Recently, there has been much discussion about how business can take on a nonprofit flavor through social enterprise and new hybrid legal structures. Here, we would like to take a look at the profitable side of nonprofits in Part I and its relation to different legal structures in Part II.
The idea of nonprofits earning income can seem like an oxymoron as first blush but, as a recent Inc. Magazine article highlighted, the National Center for Charitable Statistics estimates that in 2008 nearly 70% of the $1.4 trillion generated by nonprofits was from the sale of goods and services, or what is generally referred to as earned income. The hesitation to put “profits” and “nonprofit” in the same sentence is not without merit. While there is no rule prohibiting a nonprofit from engaging in income-generating activities, this does not equate with a carte blanche approval by the IRS to engage in such activities. Earned income triggers certain rules in the Internal Revenue Code and the IRS can levy severe penalties such as revocation of tax-exempt status. In this article we will address generally two main issues that nonprofits, and specifically public charities, should be looking at when considering or conducting earned income activities: (1) whether such earned income is taxable and (2) whether the earned income activities jeopardize the tax-exempt status of the organization.
When is the earned income taxable?
The IRS categorizes earned income into two categories: related and unrelated. A public charity generally does not pay taxes on related income, but it does pay taxes on unrelated business income at the corporate rate, also called the unrelated business income tax (UBIT). See IRC Section 511. The IRS determines whether earned income is related or unrelated using a three-part analysis. The general rule is that income is treated as unrelated if it is:
- A trade or business;
- Regularly carried on; and
- Not substantially related to the organization’s exempt purpose.
IRC Section 512(a)(1).
Of the three factors, the third “substantially related” factor is generally the one that requires more thought and attention. The IRS uses a facts and circumstances approach to determine whether an activity “contribute[s] importantly to accomplishing [the organization’s exempt] purpose (other than through the production of funds)” and is therefore substantially related. IRS Publication 598; see Treas. Reg. 1.513-1(d)(2). In other words, the analysis hinges upon the nature of the activity that is the source of the revenue, not the revenue’s ultimate destination. The fact that activity would generate revenue that could be used to pay for the organization’s charitable programs or activities does not make the activity “substantially related.” The conduct of the activity itself must have a substantial casual relationship to the exempt purpose for which exemption was granted in order to meet this requirement. Treas. Reg. 1.513-1(d)(2).
The IRS also provides for certain exclusions from UBIT for activities that may otherwise be considered unrelated. Such exceptions include activities run by a volunteer workforce; activities carried on for the convenience of its members, students, patients, officers, or employees; or the selling of donated merchandise. Treas. Reg. 1.513-1(e)(1), (2), (3).
Additionally, the IRS does not take an all or nothing approach to unrelated business income. If an activity is “conducted on a larger scale than is reasonably necessary to perform an exempt purpose,” the part that is more than needed is treated as unrelated and subject to UBIT. Treas. Reg. 1.513-1(d)(3). Each activity from which income is derived must furthermore be analyzed separately. An activity is either related or unrelated, regardless if “they are carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.” Treas. Reg. 1.513-1(b). These principles are encompassed in what is sometimes referred to as the fragmentation rule.
Museums are a classic example of the fragmentation rule. Running a restaurant will generally not alone be substantially related to the exempt purpose of a museum (e.g., educational). However, the restaurant may fall under the convenience exception if it is done for the convenience of its members. Thus, for example, a museum’s upscale restaurant with circumstances such as being designed partly as a public restaurant, being regularly advertised in magazines, and serving restaurant patrons that do not have to pay museum admittance fees would all contribute to a determination that the restaurant activity is larger than necessary to serve visitors and staff under the convenience exception. Therefore, the part in excess (i.e., the museum restaurant’s sales to the general public) would be subject to UBIT. See IRS Technical Advice Memorandum 97-20-002 as summarized by Hurwit & Associates.
Fragmentation can also be seen with museum gift shops, in which particular items or lines of merchandise can be individually characterized as related or unrelated. The selling of merchandise may be substantially related to a museum’s exempt purpose in educating the public about art and art appreciation. Thus, for example, the selling of items to the public by an art museum devoted to the exhibition of American folk art of merchandise such as reproductions of works in the museum's own collection or instructional literature concerning the history and development of American folk art would be considered substantially related to achievement of the museum's exempt educational purpose. However, the sale of scientific books and souvenir items related to the city where the museum is located would be considered unrelated and subject to UBIT; the fact that these items are sold in the same gift shop as the related activities does not change the unrelated nature of the latter activity. See Rev. Rul. 73-105, 1973-1 C.B. 264.
As explained in the Treasury Regulations, the primary objective in adopting UBIT “was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete.” Treas. Reg. Sec. 1.513-1(b). And although these activities can create profits, it is important to note that it does not depend on actual realization of profits: “… where an activity carried on for the production of income constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in profit.” Treas. Reg. Sec. 1.513-1(b).
Are we engaged in too much unrelated business activity?
It important to emphasize that generating unrelated business income is okay (though remember, taxable) and sometimes can be extremely helpful for the nonprofit to supplement donations and help assure a more predictable revenue stream. The caveat is that unrelated business activities are permissible only up to certain limit. The IRS requires public charities to be operated primarily for exempt purposes. Therefore, while some unrelated activities can occur, the primary activities of the organization must be exempt. Therefore, monitoring the amount of activity generating unrelated business income is critical.
The difficult part is in knowing how much is too much because there is no exact amount or percentage rule provided by the IRS. Generally, it may be reasonable to assume an organization would have a difficult case arguing a primary exempt purpose if the unrelated business activity produced 50% of the organization’s total gross income, but that does not inform organizations what levels below 50% would be acceptable. Because there is no hard and fast rule and rules of thumb can vary among practitioners (though 20% is common), organizations should seek appropriate counsel if they are concerned about the amount of unrelated business activity.
Organizations earning income from related activities as defined by the Internal Revenue Code, on the other hand, do not have this similar concern. For example, the Goodwill Industries of San Francisco and San Mateo reported on its 2009 Form 990 that approximately $27M of its $34M revenue (roughly 80%) was from program services, and of its program service revenue, about 99.8% came from merchandise sales at its stores. Aside from selling donated merchandise (an exception to UBIT), the operation of the Goodwill stores also serves as training centers for the program participants. Thus, Goodwill Industries is able to rely heavily on earned income because there is a substantial casual relationship between the store operation and the mission of Goodwill Industries, as described on the Goodwill Industries International’s website, to enhance “the dignity and quality of life of individuals, families and communities by eliminating barriers to opportunity and helping people in need reach their fullest potential through the power of work.”
Here we’ve covered some basic concepts of UBIT but the rules surrounding unrelated business income include many more principles and exceptions. The UBIT analysis can become much more difficult depending on the nature and complexity of the activity such as engaging in activities that are typically commercial, and organizations are encouraged to seek appropriate resources and expertise when addressing these issues.
"The Profitable Side of Nonprofits - Part II: Different Legal Structures" is available here.
IRS Stay Exempt provides a virtual workshop on unrelated business income that can be accessed here.
A more detailed analysis of the UBIT analysis can be found in the IRS Publication 598 “Tax on Unrelated Business Income of Exempt Organizations” (PDF; online) and the article “Legal Framework for Earned Income” by Robert A. Wexler of Adler & Colvin.
Patrick Sternal of Runquist & Associates also provides a summary in “Guidelines for Nonprofit Organizations: Regarding Unrelated Business Income Tax (UBIT)” available here.