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It seems innocent enough and the right thing for your church to do: rent out some excess space or land, open a bookstore, or start a childcare center. Then, praise God, the ministry grows tremendously.

Your competitors may not be so pleased with your business operation. You didn't think you were operating a business, but that's how bookstores down the road view what you're doing. To them, you're a retailer or service provider, not a ministry. And one big advantage you've got over them is that your income is tax-exempt.

When Ministry Becomes Business
Churches and religious organizations start revenue-generating operations for two reasons. For some, the activity starts as a ministry and is intended to remain that, but the ministry generates some nonvital cash flow. For others, cash flow is critical to the success of the ministry.

The difference between the two types of cash flow is critical to the Internal Revenue Service. The IRS has been paying closer attention to the business operations of tax-exempt organizations to determine whether each activity is an extension of the mission of the organization or a freestanding business with income that should be taxed.

The line between the two can be fuzzy. "Most churches don't engage in activities that would generate unrelated business income," says Chip Watkins, an attorney with Webster, Chamberlain, & Dean in Washington, D.C. Yet he cautions, "Larger churches, because of their complexity, may have commercial activities unrelated to specifically religious or educational purposes. Or there may be unrelated business income generated by certain dealing in debt-financed land or rental of a debt-financed facility."

The IRS allows nonrelated business income. But income—as distinct from donations—is taxable if it stems from an activity not "substantially related" to the organization's activities and income. What does that mean? According to IRS regulations, "substantially related" means the trade or business must "contribute importantly to the accomplishment of the exempt purpose of an organization."

The IRS applies three standards when considering whether the activities of tax-exempt organizations are taxable. Income is presumed to be exempt from taxes unless the activity

1. Is not substantially related to the organization's exempt purpose or function,
2. Is a trade or business, and/or
3. Is regularly carried on.

In addition, the income must amount to at least $1,000 in a fiscal year. So how should churches interpret these three points?

The unrelated business income (UBI) issue surfaced in the 1970s and 1980s when nonprofit hospitals aggressively developed revenue-producing activities. For example, the rehabilitation units of some hospitals had exercise equipment standing idle at certain times of the day. Hospital administrators thought, Why not open a community health club and charge membership fees? For-profit club owners objected because the hospital's tax-exempt status provided an advantage. In another example, colleges developed textbook depots into full-service retail bookstores, rankling other booksellers who paid taxes on their income.

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