EA Part 2 Tax-Exempt Organizations: 501(c) Rules and Unrelated Business Income

Tax-exempt organizations represent a smaller but consistently tested portion of Part 2. The exam expects you to know the requirements for tax-exempt status, the distinction between public charities and private foundations, and — most heavily tested — when an exempt organization owes tax on unrelated business income. These questions are answerable with focused preparation even if you have no background working with nonprofits.

501(c)(3) Requirements

Section 501(c)(3) of the Internal Revenue Code grants tax exemption to organizations that meet all of the following requirements:

Organizational test: The organization must be organized exclusively for one or more exempt purposes — religious, charitable, scientific, testing for public safety, literary, educational, fostering national or international amateur sports competition, or prevention of cruelty to children or animals. The governing documents (articles of incorporation or trust agreement) must limit the organization's activities to these purposes and require that assets be distributed to other exempt organizations upon dissolution.

Operational test: The organization must be operated primarily for exempt purposes. The primary activities — judged by time, effort, and resources — must further the exempt purpose. Insubstantial non-exempt activities are tolerated; substantial non-exempt activities can jeopardize exemption.

Private benefit prohibition: No part of net earnings may inure to the benefit of any private shareholder or individual. Reasonable compensation to employees and service providers is permitted; excessive payments to insiders are not.

Political activity prohibitions: 501(c)(3) organizations are absolutely prohibited from participating in or intervening in political campaigns on behalf of or in opposition to any candidate for public office. Violation can result in immediate loss of exemption. Legislative lobbying is permitted in an insubstantial amount (or more if the organization makes a Section 501(h) election limiting lobbying expenditures).

To obtain recognized exempt status, the organization files Form 1023 (or Form 1023-EZ for smaller organizations). Churches and small organizations meeting certain requirements may qualify for exemption without filing, though applying is standard practice.

Public Charity vs. Private Foundation

Every 501(c)(3) organization is either a public charity or a private foundation — the distinction matters because private foundations face substantially more restrictive rules.

Public charities receive support broadly from the public (churches, schools, hospitals) or function as supporting organizations. They are subject to less IRS oversight and fewer operational restrictions.

Private foundations are typically funded by a single donor, family, or corporation and do not meet the public support tests. They are subject to:

Minimum distribution requirement: Must distribute at least 5% of the fair market value of non-charitable-use assets annually for charitable purposes
Self-dealing prohibitions: Transactions between the foundation and disqualified persons (substantial contributors, foundation managers, etc.) are prohibited
Excess business holdings rules: A foundation and its disqualified persons cannot together own more than 20% of any business
Jeopardizing investment rules: Investments that jeopardize the foundation's exempt purpose can trigger excise taxes
Taxable expenditure rules: Expenditures for lobbying, political activity, or non-charitable grants without adequate safeguards are taxable

Private foundations file Form 990-PF rather than Form 990.

Unrelated Business Taxable Income (UBTI)

Tax-exempt organizations are not universally exempt from income tax. When an exempt organization regularly carries on a trade or business that is not substantially related to the exempt purpose that justifies the exemption, the income is unrelated business taxable income (UBTI) and is taxed at regular corporate income tax rates (21%).

Three elements must all be present for income to be UBTI:

It is income from a trade or business
The trade or business is regularly carried on
The trade or business is not substantially related to the organization's exempt purposes

Important Exceptions to UBTI

Several categories of income are excluded from UBTI even if the activity would otherwise qualify:

Passive income: Dividends, interest, annuities, royalties, and capital gains are generally excluded
Rents from real property: Generally excluded, unless the property is subject to acquisition indebtedness (debt-financed property rules bring this income into UBTI)
Volunteer workforce: Activities conducted substantially entirely by volunteers are excluded
Donated merchandise: Sales of merchandise substantially all of which was received as charitable contributions are excluded (e.g., a thrift store operated by a charity)
Convenience exception: Businesses operated primarily for the convenience of members, students, patients, officers, or employees of the exempt organization are excluded

Common UBTI Examples

An exempt hospital running a parking garage open to the general public
A university operating a hotel that rents rooms to the public
A trade association selling mailing lists to nonmembers
An exempt organization earning income from debt-financed real property

Form 990-T

Exempt organizations with $1,000 or more of gross UBTI file Form 990-T to report and pay the tax. The filing requirement applies even if the organization owes no tax due to deductions. Private foundations and tax-exempt trusts have different due dates than other exempt organizations.

Annual Filing Requirements: Form 990

Most 501(c)(3) organizations must file an annual information return with the IRS. The form used depends on size:

Form 990-N (e-Postcard): Organizations with gross receipts normally $50,000 or less
Form 990-EZ: Organizations with gross receipts below $200,000 and total assets below $500,000
Form 990: All others

Churches and certain church-affiliated organizations are not required to file Form 990. Failure to file for three consecutive years results in automatic revocation of tax-exempt status.

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