Boosting revenue can be tricky for nonprofits. Could the activity be considered taxable?
Nonprofit entities have reacted to today’s economic realities by proactively increasing their sources of revenue, whether from seeking more charitable donations or from boosting their program service revenue. When considering whether to expand their sources of revenue beyond these two typical sources, nonprofits should be aware of some possible unintended tax consequences.
Some revenue-producing activity by nonprofits is considered commercial activity, even though the income is used to further the nonprofit’s mission. This is called “unrelated business income,” and is taxable. The short answer to the question is no. Not all activities of nonprofits are tax exempt. Some can be subject to taxation on revenue that is earned in ways unrelated to their exempt purposes.
What is Taxable, What is Not?
An activity could be subject to tax if it is: 1) income from a trade or business; 2) such trade or business is regularly carried on by the organization; and, 3) the conduct of such trade or business is not substantially related to the organization’s performance of its tax-exempt function. All three must apply for an activity to constitute an unrelated trade or business.
Making a Profit is OK
A trade or business is defined as any activity carried on with the intent to make a profit through the sale of goods or performance of services. A trade or business activity does not lose its identity simply because it does not make a profit. The imposition of the unrelated business income tax was to ensure that nonprofits would not unfairly compete with for-profit companies by virtue of their tax-exempt status.
The IRS may rule that an activity is “regularly carried on” if there is “frequency and continuity,” and the activity is pursued in a manner generally similar to comparable commercial activities of non-exempt organizations. For example, many nonprofit organizations solicit sponsorships for annual galas, awards ceremonies or fundraising events. This activity is not “regularly carried on” by the organization, because it happens only occasionally or sporadically. Preparation time for an event is not a factor in determining whether an activity is engaged in an ongoing matter. Rather, the duration of the event itself is the overriding factor. The operation of a sandwich shop by a hospital auxiliary for only two weeks at a state fair would not be the regular conduct of a trade or business. But the conduct of year-round business activities for one day each week would constitute the regular carrying on of a trade or business.
A nonprofit can engage in a trade or business without coming up against regulations that would cause it to be subject to tax, as long as the activity substantially relates to its exempt purpose. Understanding the relationship between the exempt purpose of the organization and the activities undertaken ultimately determines whether the trade or business activity is “related” and exempt from tax. A key in this identification process is the size and extent of the activities. Those on a scale larger than is “reasonably necessary for performance of such functions,” will likely be considered unrelated trade or business, and thus subject to tax.
For example, a nonprofit organization’s training program to help homeless people become self-sufficient could be a business activity that contributes importantly to accomplishing the organization’s exempt purpose. The organization’s income from the operation of a paper shredding service for businesses could be exempt from tax if the program’s clients/trainees are the primary employees (except for those responsible for providing the training and supervision), and all of the work involved in the business activity is performed by them. This “employment” must be a transitional period whereby the program’s client/trainees may only work in the program for a limited period of time (e.g., the organization helps the client/trainees find a job that enables them to be self-sufficient, and the client/trainee is only afforded the training “employment” until that time). If the organization’s paper shredding business becomes so successful that the nonprofit cannot operate it with just the individuals in the program and must hire outside workers, then the income may be taxable.
Advertising is a Factor
The IRS often looks at advertising as a way to determine whether nonprofit activities are subject to tax. Advertising is defined as “any message or other programming material which is broadcast or otherwise transmitted, published, displayed or distributed, and which promotes or markets any trade or business, or any service, facility or product.” If a nonprofit solicits, sells, and publishes advertisements for commercial vendors in its publication, the advertising revenue is taxable to the extent that revenues exceed the direct cost of the publication even though the publication contains content related to the organization’s exempt purpose.
Putting It All Together
Understanding the above definitions is a key to determining whether an activity qualifies as a tax-exempt trade or business within a nonprofit entity. All unrelated activities of a tax-exempt organization are subject to federal taxation in the same manner as any C corporation and could also be subject to state taxation.
So even though some activities by a nonprofit to increase revenue may be subject to tax, they may be worth the additional accounting, filing and payment of tax to support the nonprofit’s mission. Your CPA can assist you and your board of directors in determining what the potential tax consequences might be, and if significant revenue could be generated to support the organization’s mission.
For more information on how your company can achieve better results, contact the team at Pulakos CPAs – where Performance Matters™!