Tax-exempt 501(c)(3) organizations, such as museums and zoos, often operate gift shops as an ongoing part of their regular operations. If your organization earns income through such a gift shop, you’ll need to understand whether (and how much of) that income constitutes unrelated business taxable income—because if it does, you’ll be subject to income tax on the net income even though your organization as a whole is generally exempt from income tax.
Unrelated business income (UBI) is identified using a three-criteria test. UBI is, first, income from a trade or business activity with a profit motive that is (two) carried on regularly. Last, it is unrelated to the exempt purpose of the exempt organization. The primary determination then becomes whether a gift shop’s activity is related to the organization’s exempt purpose.
Separating Related from Unrelated Income
In an April 2014 private letter ruling, the IRS shed new light on the subject by drawing a distinction between goods that relate directly to an organization’s exempt purpose and those that do not. Those that contribute importantly to an organization’s purpose are exempt, while those that do not are taxable.
More specifically, a gift shop item that is utilitarian, ornamental, or a souvenir (related, for example, only to the city the shop was located in), is likely not related to the organization’s exempt purpose, and its sale generates UBI. On the other hand, an item that holds educational value related specifically to your organization—such as a topically relevant documentary, book, children’s toy, or reproduction of a piece of art—will likely be considered connected to your organization’s exempt purpose and therefore related.
In the situation the private letter ruling addressed, the taxpayer provided the IRS with descriptive literature or educational material for each item along with a statement regarding how the sale of each item contributed importantly to the achievement of the organization’s exempt purpose. As such, the IRS held that the sale of the items was substantially related to the museum’s exempt purpose and as a result didn’t generate UBI.
Note that according to IRS regulations, educational is defined as the instruction of the public on subjects useful to the individual and beneficial to the community. The simple sale of educational items by an exempt organization doesn’t automatically mean the activity is related to the organization’s exempt purpose. General educational materials on subjects unrelated to your organization’s purpose will be considered taxable.
For organizations that do operate gift shops, it may be helpful to establish nexus between your organization’s purpose and the goods sold in your shop should your tax position be called into question. Written material that accompanies your items—such as descriptive literature that educates the purchaser as to the item’s significance and relationship to the accomplishment of your exempt purpose—will help establish nexus between your organization and the goods you sell, directly connecting the sale to your exempt purpose and therefore making it more likely the sale will not be considered UBI.
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The tax laws surrounding unrelated business income can be complex. To learn more about the tax status of your gift shop or similar operations, or for insight on establishing and documenting nexus with your organization’s exempt purpose, contact your Moss Adams not-for-profit professional.