Operating a Business as a Nonprofit Organization
By Jeremy Chen
A common question that nonprofit organizations ask is whether they can operate trades or businesses to generate income to fund their charitable activities? The short answer is, yes. There are, however, two primary concerns that arise when a nonprofit operates a trade or business. First, is the revenue generated by the business taxable? And second, will the nonprofit’s tax-exempt status be at risk of revocation if the business operations become too substantial? This article will provide some basics about when these concerns are triggered.
PART 1 – The Unrelated Business Income Tax (UBIT)
As is commonly known, a nonprofit organization with 501(c)(3) tax-exempt status generally does not pay taxes on income that it generates. The IRS, however, imposes a tax on any “unrelated business income” (UBI) generated from a trade or business operated by a nonprofit.¹ The reason for this tax on UBI is to avoid giving 501(c)(3) nonprofits an unequal competitive advantage over commercial businesses that must pay taxes on income generated from their performance of the same business activity.
Unrelated business income is defined by the IRS as “the income from a trade or business regularly conducted by an exempt organization and not substantially related to the performance by the organization of its exempt purpose or function, except that the organization uses the profits derived from this activity.”²
To determine whether income generated from a nonprofit organization’s business or trade is taxable as UBI, the following three requirements must be met:
- The activity constitutes a trade or business;
- The trade or business is regularly carried on; and
- The trade or business is not substantially related to the organization’s exempt purpose.
If any one of these requirements is not met, then no unrelated business income tax is owed.
Applying the 3 Requirements of Unrelated Business Income
The way the three UBI requirements are interpreted and applied is based on regulations, rulings, and cases from the U.S. Treasury Department, the IRS, and federal courts, all of which vary in breadth and scope of application. Thus, the rules are not by any means clear-cut. Rather, determining the applicability of the three requirements should be based on the facts and circumstances of each particular case. The following discussion provides some general guidelines on how the three UBI requirements are applied in practice.
- Trade or Business
A “trade or business” generally includes any activity conducted to generate income from selling goods or performing services. This requirement is relatively straightforward and would likely apply to most situations where a nonprofit sells products or performs services.
- Regularly Carried On
A nonprofit’s business activities are generally considered regularly carried on depending on how frequently and continuously they are conducted, and whether they are conducted in a manner similar to commercial activities of businesses that are not tax-exempt.
These two examples are only a small sample of the many cases and rulings dealing with the regularly carried on requirement. A more thorough analysis should be conducted of all relevant facts and circumstances of a proposed business activity in determining whether this requirement is met.
- Not Substantially Related
A business activity is considered substantially related to a nonprofit’s exempt purpose if it contributes importantly to accomplishing that exempt purpose. Further, the mere fact that the income generated from a business activity is used to further the nonprofit’s exempt purpose does not make that business activity substantially related. Instead, the facts and circumstances of each particular case are used to determine whether an activity contributes importantly to a nonprofit’s exempt purpose. Some of the main factors that are considered in making this determination are:
- Whether the size and extent of the activities exceed the nature and need of the exempt purpose being furthered,
- Whether the fees charged are at or below cost,
- Whether a charitable class is served rather than the general public, and
- Whether the business activity is conducted on a larger scale than is reasonably necessary to perform the exempt purpose.
A good example of substantially related business activity would be an art museum gift shop selling art-related merchandise such as prints of art and books about artists. The sale of souvenirs of the city in which the art museum is located, however, would not be considered substantially related; and UBIT would be owed on the income from the souvenir sales. Additionally, some of the more common examples of unrelated business activities are advertising, gaming, and rental income.
This UBI requirement poses more uncertainty than the others because exempt purposes amongst nonprofits greatly vary. A nuanced analysis of all relevant facts and circumstances of a proposed business activity and the nonprofit’s exempt purpose should be conducted to determine whether this requirement is met.
Exceptions to Unrelated Business Income
Certain business activities can be carried on without being subject to UBIT because they are specifically excluded from being defined as UBI. There are many specific exceptions, but the most common ones are:
- Business activities conducted substantially by a volunteer workforce,
- Business activities conducted for the convenience of members, students, patients, or employees (e.g. cafeterias in schools and hospitals that serve students or patients),
- Businesses that sell substantially all donated merchandise,
- Distribution of low-cost items that are incidentally given to donors solicited for contributions, and
- Corporate sponsorship payments.
PART 2 – UBI and Loss of Tax-Exempt Status
A common concern for nonprofits conducting substantial business activities is whether they will be at risk of losing their tax-exempt status for having too much UBI. This concern is not unfounded, but the focus on a specific number or percentage is misplaced.
Generally speaking, there is no clear-cut rule about how much UBI will cause the IRS to disqualify a nonprofit’s tax-exempt status. In fact, a Treasury Department regulation states that a 501(c)(3) organization can operate a business as a substantial part of its activities if such business activities further the organization’s exempt purpose and the nonprofit is not primarily organized for the purpose of carrying on an unrelated business.³
Rather than focus on the amount or percentage of UBI, the IRS applies the “reasonably commensurate” test to a nonprofit’s particular facts and circumstances. The “reasonably commensurate” test allows a nonprofit organization to have substantial UBI as long as it carries out charitable programs that are reasonably commensurate with its financial resources. In other words, the IRS looks at the nonprofit’s operations as a whole by evaluating how the nonprofit holds itself out to the public, the impact of its exempt activities, and how much of the nonprofit’s resources, effort, and time is expended on business activities in comparison to that of its exempt purpose.
Again, there is no clear-cut rule regarding how much UBI is too much, and determining this can be more art than science. Ultimately, if a nonprofit finds that its business activities are beginning to dominate over its exempt purposes, it might be advantageous to create a separate for-profit subsidiary under which it would conduct its unrelated business activities.
¹ Another significant exception to this general rule of 501(c)(3) tax-exemption is that private foundations pay a 1 or 2 percent tax, depending on the circumstances, on their investment income.
² Internal Revenue Service Publication 598 (Rev. March 2012)
³ Treasury Regulation §1.501(c)(3)-1(e)
Disclaimer. The information in this article is not legal advice, and is provided only for informational purposes. This article is only a general discussion, and does not include all relevant information regarding the topics and issues addressed within it.
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