Tax implications for fee-based offerings

Terrie Temkin
Terrie Temkin

Terrie Temkin

As the economy slows, more nonprofits are taking a second look at the way they do business. One change many nonprofits are considering is charging fees for services.

This practice is not new within the nonprofit community. On a large scale, nonprofit schools and hospitals have long charged.

By and large, the IRS has no problem with the concept. In fact, Reg. § 1.501(c)(3)-1(e) states:

An organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization’s exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513.

However, nonprofits still should proceed with caution, as certain activities can jeopardize tax exemption.

Nonprofits should keep three concerns foremost in mind when looking into charging fees for services: ensuring that the fees will not be construed as unrelated business income, any tax implications if they are considered unrelated business income, and correctly reporting this activity.

Though nonprofits should talk the options over with a nonprofit tax specialist before making major changes, there are several basic guidelines to follow.

The IRS considers an activity “unrelated business” and subject to taxation if it is substantially unrelated to the nonprofit’s exempt purpose.

As long as nonprofits charge for services that fulfill their missions, rather than merely provide cash flow to allow them to pursue their missions, they should not incur a tax obligation. Even if the services or products nonprofits offer are unrelated to their exempt purpose, they still may not be liable for unrelated business income tax (UBIT), since the IRS excludes certain activities from the tax obligation.

One such exclusion is if nonprofits use volunteers to provide services.

If the services provided are considered an unrelated business enterprise, there are several other considerations. If a nonprofit grosses $1,000 or more from such services, it must file Form 990-T and make it and all addendums available to the public.

The nonprofit would then pay taxes on this income. An important note: if the income from the provision of these services ends up being a substantial portion of a nonprofit’s revenue, it could lose its exempt status.

Finally, public charities, unlike foundations, must maintain a defined level of funding from the general public. Public charities are sub-divided into two categories: 509(a)(1) and 509(a)(2).

Organizations that raise the bulk of their money through contributions or grants are designated as 509(a)(1). Organizations that rely on fees for services or the sale of tickets for the majority of their support are designated as 509(a)(2).

Depending on an organization’s original classification, if it pursues fees for services, it may have to file an addendum to its incorporation papers with the IRS in order to be classified as 509(a)(2).

Be forewarned that it is more difficult to meet the support test for 509(a)(2) organizations. Here again, a tax advisor can provide both critical information and substantial help.

Terrie Temkin is founding partner at the Miami, Fla.-based management consulting group CoreStrategies for Nonprofits Inc. For five years, her “On Nonprofits” column appeared biweekly in the Miami Herald.

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