Many churches operate coffeehouses, bookstores, and other small businesses that attract guests and serve the needs of members. While the Internal Revenue Service (IRS) generally doesn’t tax church-related activities, not all ministry fundraising is exempt from IRS scrutiny.
The frothy hiss of a cappuccino machine greets churchgoers in hundreds of cities as they arrive for Sunday services. Drop a “suggested donation” in the cash jar, and members can enter the sanctuary sipping a steaming, hot latte. However, many churches don’t realize that if the coffeehouse is not operated exclusively for the ministry’s 501(c)(3) purposes, it is likely considered by the IRS to be a for-profit entity.
That’s one of the main reasons legislators enacted the Unrelated Business Income Tax (UBIT). The tax addresses concerns that tax-exempt organizations have an unfair competitive advantage over commercial businesses. UBIT subjects churches to taxation on business activities not substantially related to their tax-exempt purpose.
There are three questions that determine whether UBIT applies to a ministry’s income. If you can answer “yes” to all three questions, then you may owe unrelated business income tax.
It is important to remember that the IRS and the courts will ultimately determine what is or is not “substantially related” to your ministry’s exempt purpose.
Example: A church’s youth group sells fireworks for a few weeks each summer as a fundraiser. State law restricts the sale of fireworks by vendors without special licenses to the same few weeks. The sale of fireworks is undeniably a trade or business.
Because the youth group sells fireworks each year during the same period when other for-profit vendors can sell fireworks, the IRS is very likely to determine that the youth group is regularly engaged in the trade or business of selling fireworks. Finally, the sale of fireworks has nothing to do with the church’s exempt purpose, other than to raise funds.
There are two potential exceptions to the applicability of UBIT.
Exception #1: If “substantially all” of the labor involved in the trade or business was provided by volunteers.
Exception #2: If “substantially all” of the merchandise being sold has been donated to the organization. This exception would likely apply to bake sales, craft markets, thrift stores, etc.
While some ministries see unrelated business income as something to be avoided at all costs, others reason that it's better to have taxable income than no income at all. Ministries should be cautious about adopting the second viewpoint, however, because earning too much unrelated business income could cost the ministry its tax-exempt status.
Here's a general rule of thumb to follow: If more that 15 percent of your ministry's total earnings come from unrelated business income, your ministry should consider the risk of losing its tax-exempt status and discuss this concern with a tax professional.
Leaders shouldn’t assume that all income a non-profit ministry generates is automatically tax-exempt. The best way to make that determination is to consult with a trusted tax, financial, or legal professional.
Church Law & Tax’s resource, Church's Coffee Shop Fails to Qualify for Tax-Exempt Status, provides additional helpful information (may require a subscription).
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