Federal tax law distinguishes between activities that relate to the exempt functions of a nonprofit and those activities that are unrelated. Gross revenues that are gained on unrelated business activities are subject to taxation. Because most nonprofit organizations conduct some sort of business, most of these organizations must determine whether any aspect of their businesses may be characterized as an unrelated business activity.
In order for income of a tax-exempt organization to be taxable, the income must be produced from a trade or business that the organization carries on regularly. An organization carries on a trade or business regularly if it does so frequently and continually, as opposed to sporadically or infrequently. The income must also be unrelated to the purpose for which the organization has been formed and which forms the basis for the tax exemption. Income from activities that bear a substantial relationship to the purpose of the nonprofit entity are not subject to tax, while income from activities that do not bear a substantial relationship to the purpose of the entity are subject to taxation.
Revenue that a tax-exempt organization gains on an unrelated business activity is subject to the federal corporate income tax that applies to non-exempt entities. An exempt organization is entitled to certain deductions related to the business that earned this income, much like a for-profit entity may be entitled to deductions for certain activities.