Earned income strategies are a hot topic for nonprofits right now. And why not? Most organizations crave the security offered by a steady stream of cash flow from an activity that board members don’t consider “begging.” But have you considered whether the new revenues are actually taxable? That’s right, not everything a nonprofit does is tax-exempt. The commerciality doctrine was enacted many years ago to prevent nonprofits, including faith-based organizations, from unfairly competing with for-profit businesses. Essentially, if your nonprofit is engaging in a business similar to a for-profit entity, you’ll probably owe taxes like a for-profit business. However, as with most tax rules, there are plenty of exceptions.
What makes an activity taxable? There are three criteria that must be in place for revenues from an activity to be considered taxable unrelated business income:
1. The activity is regularly carried-on
2. The activity is operated with the intent to make a profit
3. The activity is not substantially related to the organization’s exempt purpose
It’s important to remember that it doesn’t matter what you do with the revenues, the taxable nature is determined based on the activity itself. We often hear something like “well, the activity didn’t relate to our exempt purpose, but we used all the revenues to fund our programs.” The revenue is potentially taxable because the activity that generated the revenue didn’t directly further the exempt purpose of the organization. If the activity is also regularly carried-on and intended to make a profit, it will probably be taxable. Common example of taxable income include rental income, advertising and certain services.
However, multiple exceptions to the general rule make things a little more complicated. Using volunteers to perform services may mean those services aren’t taxable, and owning a building with no mortgage typically allows you to earn rent income tax-free. There are other exceptions for certain situations, so be sure to consider whether you can structure your activity to avoid taxability.
A common misconception is that there is some specific percentage or dollar amount of taxable income a nonprofit is allowed each year. The actual rule is much more vague than most people realize, and it’s not focused on the revenues. The real issue is how the organization’s resources are being used. This includes resources like money, property and staff time. If you’re concerned that your organization is devoting too much of its resources to activities unrelated to the exempt purpose, ask yourself this: Is the organization organized and operated primarily for an exempt purpose? If the answer is no or you’re not sure, the exempt status of your organization could be in jeopardy.
There are a lot of creative new revenue streams being created by nonprofits right now in response to government funding cuts, more competition for donors and even competition from for-profits. If the new rules allowing general crowd funding by small businesses passes, it could lead to many individuals funding exciting new entrepreneurial ideas instead of giving to charitable causes. Nonprofits are naturally looking for ways to generate consistent revenues that aren’t so heavily dependent on the unpredictable generosity of donors. Earned income can be a great diversification strategy for nonprofits, although it should not be considered a solution. The number of for-profit businesses that don’t survive should be an indication of how difficult it can be to create a reliable earned income structure. It’s important to have a realistic budget, appropriate policies and procedures and a good understanding of the potential tax implications in order to create a strong, sustainable earned income model for your nonprofit. Let us know if we can help you evaluate your earned income strategy!
