This month on Tony Martignetti Nonprofit Radio, Emily and I discussed with Tony the topics of earned income and the unrelated business income tax. You can listen to a recorded version here or check it out (in a few days) on ITunes.
Frequently Asked Questions
Note: To provide a more easily understandable overview, we answered these in general terms without addressing many of the exceptions, modifications, and nuances involved in this tricky area of the law.
How can nonprofits generate revenues other than through donations and grants?
Many nonprofits generate substantial revenues by charging fees for services or goods; selling licensing rights to their written, audio, visual, and multimedia works; and renting space.
What do nonprofits sell?
Mostly, they sell goods and services that are related to their mission. Hospitals sell health care services; schools charge tuition; museums and arts organizations charge admission and ticket fees. Sometimes, they sell things that have nothing to do with their mission – and that’s when they may have unrelated business issues.
What is the difference between a related business and an unrelated business?
For a charity, a related business is one that advances the organization’s charitable purposes without considering where the profits go. It’s the activities themselves that contribute importantly to advancing the mission, regardless of whether any money is generated. An unrelated business is one where the activities have nothing to do with advancing the mission. Generally, it is carried out to generate revenues that will be used to advance the mission. Revenues generated by unrelated businesses may be subject to unrelated business income tax.
Is it hard to tell whether the business activity is related or unrelated?
Sometimes. It’s definitely fact-specific. Does selling clothes and other retail items further a charity’s mission? It can if, like Goodwill, operation of the business provides education, job training, and work experience for a disadvantaged class of individuals. Does selling girl scout cookies contribute importantly to the charitable purposes of the Girl Scouts? They think so. It’s also important to note that the IRS looks at the size and extent of the activities involved and compares them to the nature and extent of the exempt function that they intend to advance. So, if you run a nonprofit day care to serve a charitable class of individuals but expand it to serve the rich community next door, the IRS may treat the expanded portion as an unrelated business.
Can a business be partially related and partially unrelated?
Yes. This is what the IRS refers to as the fragmentation rule. And a museum gift store is the way it’s often explained. A museum sells an art print, it’s related. It sells a city souvenir mug, it’s unrelated. So, the IRS treats them as separate businesses, and the sale of unrelated items is an unrelated business subject to the unrelated business income tax.
How can you tell if the sale of an item is related or unrelated?
We look at the primary purpose behind the production and sale of the item. Is it charitable or educational? Or is it mainly for ordinary use (like a mug), ornamental, or souvenir in nature? It gets tricky when we have something like a mug with a Van Gogh print design. What is the primary purpose? I think it can go either way, and how we might sway that analysis is by attaching an educational label to the mug.
What is the unrelated business income tax?
It’s a federal income tax that tax-exempt organizations must pay on certain income generated from their unrelated business activities if those activities are regularly carried on like a for-profit and not subject to certain exceptions. So, a monthly bake sale would not be regularly carried on, but a bake shop open daily from 9-5 would. The tax rate is the normal corporate tax rate (generally 15-35%).
Why do we have this tax?
It was created in 1950 to primarily address the problem of unfair competition with for-profit businesses and the problem of large nonprofits, like universities, buying for-profit businesses and not paying any taxes when running them within the nonprofit. You can imagine a small business being upset if its biggest competitor was bought by a nonprofit which paid no taxes and therefore had a huge competitive advantage.
Are all unrelated businesses subject to taxes?
No. There are several exceptions and modifications. The most common exceptions: businesses carried on by volunteer labor, businesses carried for the convenience of members/students/patients (like a student bookstore), and businesses selling donated goods (like many thrift shops). The biggest modification is for passive income, like interest, dividends, rents, and royalties, which are generally exempt. But it gets complicated because there are exceptions to these exceptions too (for example, when the nonprofit bought the investment assets with borrowed money).
How much earned income can you have?
There’s no limit to the amount of earned income you can have from related businesses. But 501(c)(3) organizations must be operated primarily for their charitable, educational, religious, or other tax-exempt purposes. And only an insubstantial amount of its activities may be the carrying on of an unrelated business without jeopardizing its tax-exempt status. But the IRS doesn’t tell us how to determine what is substantial other than to look at all the facts and circumstances. Many attorneys in this area say if you’re generating over 20% of your gross income from unrelated businesses, you’ve got to be very careful and should confer with an attorney. But there are cases where over 50% is allowed and I’m sure there can be cases in which less than 20% can get you in trouble. The key consideration may be the percentage of the charity's resources devoted to the unrelated business activities.
What do you need to do before starting a business?
Determine whether it makes business sense to run it. Some early things to consider are whether you have assets that are worth selling and whether selling those assets are compatible with your mission. You probably don’t want to be a green nonprofit with a business selling bottled water, that would be considered not very friendly to the environment. You also need to consider whether you have the capacity to engage in the business. Do you have the startup money, a business-capable staff, and knowledge of the market? Most businesses fail and if you don’t have special expertise or advantages, you may find it a great challenge that distracts the organization from engaging in activities that better further the mission (mission creep/mission drift). Is it worth the investment risk? What harm would be done if the business failed?
Are there laws/risks I need to be aware of when starting a business?
You need to think about all the laws and risks related to the business and how to ensure compliance and smart risk management. That may mean thinking about employment issues, intellectual property issues, social media issues, sales taxes, licenses, permits, and insurance, among other things. Also, if there are any insiders of the organization (like its board members and officers) that stand to benefit personally from any business activities of the organization, you should talk with a lawyer about conflict of interest issues that could result in penalties and sometimes even worse, a public relations disaster.
If an insider gets too much of a benefit without giving fair value back to the organization, it may be deemed private inurement and result in the revocation of the organization’s 501(c)(3) status, which would generally mean the end of the organization. If it’s bad, but not so bad as to call for the organization’s exempt status, it may be considered an excess benefit transaction that results in penalties to the insider who illegally benefited from the transaction and possibly to board members who approved the transaction knowing it to be a problem. There may be state law issues as well against self-dealing, where insiders are benefiting unfairly from transactions with the organization.