CPA Exam — REG (Regulation)Federal Taxation of EntitiesEasy
A client, a tax-exempt organization recognized under IRC Section 501(c)(3), operates a small cafe on its premises. The cafe is open to the public and serves coffee, pastries, and light lunch fare. The cafe's primary purpose is to provide vocational training for individuals with disabilities, who comprise 90% of the cafe's workforce. All profits from the cafe are used to fund the organization's charitable programs. Is the income generated by the cafe subject to Unrelated Business Income Tax (UBIT)?
- AYes, because the cafe generates a profit, which is considered unrelated business income.
- BYes, because the cafe is open to the public and competes with commercial businesses.
- CNo, because all profits are used to fund the organization's charitable programs.
- DNo, because the cafe's activity is substantially related to the organization's exempt purpose of vocational training.
Show answer & explanationAnswer & explanation
Correct answer: D. No, because the cafe's activity is substantially related to the organization's exempt purpose of vocational training.
The cafe's operation, while commercial in nature, is substantially related to the organization's exempt purpose of providing vocational training for individuals with disabilities. Therefore, the income is not subject to UBIT.
Why the other options are wrong
- A. Profit generation alone does not trigger UBIT if the activity is substantially related to the exempt purpose.
- B. While it competes, the 'substantially related' test takes precedence for UBIT determination.
- C. The destination of income is a factor, but the 'substantially related' test is primary for UBIT determination.
UBIT - Substantially Related Activity
Income from a trade or business regularly carried on by a tax-exempt organization is not subject to Unrelated Business Income Tax (UBIT) if the activity is substantially related to the organization's exempt purpose.
- An activity is 'substantially related' if it contributes importantly to the accomplishment of the organization's exempt purposes.
- The size and extent of the activities involved must be considered in relation to the nature and extent of the exempt functions.
- Vocational training programs are a common example of substantially related activities.
Memory trick: UBIT: Unrelated, Business, Important, Taxed. Is it really for the mission?