Are you tired of endless grant applications, expenditure tracking, report writing? Do you know that you have great services and could probably market more great services or products through a natural expansion of your programs? Are you thinking it would just be so much easier if you could raise your own revenue through earned income?
In this challenging fundraising climate, organizations are becoming more creative about how they bring money in the door. Creative thinking is great, and the desire for revenue with no restrictions on use is attainable, but requires careful planning to understand all the potential results.
Income-generating activities may involve tax implications, including taxes on possible unrelated business income, and might even impact tax-exempt status. Nonprofits must understand the legal considerations for monetizing existing resources (e.g., licensing and renting space) and carefully control and manage the corporate structure of social enterprises. These issues are interrelated and should be analyzed thoughtfully and thoroughly.
Unrelated Business Income Tax
It’s important for 501(c)(3) nonprofits to understand that not all revenue is tax-exempt. Income is taxable to otherwise tax-exempt nonprofits when it results from:
- A trade or business (in which there is a profit motive) that is:
- Regularly carried on (i.e., not once a year at an annual gala/golf outing/gift wrap sale) and
- Not substantially related to the organization’s own specific exempt purpose (i.e., not any tax-exempt purpose, but the particular organization’s own stated tax-exempt purpose).
The rationale for taxing is to prevent unfair competition with for-profit (and nominally tax-paying) businesses. Nonprofits sometimes struggle with this concept, believing that if all the revenue goes back to the charity, it should not be taxed. But it’s the way the revenue is generated that determines its taxability, not the money’s ultimate purpose.
Sidebar: To learn about how it came to pass that unrelated business became taxable to nonprofits in 1950, see The New Yorker article from 1977, The Law School and the Noodle Factory. That article is behind a pay wall, though you can learn a little bit about the situation that prompted the tax in The First Annual NYU Law Pasta Commemoration.
There are many exceptions to Unrelated Business Income Tax (UBIT), and if a nonprofit is making money using one of these methods, then it doesn’t have to worry about taxes. These exceptions include royalties and licensing fees from use of intellectual property, such as curricula, trademarks, and patents; rental income (with some limitations); income from activities conducted entirely by volunteers; and income from the sale of donated merchandise (such as in the case of thrift stores).
It’s important to remember that income-generating activities are not taxed if they are conducted as part of, or closely related to, a 501(c)(3) nonprofit’s exempt purposes. Examples include scientific research and sale of patents if there is a benefit to the public; aids in education, published and thus available to the public; disease research; provision of childcare or home health care; job training; and provision of low-income housing. There are many more examples, and nonprofits should consult with a tax professional for advice about a particular activity.
Too Much Unrelated Business Activity
A charity is permitted to engage in unrelated business activities so long as it pays the appropriate tax. And for many nonprofits, the tax is manageable in light of the revenue it raises. But at a certain point, even if the nonprofit is happy to pay the tax, taxable income may become too great a percentage of revenue to allow the charity to meet the public support test or otherwise impact the substantiality of its charitable activity. There is no bright-line test to determine how much non-exempt activity is too much to undertake; the calculation is not percentage-based, although the public support test must be met.
Tax-exempt status is generally not at risk if the activity has a direct relationship to a non-commercial exempt purpose of the organization; the revenue generated is relatively small compared to the organization’s overall activities and not greater than necessary to accomplish the exempt purpose; and the activity is not competing with activities carried on by the business community. Special attention will be needed to account for staff and other resources of the nonprofit used to support the revenue generating activities.
Many groups decide to avoid the UBIT risks to the nonprofit by forming a for-profit subsidiary, from which the profits can flow up to the “parent” non-profit as non-taxable dividends. In this case, the nonprofit must use caution in how much investment the nonprofit makes in this sub – is it adequately capitalized? Will the income cover the sub’s tax obligations with enough to spare to truly benefit the charitable parent?
Also, it’s critical that there are arm’s length agreements between the two corporations and that the charity receives fair market value for its services. If control of the sub is too close, however, liability issues might cross corporate entity boundaries and come back to the charity. Separate boards; separate board meetings; separate corporate records – all are important to monitor and document. See our article, Section 501(c)(3) Tax-Exempt Entities Forming Affiliations With Other Entities: Benefits, Risks, and Structural Considerations.
Some nonprofits form a separate, uncontrolled corporation to conduct the activity. Obvious disadvantages of this option are a lack of control, which might affect revenue back to the nonprofit and thus eliminates the reasons for starting this activity in the first place.
Charitable organizations should consider the many available ways to earn money and strengthen their revenue stream and flexibility. With careful planning and tax advice, a nonprofit can improve its self-sufficiency and decrease its reliance on highly restricted funding.
Please contact Pro Bono Partnership if you have questions about the legal aspects of revenue-generating activities.
Nancy Eberhardt is the New Jersey Director of Pro Bono Partnership and a regular contributor to the Dodge Blog. Pro Bono Partnership provides free business and transactional legal services to nonprofits serving the disadvantaged or enhancing the quality of life in neighborhoods in New York, New Jersey and Connecticut. To learn more about Pro Bono Partnership, please visit www.probonopartner.org or call 973-240-6955. Photo at top courtesy of Creative Commons / perzonseowebbyra.se