Understanding Unrelated Business Income

The Internal Revenue Code (IRC) Section 501 grants tax-exempt status to a variety of organizations. However, a tax-exempt entity, such as a nonprofit or educational organization, may still be liable for taxes if they receive income from unrelated business activities.

Unrelated business activities are basically defined as activities carried on by a nonprofit organization that is outside of the IRS-approved scope of said organization.

Unrelated Business Income (UBI) ensures that tax-exempt organizations compete fairly with taxable companies in profit-generating activities. The taxation of UBI (UBIT) makes tax-exempt entities think twice about engaging in business that is unrelated to their IRS-approved purpose.

Organizations have a lot to consider when determining if an activity is considered unrelated business, and potentially taxable.

Below is a example of UBI, related to litigation between the IRS and Mayo Clinic:

In 2018, a lawsuit was filed against Mayo Clinic alleging that certain debt financed income was subject to UBIT. Between 2018 and 2021, the district court and Eight Circuit Court of Appeals (Eight Circuit) went back and forth on their rulings, debating whether Mayo Clinic was an educational organization or not. If Mayo Clinic was determined to be an educational organization, then its debt-financed income would not be subject to UBIT.

To reach a decision, the court analyzed the following:

• Mayo’s primary purpose: The court ultimately concluded that Mayo’s systemwide entities were highly integrated and that Mayo’s subsidiaries conducted activities that supported the organization’s mission.
• Defining the term “primary”: The court noted that the Eighth Circuit left open the legal question of whether to interpret “primary” to mean a “substantial purpose” of the organization or its “most important purpose.” They concluded that “primary” means “substantial.”
• Was Mayo Clinic’s primary purpose educational? The court found that the clinic was founded with the purpose of providing medical education and that it has consistently maintained its educational purpose over time. Mayo’s educational purpose is reflected in its bylaws and governance documents. The court concluded that education is a substantial part of Mayo’s reason to exist and said it would’ve arrived at the same conclusion had the test been whether it was Mayo’s “most important” purpose.
• Did Mayo have any substantial noneducational purpose? A substantial non-educational purpose would destroy the UBIT exemption regardless of the number or importance of truly educational purposes. The court determined that Mayo didn’t have any substantial non-educational purposes.

Ultimately, Mayo Clinic was found to be an educational organization. As a result, the court entered judgment in favor of the Mayo Clinic and held that the debt-financed income was not subject to UBIT.

Undergoing litigation surrounding your organization can be taxing. It’s crucial to have a financial partner who is knowledgeable about your organization’s operations and what refunds, credits and deductions your organization is allowed.

If you’re looking for assistance in determining whether your organization’s activities are considered exempt from UBIT, we encourage you to schedule a one-on-one call with a tax expert from SST Accountants & Consultants. With more than 30 years of experience, our team ensures a complete understanding of industry standards and will provide your organization with personalized, professional excellence to support your long-term success.