A tax-exempt organization is exempt from tax on income that furthers its purpose. Income from a regularly conducted business that is not substantially related to that purpose is a different matter. That income is subject to the unrelated business income tax (UBIT) and reported on Form 990-T. The financial statement audit does not opine on tax compliance, but unrelated business activity affects the tax liability, the disclosures and the auditor's risk assessment, so it belongs in the planning conversation with every nonprofit client.
This guide covers the definitions in the Internal Revenue Code, the main exclusions, the reporting trigger and the audit steps. It paraphrases the statute and IRS guidance and is not tax advice; the Code sections and the Form 990-T instructions control.
The definition
Under IRC 512(a)(1), unrelated business taxable income is the gross income derived by the organization from any unrelated trade or business, less the related deductions, subject to the modifications in section 512(b). The IRS describes unrelated business income as income from a trade or business that is regularly carried on and is not substantially related to the organization's exempt purpose.
Under IRC 513(a), an unrelated trade or business is one the conduct of which is not substantially related, aside from the need for income or the use of the profits, to the exercise or performance of the organization's exempt purpose. The organization's need for the money, and what it does with it, do not make an activity related.
Three questions come out of the definition: is it a trade or business, is it regularly carried on, and is it substantially related to the exempt purpose. The auditor is not deciding the legal answer for the client, but should see that management has asked.
Statutory exceptions
Section 513(a) carves out three activities that are not treated as an unrelated trade or business:
- Volunteer labor. An activity where substantially all the work is performed for the organization without compensation.
- Convenience. For section 501(c)(3) organizations and certain colleges and universities, an activity carried on primarily for the convenience of members, students, patients, officers or employees.
- Donated merchandise. The sale of merchandise, substantially all of which was received by the organization as gifts or contributions.
A thrift shop that sells donated goods is the classic case for the third exception. A gift shop selling purchased goods to the public is a different fact pattern and invites the question.
Modifications
Section 512(b) excludes certain income from the computation, along with related deductions:
- Passive investment income: dividends, interest, payments with respect to securities loans and annuities.
- Royalties.
- Rent from real property. The exclusion does not apply if more than 50 percent of the total rent under the lease is attributable to personal property, or if the rent depends in whole or in part on the income or profits derived by any person from the leased property, other than an amount based on a fixed percentage of receipts or sales.
The exclusions are not absolute. The statute contains further rules, including for income from debt-financed property, that this guide does not cover. When a client holds mortgaged real estate or an operating business in a partnership, escalate the question to the tax specialist.
Separate computation by activity
Section 512(a)(6) requires an organization with more than one unrelated trade or business to compute unrelated business taxable income separately for each. Net operating loss deductions are computed separately for each trade or business too, so a loss in one activity does not reduce the income of another. The results are summed, and the specific deduction of $1,000 under section 512(b)(12) applies once to the total.
The practical effect for the accounting records is that the books need to support activity-level results. A single ledger account called "Unrelated income" that blends advertising, a gift shop and an event will not support the computation. Ask whether the client tracks revenue and directly connected expenses by activity, and how shared costs are allocated.
The Form 990-T trigger
An organization with $1,000 or more of gross income from an unrelated business must file Form 990-T, in addition to its annual return, Form 990, 990-EZ or 990-PF. It must pay estimated tax if it expects to owe $500 or more for the year. The consolidated return rules do not apply to exempt organizations except those with title holding companies. The 2025 Form 990-T instructions set the due date at the 15th day of the 5th month after the end of the tax year for most organizations. An employees' trust under section 401(a), an IRA, a Roth IRA, a Coverdell ESA or an Archer MSA files by the 15th day of the 4th month. A due date that falls on a Saturday, Sunday or legal holiday moves to the next business day, and Form 8868 requests an automatic extension. Check the instructions for the tax year in question.
Note that the $1,000 trigger is based on gross income from the unrelated business, which the instructions define as gross receipts minus the cost of goods sold. It is not net income, and an activity that loses money can still require a return.
What the auditor does
The auditor should address unrelated business income in three places.
Risk assessment. Ask about activities beyond the core mission: advertising and sponsorship, rentals, travel programs, retail sales, fee-based services open to the public, and income from partnerships. Read the board minutes and the prior-year Form 990-T, if one was filed. Compare the revenue streams in the general ledger with the list of exempt-purpose activities.
Tax liability and disclosures. Determine whether an income tax liability or a related accrual is needed, and obtain the client's computation. Confirm that estimated tax payments are recorded and that any refund or balance due ties to the return. Where management has taken a position that an activity is related, consider whether the position affects the financial statements and disclosures, and whether the audit file should show management's reasoning.
Alignment between the return and the statements. The organization's Form 990 and Form 990-T are filed on information the financial statements also use. Differences in revenue classification or expense allocation between the statements and the returns need explanations. See nonprofit financial statements under ASC 958 for the broader context, and the glossary page on unrelated business income tax.
Audit steps in sequence
- Obtain the list of revenue streams and classify each as related or potentially unrelated, noting management's basis.
- Identify regularly carried on activities with third-party customers outside the mission.
- Obtain the prior Form 990-T and the current computation, if any.
- Test that revenue and directly connected expenses are tracked by activity.
- Recompute the tax from the client's schedule, or review the specialist's computation.
- Test estimated tax payments and the year-end accrual.
- Document conclusions and communicate any control weakness in tracking and allocation to those charged with governance.
Common issues
- Sponsorship income recorded as a contribution without analysis of what the sponsor receives.
- A gift shop or café treated as related without a documented basis.
- Rental income from a facility with personal property components.
- No activity-level cost tracking, leaving allocations of shared expenses unsupported.
- A return not filed because net income was negative when gross income met the trigger.
CORAA prepares ready-to-review audit files for US CPA firms, including revenue-stream classification schedules and tie-outs of the books to the returns. The firm keeps the client, the review and the signature. See /us.
Sources
- Internal Revenue Service, Unrelated business income tax: https://www.irs.gov/charities-non-profits/unrelated-business-income-tax
- Internal Revenue Service, About Form 990-T, Exempt Organization Business Income Tax Return: https://www.irs.gov/forms-pubs/about-form-990-t
- Internal Revenue Service, Instructions for Form 990-T (2025): https://www.irs.gov/pub/irs-pdf/i990t.pdf
- Legal Information Institute, 26 U.S.C. 512, Unrelated business taxable income: https://www.law.cornell.edu/uscode/text/26/512
- Legal Information Institute, 26 U.S.C. 513, Unrelated trade or business: https://www.law.cornell.edu/uscode/text/26/513
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error