In the current economic climate, nonprofit organizations are competing for scarce resources while funding sources continue to shrink and the need for services continues to increase.
This seemingly impossible problem creates real challenges for nonprofits.
The need to be creative when it comes to cultivating and expanding funding sources is more apparent today than ever before.
And if that isn’t difficult enough, the problem is further complicated by the need to do this within the parameters of the Internal Revenue Code in order to maintain exempt status.
One avenue to be explored is to generate income from commercial sources. This income may be taxable to the exempt organization, but if done correctly, it will not harm exempt status.
The concept of “unrelated business income” has been around for over 60 years.
The tax on this form of income was enacted into law in 1950 when it was decided that the practice of exempt organizations engaging in commercial-type activities created unfair competition for their taxable counterparts.
Income is considered unrelated business income if it is obtained from a trade or business that is unrelated to an organization’s exempt function, if it is regularly carried on, and if it does not meet one of several exceptions.
It is the source of the income, not its ultimate use, that determines its status as unrelated business income. The fact that the income earned is used for the exempt function is irrelevant.
Although it is acceptable for an exempt organization to engage in some taxable activities, exempt entities must meet an operational test to maintain exempt status under the Internal Revenue Code.
Under this test, an organization must engage primarily in activities that further its exempt purpose, and other non-exempt functions must be considered insubstantial.
The terms “primarily” and “insubstantial” are not defined in the Internal Revenue Code or the Treasury Regulations.
Therefore, one must look at case law for an idea of how these terms are defined.
In determining if a non-exempt activity is substantial, the IRS typically looks at the amount of revenue obtained, the amount of expenditures made, and the amount of time spent by staff.
The IRS seems to weigh more heavily the factors related to use of exempt resources, such as staff time and expenditures, than it does the revenue raised.
Additionally, the IRS will consider whether the unrelated activity in some way furthers the exempt purpose of the organization. If it does, it is less likely to threaten exempt status.
If income generated from unrelated business income becomes significant, the activity can be moved into a taxable subsidiary.
As long as the exempt organization does not manage the day-to-day operations of the subsidiary, the separation of the activity will shelter the exempt status of the nonprofit organization.
Care must be taken to structure this properly to avoid pitfalls.
For example, certain payments made by the taxable corporation to the exempt parent, such as for interest on debt or rent, will result in unrelated business income for the parent.
There are several exceptions to the rules for unrelated business income. As such, many activities that would otherwise be subject to tax can continue to be exempt.
Using volunteers rather than paid staff to handle a trade or business activity will make the activity non-taxable.
Organizations that are exempt under IRC Section 501(c)(3) can participate in trade or business activities that are predominantly for the convenience of members, students, patients, etc.
Examples of these are university book stores or hospital cafeterias and gift shops.
Sales of donated merchandise are also exempt from unrelated business income tax.
Other examples of activities not subject to the unrelated business income tax are the receipt of royalties and rental income from real estate that is not subject to debt.
Trade or business activities that further the exempt purpose of a nonprofit organization can add to the bottom line.
Finding activities that will have synergies with an organization’s exempt purpose should allow the organization to spread its fixed costs over more revenue dollars.
If done correctly, the addition of unrelated business activities can result in a benefit to the organization and to the community it serves.
Jane Pfeifer, CPA, is a shareholder in the tax department of Clark Schaefer Hackett, an accounting and consulting firm based in Ohio.