that the Form 990-T is generally available to the public.⁶⁸

Tax liability for unrelated business income is equal to the tax liability for a corresponding non-exempt organization.⁶⁹ Note that the Tax Cuts and Jobs Act of 2017 now requires nonprofits to separately report UBIT for each unrelated business activity; nonprofits can no longer use deductions from one unrelated business to offset tax due from another unrelated business.⁷⁰

For more information, see the (1) Form 990-T instructions; (2) the sample Form 990-T; and (3) the transcript of an IRS course on Form 990-T.  

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¹ See I.R.C. § 514. This is an additional provision of the Tax Code dedicated to UBIT, covering taxation of debt-financed income.

² Treas. Reg. 1.501(c)(3)-1(e). See also Better Business Bureau of Washington, D.C. 10 v. U.S., 326 U.S. 279 (1945); Presbyterian and Reformed Publishing Co. v. Commissioner, 743 F.2d 148 (3rd Cir. 1984); Living Faith, Inc. V. Commissioner, 950 F.2d 365 (1991).

³ See Treas. Reg. § 1.501(c)(1).

⁴ See generally, Rev. Rul. 64-182 (1964), and Living Faith, Inc. v. Comm’r, 950 F.2d 365 (7th Cir. 1991).

⁵ Rev. Rul. 64-182 (1964), and I.R.S. Priv. Ltr. Rul. 8042012 (July 3, 1980).

⁶ I.R.S. Gen. Couns. Mem. 38742 (June 3, 1981) (explaining the commensurate in scope test).

⁷ For further detail on the issue of staff time, see section on Volunteer Exception below.

⁸ Zagfly, Inc. v. Comm’r, 105 T.C.M. 1214 (2013).

⁹ Id.

¹⁰ Id.

¹¹ Living Faith, Inc., 950 F.2d 365.

¹² Id. (explaining that the “commercial hue” of the activities conducted are relevant).

¹³ B.S.W. Grp., Inc. v. Comm’r, 70 T.C. 352, 358 (1978).

¹⁴ Living Faith, Inc., 950 F.2d 365.

¹⁵ Id. at 376.

¹⁶ Id.

¹⁷ B.S.W. Grp., Inc. v. Comm’r, 70 T.C. 352, 358 (1978).

¹⁸ See IRS, Technical Advice Memorandum, TAM 9132005.

¹⁹ I.R.C. § 511(a)(2).

²⁰ I.R.C. § 512.

²¹ I.R.C. § 513.

²² C.F. Mueller Co. v. Comm’r, 190 F.2d 120 (3d Cir. 1951).

²³ Id. at 121.

²⁴ S. Rep. No. 2375, 81st Cong. 2d Sess. 27 (1950), 28-9.

²⁵ I.R.C. § 512(a)(1).

²⁶ I.R.C. § 513(c).

²⁷ I.R.S. Priv. Ltr. Rul. 9338043 (June 29, 1993).

²⁸ Id.

²⁹See Treas. Reg. § 1.513-1(c)(2).

³⁰ Veterans of Foreign Wars v. Comm’r, 89 T.C. 7, Rep. (CCH) 44022 (1987).

³¹ Id. at 29-34.

³² Id.

³³ Id.

³⁴ Treas. Reg. § 1.513-1(d)(2).

³⁵ U.S. v. American College of Physicians, 475 U.S. 834 (1986).

³⁶ Id. at 836.

³⁷ Id. at 849.

³⁸ Id.

³⁹ I.R.C. § 513(a)(1).

⁴⁰ St. Joseph Farms of Ind. Bros. of Congregation of Holy Cross, Southwest Province, Inc. v. Comm’r, 85 T.C. 9, Tax Ct. Rep. (CCH) 42191 (1985).

⁴¹ Id.

⁴² Shiloh Youth Revival Centers v. Comm’r, 88 T.C. 865 (1987).

⁴³ I.R.C. § 513(a)(2).

⁴⁴ See I.R.S. Priv. Ltr. Rul. 9720002 (May 16, 1997).

⁴⁵ Id.

⁴⁶ Id.

⁴⁷ Treas. Reg. § 1.513-1(b).

⁴⁸ The Hope School v. U.S., 612 F.2d 298.

⁴⁹ Id. at 303.

⁵⁰ Id. at 304.

⁵¹ I.R.C. § 513(i)(1).

⁵² I.R.C. § 513(i)(2)(A).

⁵³ Id.

⁵⁴ Treas. Reg. 1.513-4(c)(2)(iv).

⁵⁵ Treas. Reg. 1.513-4(c)(2)(v).

⁵⁶ See Treas. Reg. 1.513-4(f).

⁵⁷ Id.

⁵⁸ Id.

⁵⁹ I.R.C. § 513(f)(1).

⁶⁰ I.R.C. § 513(f)(2)(A)-(C).

⁶¹ Julius M. Israel Lodge of B’Nai B’rith No. 2113 v. Comm’r, 98 F.3d 190 (5th Cir. 1996).

⁶² Id. at 193.

⁶³ I.R.C. § 513(a)(3).

⁶⁴ I.R.C. § 513(h)(1)(B)(i).

⁶⁵ I.R.C. § 512(b).

⁶⁶ I.R.C. § 514.

⁶⁷ Treas. Reg. § 301.6033-2(i).

⁶⁸ See Notice 2007-45Notice 2007-45, as modified by Notice 2008-49Notice 2008-49

⁶⁹ I.R.C. § 511.

⁷⁰ For further details on how the Tax Cuts and Jobs Act of 2017 changed the UBIT requirements, see 85 FR 23172.