UBIT Donated Goods Exception for 501(c)(3) Organizations

A 501(c)(3) can sell donated goods without owing unrelated business income tax by relying on the UBIT donated goods exception in Internal Revenue Code Section 513(a)(3), which removes from the definition of “unrelated trade or business” any sales activity where substantially all of the merchandise was received as gifts or contributions.¹ Without it, a thrift store’s net profits would be taxed at the 21 percent corporate rate, because retail sales are not themselves a charitable purpose. The IRS has confirmed the exception applies broadly to thrift shop operations run by exempt organizations.²

The exception is all-or-nothing for any given retail operation. If it qualifies, every dollar of sales revenue drops out of the UBIT calculation. If it fails, the entire operation’s net income becomes unrelated business taxable income under IRC Section 511.³ That binary structure makes the threshold one of the most consequential lines in nonprofit tax law.

What “Substantially All” Means in Practice

Section 513(a)(3) uses the phrase “substantially all” without defining it, and the IRS has not published a regulation setting an exact percentage for this provision. Tax advisors and the nonprofit community widely treat 85 percent as the working benchmark: at least 85 percent of the merchandise sold should come from donations rather than purchases. That figure draws from how the IRS reads “substantially all” in other tax contexts, but there is no published ruling applying it specifically to Section 513(a)(3).

Organizations that buy supplemental inventory to fill gaps on the shelves need to be careful. If purchased goods drift above roughly 15 percent of total merchandise, the entire retail operation risks losing the exception. A single quarter of heavy purchasing can push the annual figure past the threshold, so the safer approach is to track the donated-versus-purchased ratio continuously rather than checking it once a year. When purchased inventory is necessary, keeping it well below 15 percent leaves a margin of safety.

What Counts as Donated Merchandise

The statute covers “merchandise received as gifts or contributions,” which sweeps in almost any tangible property donated without the donor receiving compensation or services in return. Clothing, furniture, appliances, books, electronics, artwork, jewelry, sporting goods, vehicles, and seasonal decorations all qualify. The item’s value or condition does not matter, and neither does whether the donor claims a charitable deduction on their own return. What matters is the source: the organization received the item as a gift rather than buying it.

Items donated by businesses clearing excess inventory qualify on the same footing as items from individual households, provided the transfer is a genuine gift. Goods contributed for a fundraising auction also qualify if they were donated to the organization rather than purchased for the event. Merchandise bought from a wholesaler, a liquidation sale, or another retailer is not donated, regardless of how low the price.

Two Related Exceptions That Can Save an Operation

Section 513(a) contains two other exceptions that often overlap with the donated goods rule. They are evaluated separately, so qualifying under any one is enough to exclude the income.

Volunteer labor under Section 513(a)(1) excludes any trade or business in which substantially all the work is performed by unpaid volunteers. A charity shop staffed almost entirely by volunteers qualifies regardless of where its merchandise came from, so this rule can protect the income even when purchased goods exceed the donated-goods threshold.¹
Convenience of members under Section 513(a)(2) excludes a business run primarily for the convenience of members, students, patients, officers, or employees of a 501(c)(3). This is less common for thrift stores but matters for hospital gift shops, campus bookstores, and similar operations.¹

What It Costs When the Exception Fails

If a retail operation flunks the substantially-all test, its net income becomes unrelated business taxable income (UBTI), taxed at the flat 21 percent corporate rate under IRC Section 11.³ UBTI is gross income from the unrelated business minus directly connected expenses, computed with the modifications spelled out in IRC Section 512.⁴

Every exempt organization gets a $1,000 specific deduction against total UBTI under Section 512(b)(12).⁴ Dioceses and similar religious structures get an additional $1,000 deduction for each local unit. The deduction is modest, but for a small operation with thin margins, it can reduce or eliminate the tax bill entirely. Some states also impose their own tax on UBTI, so an organization operating in a state with a corporate income tax should check whether UBTI triggers a state-level obligation.

Records That Hold Up Under Audit

Detailed records are the practical backbone of the exception. If the IRS questions whether substantially all merchandise was donated, the organization needs to prove it with data, not estimates. An effective system tracks three things for every item that enters inventory: the source (donated or purchased), the date received, and a description of the item.

Each item should carry an internal tag or code identifying whether it was donated or bought, so management can calculate the donated-goods ratio at any point during the year. Aggregating these figures monthly or quarterly catches a drift toward purchased inventory early. Organizations that rely on a year-end snapshot often discover a problem too late to correct it.

Donor acknowledgment letters provide a second layer of evidence. They should include the date of the gift and a general description of the items, though they do not need to assign a dollar value. Keeping the acknowledgment letters and the corresponding inventory entries linked in a centralized, backed-up system makes it straightforward to reconstruct the data trail for any period the IRS asks about.

Filing Form 990-T Even When No Tax Is Owed

Any exempt organization with $1,000 or more in gross income from a regularly conducted unrelated trade or business must file Form 990-T. Gross income here means gross receipts minus cost of goods sold. Even when the donated goods exception eliminates all of the tax, the organization still files the form, reports the revenue, and applies the exclusion so the taxable amount is zero. Filing must be done electronically.⁵

For calendar-year organizations, Form 990-T is due May 15, with an extended deadline of November 15 if the organization requests an extension.⁶ Fiscal-year filers use the same pattern: the return is due by the 15th day of the fifth month after the tax year ends. If a due date lands on a weekend or legal holiday, it shifts to the next business day.

The figures reported on Form 990-T need to match the organization’s internal inventory records. The IRS uses the form to verify claimed exclusions, so any mismatch invites scrutiny. Whoever prepares the return should have direct access to the donated-versus-purchased tracking data.

Penalties, Interest, and How Far Back the IRS Can Reach

An organization that owes UBIT but fails to file Form 990-T on time faces a penalty of 5 percent of the unpaid tax for each month the return is late, up to 25 percent. For returns more than 60 days overdue, the minimum penalty is the lesser of the tax due or $525. Late payment of tax after filing triggers a separate penalty of 0.5 percent per month on the unpaid balance, also capped at 25 percent.⁵

Interest accrues on top of penalties. The federal underpayment rate for the quarter beginning April 1, 2026, is 6 percent, compounding daily, and large corporate underpayments face 8 percent.⁷ These charges add up quickly when an organization incorrectly claimed the exception for several years, because the IRS can assess penalties and interest going back to each return’s original due date.

The IRS generally has three years from the date a return was due or filed, whichever is later, to assess additional tax. That window extends to six years if the organization reported 25 percent or less of its gross income, which could happen if income was excluded that did not actually qualify under Section 513(a)(3).⁸ There is no statute of limitations at all for fraudulent returns or returns that were never filed. Given these timelines, retaining inventory records, donor acknowledgment letters, and Form 990-T workpapers for at least seven years is the standard protective practice.

An organization that expects its UBIT liability to be $500 or more for the year must also make quarterly estimated tax payments.⁵ That situation arises when the donated goods exception does not fully cover the retail income, or when the organization has other taxable unrelated business activities. Falling short of the required installments triggers an underpayment penalty at the same federal rate that applies to other underpayments.

1
Office of the Law Revision Counsel. 26 USC 513 – Unrelated Trade or Business
2
Internal Revenue Service. Unrelated Business Income Tax Exceptions and Exclusions
3
Office of the Law Revision Counsel. 26 USC 511 – Imposition of Tax on Unrelated Business Income
4
Office of the Law Revision Counsel. 26 USC 512 – Unrelated Business Taxable Income
5
Internal Revenue Service. Instructions for Form 990-T
6
Internal Revenue Service. Return Due Dates for Exempt Organizations – Form 990-T (Corporations)
7
Internal Revenue Service. Internal Revenue Bulletin: 2026-08
8
Internal Revenue Service. Time IRS Can Assess Tax