What Are the Tax Implications for Nonprofit Business Activities?
When Profit is Ok and When It Is Not
Many nonprofits feel the economic squeeze as the competition for donations, foundation grants, and even government funding grows ever more demanding.
Consequently, charitable organizations by the hundreds have dabbled to one degree or another with earned income.
But all nonprofits should be careful. Not all earned income enterprises become successful, and there are tax consequences for those that do turn a profit.
Here are some of the basics of how it all works.
What's the Difference Between Related and Unrelated Business Activity?
What do you need to know about nonprofit "profits"? How do you distinguish between taxable business activities and those that are not taxable? What is all the fuss about "unrelated" business activities?
Even though nonprofit organizations are not created to pursue profit, sometimes they have them. Profit is not denied to the nonprofit as long as that profit was generated through mission-related activities.
However, some profit is taxable, and some profit is not. Many nonprofits engage in "related" business activities to help sustain their primary mission. Any profit from such activity is tax-exempt.
What is a mission-related business activity?
Let's use an example of a museum that offers summer courses to high school students in art appreciation for a fee. Since the museum's mission involves the education of the public about art, the proceeds from such courses are tax-exempt.
Profit from an "unrelated business activity" may be taxable. The tax is called the UBIT (unrelated business Income tax). An example could be if the museum publishes a magazine that carries advertising that has nothing to do with its mission of art education and preservation. The income from the advertising would be unrelated and taxable.
What is unrelated business activity?
The IRS says that unrelated business activity has these three attributes:
- It is a trade or business,
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the organization.
So, your nonprofit pre-school's once-in-a-while bake sale would not qualify for UBIT, but running a pizza parlor on the side likely would.
How much unrelated business income does the IRS allow?
I asked Emily Chan, a nonprofit attorney, for her opinion. Here's what she said:
Nonprofit organizations are generally limited in the amount of unrelated business activities they can conduct.
But the Internal Revenue Service (IRS) has not been specific about how much permissible earned income can be generated by unrelated sources.
Although no fixed percentage limitation exists, there are two main reasons why unrelated business income raises concern for public charities and most other exempt organizations under Internal Revenue Code section 501(c).
- First, unrelated business income is taxable at the corporate tax rate (i.e., subject to the unrelated business income tax (UBIT).
- Second, an exempt organization cannot engage in more than an insubstantial amount of unrelated business activity without risk of losing its tax-exempt status.
An "unrelated business" is defined by the IRS as a trade or business that is regularly carried on, and not for the most part related to the exempt purpose of the organization.
A related business means that the income-generating activity supports the organization's exempt purposes, and does not just produce income.
Whether or not the activity produces income is not the most important fact. But what does matter is if that activity supports the organization’s mission.
The analysis of related vs. unrelated business activities can become quite complex. For instance, individual items sold in a museum gift shop could be classified either way.
There are also exceptions to the rule under Internal Revenue Code section 513(a) for certain activities.
These exceptions include:
- Activities run by a volunteer workforce
- Activities carried on for the convenience of its members, students, patients, officers, or employees
- Selling of donated merchandise. (Passive income, such as interest, dividends, rents, and royalties is also generally excluded from unrelated business income.
Serious issues would likely exist under the unrelated business income rules for an organization with over 50 percent of its total gross income produced from unrelated business activity.
However, regulations are imprecise about where to draw the line below that 50 percent mark.
Without a fixed percentage limitation from the IRS, legal advisers often use various rules of thumb, although 20 percent is common.
Organizations should seek appropriate counsel or expertise when engaging in business activities.
If the activities do not meet the definition of an unrelated business or fall under an exception or exclusion, the organization may have much more flexibility in how it engages in such activities without triggering any penalties.
Although a nonprofit can engage in unrelated business activities and pay taxes on the profit, it's important to be careful. At the very least, figure out whether your business operations are taxable, partially taxable or not taxable at all. Your accountant can figure all of this out for you.
Too much unrelated commercial activity may prompt the IRS to take a second look at your 501(c)(3) tax-exempt status.
Here's what to watch for:
- Make sure that your business activity doesn't absorb too many resources from staff or volunteers. Always keep in mind what your mission is. Focus most of your resources on that.
- Don't let the income from business ventures become too large a percentage of your total annual income. Public charities are required to get most of their revenue from the public, such as from donations or fees from mission-related programs.
- File the appropriate tax forms if you have $1000 or more of gross income from the unrelated business activity. You must file the Form 990-T when you file your 990, 990-EZ or 990-PF.
Unrelated business activity is a tricky area, so consult your legal counsel and your tax expert before you jump into anything that might trigger the UBIT. The IRS provides details on unrelated business income tax on its website.
This article is just for informational purposes. It is not intended to be legal advice. Check other sources, such as the IRS, and consult with legal counsel or an accountant.