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“In truth, there is no such thing as a nonprofit organization.”

June 22, 2009

So declared L3C creator Robert Lang, Jr. in the April 1, 2006 issue of Worth. And really, wouldn’t most people agreedesired desiredthat all organizations — regardless of tax status — can and should create more value than they consume?

But there is a misconception, perhaps born of the dichotomous thinking about for- and non-profit organizations, that nonprofits are supposed to generate social profit, not financial profit.  In my experience, many older nonprofits tend to shy away from starting new earned income funding streams.  There may be many reasons for this, but one is certainly fear of jeopardizing their tax-exempt status.

Not only is this untrue, it perpetuates a limiting dependency on foundation grants and individual donations.  So, let’s break it down.  If you’re a tax-exempt organization, what can you (and what can’t you) do?  (But first, the obligatory legal disclaimer: this is not intended to constitute legal advice and any nonprofit seeking to make significant changes in its program should seek the advice of its own attorney before doing so.)

The first thing to keep in mind is that it is possible to implement a revenue-generating business activity without altering your legal structure or jeopardizing your 501(c)(3) status.  In fact, you may not even need to amend your articles of incorporation.

Second, keep in mind that any income you generate from your business activity must be used to support your organization’s mission.  It is subject to all of the other rules that apply to tax-exempt entities, including the prohibition against self-dealing and private inurement.

The key legal effect that the adoption of a business venture will have on your organization is the potential for taxation.  As a 501(c)(3) tax-exempt organization, you enjoy the benefit of avoiding most taxes: the federal income tax, state income taxes, and even some state ad valorem taxes.  When you implement an earned income strategy, you will retain your tax-exempt benefits, at least for federal tax purposes, so long as your business activity is substantially related to your charitable mission.

If, however, you regularly carry on a business activity that is not substantially related to achieving your mission, you may be subject to an unrelated business income tax, or UBIT, on your earnings.  There are three key components to the previous sentence: in order to be subject to UBIT, (1) you must engage in a business activity, (2) that business activity must not be substantially related to achieving your mission, and (3) you must be engaging in that activity on a regular basis.

Following the above rule, consider whether your earned income venture is truly a “business activity.”  According to the IRS, a business is “any activity that is carried on for the production of income from the sale of goods or the performance of services.”  Fairly broad, and it covers most things you might think about when considering how you might leverage your organization’s abilities to earn income.

Next, ask whether your business activity is substantially related to your charitable purpose.  Your charitable purpose is what you wrote as your statement of purpose in your articles of organization when you first formed, or your mission statement.  Your business activity cannot simply generate income for your charitable purpose, nor can the activity be merely related to your purpose.  It must be substantially related – and herein lies the difficulty of the IRS’s inexact test.  Your business activity is more likely to be substantially related to your purpose if your activity is proportionate to the needs of your organization’s purpose, if you sell an item in substantially the same condition as you obtain it, and if the earning of a profit is incidental to the accomplishment of your mission.  Think of it as an activity whose primary goal is achieving your mission, while simultaneously accomplishing your secondary goal of turning a profit.

Third, look at whether you are engaging in your activity on a regular basis.  The IRS does not offer a bright-line test for what is considered “regular,” which leaves nonprofits again in the throes of uncertainty.  The commonly-discussed guideline is 15 to 20 percent, meaning that you should limit your unrelated business activity to less than 15% or 20% of your operational time or your gross income.  Another guidepost is whether you conduct your business activity in much the same way as a for-profit entity might, such that you are essentially competing with your for-profit counterparts.

The above three-part test is simplified; there are intricacies involved, as a more accurate determination of whether your organization’s activities subject it to UBIT requires analysis of IRS Private Letter Rulings and the Internal Revenue Code.  There are also a number of exceptions that may alter the analysis somewhat.  Complicated as it may seem, the take-home is hopefully clear: you can start an earned income venture without necessarily subjecting yourself to UBIT.

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