Because I am both an attorney and a CPA, I am sometimes asked by nonprofit clients whether they could lose their tax exemption for making too much money or for having a nonprofit that may compete with a commercial business. It is not only important to understand the law, but also how the accounting for the organization must be able to track the information required by these governmental agencies.
The loss of a tax exemption is very rare. Your organization is entitled to rely on the determination of exemption from the IRS that was in the letter your organization initially received. It is clear from that letter that the organization “may rely on such determination so long as there are no substantial changes in the organization’s character, purposes, or methods of operation” that was originally approved in the application for exemption. Those organizations that do lose their exemption are unable to show adherence to their charitable purpose or the IRS has penalized the organization due to malfeasance or self-dealing.
MAKING TOO MUCH MONEY
Let’s deal with the issue of the client concern with making “too much money” as a nonprofit. Tax-exempt nonprofits have to make money to cover their expenses either through their services, donations, or grants. If not, they will probably go out of business. If the profit is from the nonprofit’s exempt purpose, then any profit is not taxable.
Harvard is the best example. Harvard’s endowment sits at $36.4 billion and Harvard’s investments range from stocks and bonds to California wine vineyards.
Another example is Children’s Hospital of Boston. It earns $1.3 billion annually and owns $2.6 billion in investments in stocks and real estate. It only spends $8 million a year on free medical care.
However, there may be political or fundraising concerns around making too much money. It may become politically difficult if an organization that is charitable to retain a large surplus. It may also hinder fundraising if, in the eyes of the donors, the organization is not spending enough money on it’s mission.
NEW BUSINESS LINES CONSIDERATION
The IRS “fragments” an organization’s revenues on an item-by-item basis. For instance, if an Aquarium has a gift shop which has merchandise that would be substantially related to the achievement of an Aquarium’s exempt educational purpose, that merchandise would be considered exempt from taxes. However, if the Aquarium also sells souvenir items from the city or state it is located in, this would be subject to an unrelated business income tax.
This fragmenting must be tracked at a very low level by the accounting system. An IRC Section 501c3 organization must make quarterly estimated tax payments if it expects its unrelated business income tax to be $500 or more. A form 990-T is required if the organization’s gross income from all unrelated businesses is $1000 or more.
There are three elements that must be met in order for the unrelated trade or business to be subject to tax.
1) The trade or business must not be substantially related to the organization’s tax-exempt purpose;
2) The activity must constitute a trade or business; and
3) The trade must be regularly carried on.
1) Not Substantially Related to the Organization’s Tax-Exempt Purpose
A trade or business is not substantially related to an organization’s exempt purpose if it does not contribute importantly to the accomplishment of a proper tax-exempt purpose. The activity must have a substantial relationship to the exempt purpose for which the exemption was granted to the organization. This “facts and circumstances” test is where the IRS and the organization will frequently differ. The IRS will use a “facts and circumstances” approach to determine whether an activity “contribute(s) importantly to accomplishing (the organization’s exempt) purpose and is therefore substantially related. IRS Publication 598. See Treas. Reg.1.513-1(d)(2). The fact that the activity makes money for the organization to use in funding the organization’s purpose is not enough.
It also needs to be determined whether the activity is conducted on a larger scale than is reasonably necessary to perform an exempt function.
Finally, there may be an exclusion if activities are run by a volunteer workforce, activities are carried on for the exclusion of the organization’s members, students, patients, officers, or employees, or the selling of donated merchandise. Treasury Regulation 1.513-1(e)(1), (2), (3).
Let’s take a hypothetical to demonstrate how these issues may be decided. Let’s say there is an Aquarium in California that has a restaurant. If that restaurant is for the convenience of it’s members and employees, then it would clearly fall under the exclusion noted above and would be also considered tax-exempt. However, if the Aquarium expands the restaurant, starts advertising in magazines and serves the public (not just the members) the purpose of the restaurant has changed. These factors would contribute to the conclusion that this activity was larger than necessary to carry out the organization’s exempt purpose. The revenue derived from the public would be unrelated business income tax.
2) Activity Must Constitute a Trade or Business
The term “trade or business” generally includes any activity carried on for the production of income from selling goods or performing services. The Tax Court in Commissioner v. Groetzinger stated that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” If the activity is passive, then the activity does not rise to the level of an unrelated trade or business. The activity must be undertaken in a “competitive and commercial manner.” Disabled American Veterans v. U.S.
3) Regularly Carried On
A trade or business is considered to be “regularly carried on” if it shows a frequency and continuity and is pursued in a manner similar to that of commercial organizations. Activities that are carried on only annually are not considered regularly carried on. There are some exceptions to this rule that are beyond the purpose of this blog.
Where an organization may get in trouble with it’s tax-exempt status is when the unrelated business income gets to be a “substantial” percentage of the nonprofit’s income. While there is no standard percentage, if you organization is 20-25% of the gross income you should start to worry. If your unrelated business income is 40-45% of gross income, then it becomes difficult to prove that your organization is organized exclusively for charitable purposes. This can be cured by forming a for-profit subsidiary to protect the nonprofit organization.