In Part 1 of this Series, we discussed the various options for structuring a social enterprise. This week we turn to one of the unique issues impacting non-profit organizations who try to raise money by starting a social enterprise--unrelated business income. As a non-profit (and for this blog post, we're going to focus on 501(c)(3) organizations), how do you start a social enterprise without jeopardizing your charitable status and without incurring unexpected tax liabilities?
Nonprofits must be organized and operated exclusively for religious, educational, scientific or other charitable purposes. The general rule for business revenue earned by a nonprofit is that the revenue must be related to the organization’s charitable purpose. Otherwise, the revenue is treated as unrelated business taxable income (“UBTI”). The IRS requires nonprofits to pay tax on UBTI when engaged in commercial business activities in order to prevent tax-exempt organizations from having an unfair advantage over for-profit, taxable competitors.
Unrelated Business Taxable Income
Revenue earned by a nonprofit will be treated as UBTI when:
Generally, any activity that has a commercial counterpart (selling goods or services) is considered a trade or business. The revenue will be considered “substantially related” when it has a causal and substantial relationship to the achievement of an organization’s exempt purposes (other than the need for funds) and it contributes importantly to the accomplishment of any purpose for which the organization was granted tax-exempt status.
Certain sources of revenue are never treated as UBTI. Some examples include businesses operated by volunteers; businesses operated for the convenience of the non-profit’s members (i.e., where the goods or services are not sold to the general public); selling donated merchandise; certain convention and trade show activity; bingo games (but not other forms of gambling or the sales of other products such as food at bingo games); the sale of the organization’s mailing list to another nonprofit; qualified sponsorship payments (i.e. a payment of money, property, or services by any person engaged in a trade or business with respect to which there is no arrangement or expectation that the person will receive any substantial return benefit); and certain passive income (i.e., interest income, royalties, or dividends).
Substantially Related: Achieving a Charitable Purpose vs. Raising Money
The determining factor is the purpose behind the activity (i.e. the why), not the activity itself. For example, the IRS has held that an art museum may sell reproductions of art works on display at the museum and doing so is related to its exempt purpose as an educational organization. However, souvenir items related to the city where the museum is located are not arts related and therefore would not be considered an important contribution to the museum's exempt purpose. So the sale of art reproductions is not taxable income, but the sale of souvenir items is unrelated taxable income.
Social enterprises that provide a service, especially management, consulting, or training services, are especially scrutinized by the IRS. There are several factors the IRS considers in determining whether a social enterprise service is substantially related to an organization’s exempt purpose:
It is difficult for a non-profit to sell services at a profit without incurring IRS scrutiny.
UBTI Can Threaten Your Organization's Tax-Exempt Status
Aside from the need to pay income tax on UBTI (which requires the filing of a separate tax return in addition to the organization’s annual 990), it can also threaten your organization’s charitable status if the UBTI becomes excessive (not because UBTI itself is impermissible but because it calls into question whether the organization is still operated exclusively for charitable purposes). However, there is no bright-line rule for what percentage of an organization’s revenue can come from UBTI before the IRS intervenes. The IRS has focused its analysis on whether the organization’s charitable programs remain “commensurate in scope” with its financial resources. The amount of time and effort spent on charitable programs and activities versus commercial activities and how the business income is used should also be considered. If income from the social enterprise activity becomes a significant line item in the organization's budget, then it's time to consider establishing a subsidiary to conduct the business activity.
If you operate a non-profit organization and plan to add a social enterprise component to raise money, it's important to discuss the details with both legal counsel and your tax advisor.