Unrelated Business Income Tax: Allocating Expenses

Despite being tax-exempt entities in the eyes of the IRS, nonprofits are subject to income tax on unrelated business income. The amount of tax owed – commonly referred to as “UBIT” – is based on the unrelated business income revenue less expenses, but figuring out how to allocate an organization’s expenses to taxable activities can be complicated. Still, there are several common methods used to allocate costs to unrelated business income. 

Defining Unrelated Business Income  

In general, nonprofits owe income tax on profits from business activities that are a) regularly conducted (even if seasonally) and b) aren’t closely tied to their mission, formally called their exempt purpose. The federal unrelated business income tax rate is a flat 21%, the same as the federal corporate tax rate. Examples of activities that may generate unrelated business income include: 

• Weddings held at a nonprofit art gallery 

• Public parking in a lot owned by a nonprofit museum 

• Private events hosted by nonmembers held at a nonprofit country club 

A good rule of thumb for determining if a business activity is an unrelated business activity is to consider whether it’s competing with a for-profit business. For example, a nonprofit university’s cafe that’s open to the public is likely in competition with other local coffee shops. Since the sale of coffee and pastries is unrelated to the university’s exempt purpose, the cafe’s income would be considered unrelated business income. 

There are some named exceptions. The following do not generate unrelated business income: 

• Income from investments, royalties, dividends, capital gains, and interest 

• Business activities run by volunteer labor 

• Business activities for the convenience of members, such as a school cafeteria 

• The sale of donated merchandise, such as a Thrift Store 

• Rental real estate (unless debt was used to acquire the property) 

There’s plenty of gray area, though. Does a nonprofit museum’s gift shop generate unrelated business income? Perhaps, but there are a variety of factors that could impact that determination. It’s not one-size-fits-all which is why we recommend Talking to a nonprofit tax advisor about the potential tax effects of any contemplated business activities. 

Calculating Unrelated Business Income 

The taxes owed on unrelated business income are generally based on the activity’s revenue minus related expenses. The amount may be further reduced by tax credits and carryovers of prior-year losses. 

Revenue is typically simpler to track, but identifying related expenses can sometimes be challenging. Particularly when the same resources are used for both taxable and nontaxable purposes. 

Let’s say you run a nonprofit museum that regularly rents its atrium for private events after the museum closes for the evening. Revenues may include event space rental fees and catering fees. Expenses include the labor of staff who worked during the event and food costs – these are considered direct expenses. 

However, you can also include indirect expenses to offset your taxable event revenue. You may further reduce your unrelated business income by applying a portion of the costs shared between your taxable and nontaxable activities. These shared costs may include: 

• Supplies 

• Utilities (electricity and Wi-Fi, for example) 

• Depreciation for furniture used during the event 

• A salary paid to an event planner who coordinates taxable and nontaxable events 

Methods For Allocating Expenses to Unrelated Business Income 

Per IRS guidance, expenses related to both exempt and nonexempt purposes can be allocated on any reasonable basis. Here are three common methods used in practice: 

• Gross to gross: The ratio of gross unrelated business revenue to gross total revenue. 

• Percentage of effort: The ratio of hours an employee spent on unrelated business income activity to the employee’s total hours 

• Percentage of usage: The ratio of time that a facility is used for unrelated business income activity to total hours of facility usage 

Example: Allocating Expenses to Unrelated Business Income 

Let’s say your nonprofit has $500,000 in revenue this quarter from event space rentals, $150,000 of which is from events unrelated to the exempt purpose (i.e. weddings, unrelated business conventions). Expenses incurred solely due to unrelated events, the direct expenses, total $50,000. 

Out of the 90-day quarter, the space held taxable event rentals for 20 days. Two full-time employees of the organization split their time between exempt purpose events and unrelated events, and this quarter each spent about 25% of their time on unrelated business income activities. The organization incurs the following indirect expenses – benefiting both unrelated event space rentals and exempt purpose activities: 

• $5,000 in supplies 

• $20,000 in utilities 

• $5,000 in depreciation 

• $150,000 in salaries, 2 employees 

Here’s how a tax advisor may recommend allocating these expenses: 

Expense	Allocation method	Calculation	Unrelated business expense allocation
$5,000 in supplies	Gross to gross	$5,000 × ($150,000 ÷ $500,000)	$1,500
$20,000 in utilities	Percentage of usage	$20,000 × (20 days ÷ 90 days)	$4,444
$5,000 in depreciation	Percentage of usage	$5,000 × (20 days ÷ 90 days)	$1,111
$150,000 in salaries	Percentage of effort	$150,000 × 25%	$37,500
Total			$44,555

Based on this expense allocation, the nonprofit’s unrelated business income is $55,445 ($150,000 in revenue – $50,000 in direct expenses – $44,555 in allocated expenses). 

An experienced tax professional can determine the best method for each expense shared between your exempt and nonexempt activities – it may not be any of the ones covered by this article. Not only can an experienced tax advisor appropriately allocate costs to your unrelated business income activities, but they can also help ensure that you’ve identified all the possible shared expenses that can reduce your organization’s tax burden. 

Smith + Howard: Expert Nonprofit Tax Advisors  

Nonprofits come in all shapes and sizes, but they all exist for a similar reason: to promote a common good. At Smith + Howard, we empower our nonprofit clients to pursue their missions by helping them comply with nonprofit tax rules and maximize their impact.  

Smith + Howard’s specialized nonprofit tax advisors proudly provide a broad range of tax and assurance services to clients nationwide. To learn more about Smith + Howard’s nonprofit accounting services, contact us.