By David O. Awe (CPA, MBA)
Churches and religious organization are automatically exempted from tax payment on the net income from their exempt activities. Unlike almost all other non-profit organizations, churches enjoy these tax exemptions even if they have not obtained the exempt status determination letter under section 501 (c) 3 from the Internal Revenue Codes. This does not mean that the church cannot engage in profitable ventures. Sometimes churches find it expedient to engage in providing goods and/or services as a way of generating income. These activities frequently do not directly relate to the church’s exempt purpose which is to propagate the gospel of Christ. This is permitted by the Internal Revenue Service (unless a substantial part of the church’s resources are committed to the activities). However, income generated from such unrelated trading activities is subject to Unrelated Business Income Tax (UBIT).
According to IRS publication 528, Unrelated Business Income is “Income from trade or business that is regularly carried on by an exempt organization and that is not substantially related to the performance by the organization of its exempt purpose or function” These activities must involve sale of product or performance of services on a regular basis in a way similar to commercial ventures and for the purpose of generating income. In determining whether the business activity is substantially related to the organization’s exempt purpose, the relationship between the business activities from which the income is generated and the achievement of the church’s exempt purpose has to be considered. Unless a causal relationship can be established, the business will be considered unrelated. It is not enough that the income from such trading activities is used to finance the exempt purpose; it must contribute importantly to the achievement of the exempt purpose.
Some trading activities of the church are clearly related. For example, publication of Christian literature, operation of bookshops where religious books, tapes and CDs are sold and reproduction of sermons in tapes, CDs and DVDs for sales to church member and the public. These activities are without doubt directly connected to the church exempt purpose. Income from them is therefore not taxable. The status of some other activities such as schools and day care services is not easily determinable but in most cases they will pass as being related. Other activities such as running a furniture store, an oil change business or restaurant would be clearly outside the direct purpose of the church and profit from them would be taxable. It is very important for church organization to understand the tax implication of whatever trading activities it is going into so as to determine potential tax liabilities.
The internal revenue service specifically excludes some activities from unrelated business income tax. These activities include the following among others:
- Volunteer Labor. Where the trade is carried out with unpaid labor, the business will not be considered unrelated. For example a thrift store operated by a church where all the attendants are volunteer members of the church will not be considered as unrelated business and the income would not be subject to unrelated business income tax.
- Members’ convenience. Activities carried out principally for members’ convenience would not be considered unrelated. For example a vending machine placed in the church lobby. Income from this would not be subject to UBIT.
- Donated merchandize. A trade in which substantially all the items are gifts or contribution is not unrelated. Example is garage sales in which clothing and other materials sold to the public are contributed by members. Another example is the thrift store where goods donated my members and the general public is sold for profit.
- Distribution of low cost Sales. Unrelated business income does not include income made through activities relating to distribution of low cost articles incidental to soliciting charitable contribution.
- Exchange or rental of member list. Income from the exchange or rental of members or donor list is also not unrelated and would not be taxable.
The following incomes are specifically excluded from unrelated business income:
- Interest, dividend, annuities and other income from the church’s routine investments are not subject to UBIT.
- Royalties. This includes trademarks, copyrights and trade names.
- Gains and losses from disposition of property.
- Rental Income. Rent from real property is excluded from unrelated business income with the exception of rent from properties with outstanding mortgage.
Tax and Return Filing
All organizations including churches with unrelated business income of $1000 or more are subject to tax on the net income at corporate tax rate. A church with unrelated business income must file form 990-T on which all income from unrelated businesses must be reported. The church should make estimated tax payments if it expects tax on unrelated business to be a least $500. For churches with December year end, estimated taxes are due on the 15th day of April, June, September and December. Tax return in due on the 15th day of the 5th month after the end of the organizations year. All tax law provisions applicable to corporate tax including accounting basis, accounting period, assessment and collection procedures and penalties are equally applicable to unrelated business income.
David O. Awe is a specialist in church accounting, tax and compliance.