Unrelated Business Income and How it Affects Your Ministry

Can the IRS tax your Sunday morning coffeehouse?

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.

Does It Apply to Us?

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.

Was the income derived from a trade or business? “Trade or business” is broadly defined as “any activity that generates income from the sale of goods or providing of services.” Nearly any income a ministry might collect (other than true donations) could qualify as “trade or business” income, even the sale of hot coffee.
Is the organization regularly engaged in the trade or business? A court would compare a ministry's involvement to the amount of time commercial businesses spend in the same type of activity. For example, a church that leases spaces in its parking lot—even one day per week all year long—is considered to “regularly engage in” the trade or business of commercial parking. Weekly coffeehouses also might meet this requirement.
Is the activity unrelated to the organization’s exempt purpose? To be tax-free, an activity must be “substantially related” to the church’s exempt purpose. This question has been heavily litigated and can be the most difficult to answer. Just because money earned from business activities supports an exempt purpose doesn't make the activities tax-exempt. A ministry must demonstrate that the activities further a purpose for which the organization is exempt, such as evangelism. While a ministry might see a coffee shop or fitness center as promoting fellowship or outreach, the IRS may see those activities as unrelated business operations. This would probably be even more likely if the church displays huge signs throughout town to promote its bookstore or coffee shop.

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.

Potential Exceptions

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.

Is There a Limit to How Much Can We Earn?

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.

Consult a Professional

Leaders shouldn’t assume that all income a nonprofit 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).