COMMERCIAL ACTIVITIES, UBIT, AND TAX-EXEMPT STATUS
Lost in the daily complexity of managing an organization, one often can't see the legal forest from the trees. The following thoughts are intended to provide some context and a reassuring framework for considering legal questions as they arise on your path.
Loss of Tax Exemption is Very Rare
Your organization is entitled to rely fully on its determination of exemption from the IRS. The first paragraph of the IRS Determination Letter granting tax exempt status to your organization most likely states something like:
Based on information supplied, and assuming your operations will be as stated in your application for recognition of exemption, we have determined you are exempt from Federal income tax under section 501(c)(3) of the Internal Revenue Code.
The Internal Revenue Regulations make clear that your organization and its funders "may rely on such determination so long as there are no substantial changes in the organization's character, purposes, or methods of operation." Reg. § 1.501(a)-1(a)(2). Those relatively few organizations that do lose their tax exemption each year are most often unable to show adherence to their basic charitable purposes. And in the majority of those cases, the IRS has revoked exemption due to intentional malfeasance or self-dealing. The recently-enacted "intermediate sanctions", which allow the IRS to penalize individual offenders directly rather than the organization itself, may make revocation of exemption even more infrequent.
Internal Revenue Laws for Public Charities are Logical and Fair
Internal Revenue law relating to private foundations is arcane and often counter-intuitive, but is surprisingly logical and fair as to public charities. As you cut your way through IRS jargon you may be astonished to find that the tax code, regulations, and cases generally follow basic ethical notions of right and wrong. The overarching theme, in relation to public charities, is that since the public subsidizes nonprofits (through tax exemption and donor tax deductions), nonprofit funds are to be held for public benefit and may not inure to the benefit or private individuals. Surprisingly enough, most public charity law flows logically from this simple concept.
As a nonprofit executive, you can apply this idea in two ways. First, is to pay attention to your gut instinct. If a proposed activity or compensation plan feels wrong, it may well be illegal. Second, if you are proposing a new plan of service or revenue generation, or even profit-sharing, and your true, bottom-line motivation is furthering your organization's charitable aims, then a legal plan can probably be structured. There is likely a way to construct the proper contractual arrangement or legal entity to comply with public charity tax law.
Commercial Activity is Not a Bar to Exempt Status
Of all the legal and public-perception problems faced by the nonprofit sector, probably no issue has caused more debate and confusion, and less action, than the extent to which nonprofit organizations may compete with for-profit businesses.
One of the enduring misconceptions about fee-for-service nonprofits is that they are prohibited from engaging in activities similar to those carried on by commercial enterprises. It is still believed that there are distinct nonprofit and for-profit principles and methods of conducting business. Many nonprofit organizations themselves operate under a vague fear that commercial operations imperil their tax-exempt status.
Nowhere in the Internal Revenue Code does such a prohibition appear. In fact, the Internal Revenue Regulations specifically permit commercial activity. The Regulations state:
An organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes. Reg. § 1.501(c)(3)-1(e).
In addition, no case has held that an organization may be denied exemption solely on the basis of its conduct of commercial activities. The federal cases to date involve loss of exemption based not on the presence of commercial activities, but on the lack of a connection between those activities and tax-exempt purposes. For instance, an organization was formed to disseminate publications containing investment advice. The court held that the organization was not entitled to tax exemption because it was not engaged in charitable or educational activities. Rather its purpose was primarily a "business" one. American Institute for Economic Research v. United States, 302 F.2d 934 (Ct. Cl. 1962).
Exemption has also been denied to commercially-oriented organizations not because of excessive commercial activity but because the activity generated profits which were inappropriately distributed to private individuals. For example, an organization formed to operate summer camps was denied exemption because most of its funds were paid to its two founders. Make a Joyful Noise, Inc., v. Commissioner, TC Memo 1989-4, 56 TCM 1003.
However, because of the continuing confusion at all levels of government between commercial methods of operation on the one hand and commercial purposes on the other, this issue should be monitored if you do have significant commercial income. An earlier ruling demonstrates why this is so.
An organization associated with the Seventh-day Adventist Church operated vegetarian restaurants and health food stores. Even though the purposes of the organization, i.e., preparing and selling food at full retail value, did not qualify for tax exemption, the Court denied exemption on a more murky basis. It ruled that the organization's activity was in direct competition with other restaurants and health food stores. The court stated its impression, without further corroboration, that "Competition with commercial firms is strong evidence of a substantial nonexempt purpose." Living Faith, Inc. v. Commissioner, 60 T.C.M. 710 (1990).
Unrelated Business Income Threatens Exemption Only If Comprising a Substantial Portion of Revenues
Simply stated, unrelated business income is income derived from activities unrelated to a tax-exempt organization's purposes. It is taxed as if earned by a comparable for-profit entity at regular corporate rates.
For purposes of determining unrelated business income taxes, the IRS fragments an organization's revenues on an item-by-item basis. Thus, the sale by an art museum shop of art reproductions is a related activity, but the sale of books on science is not. Rev. Rul. 73-104, 1973-1 C.B. 263, Rev. Rul. 73-105, 1973-1 C.B. 263. Likewise, the sale by a college bookstore of books and supplies is related activity, while the sale of clothing and plants is unrelated and therefore taxable. IRS Private Letter Ruling 8025222.
In their bookkeeping practices, exempt organizations must record and account for each item of sale separately. Unrelated income must be reported annually to the IRS on Form 990-T. In addition, estimated taxes on unrelated income must be paid to the IRS quarterly.
If unrelated business income comprises a "substantial" portion of an exempt organization's income, a loss of tax-exempt status may result. Indiana Retail Hardware Association v. U.S., 366 F.2d 998 (Ct. Cls. 1966). Many organizations unnecessarily fear such a loss of exemption not realizing that establishing a for-profit subsidiary protects the tax exemption of the parent organization.
There is no fixed standard for determining what constitutes a "substantial portion" of an organization's income. In the absence of a threshold level, I generally suggest that an organization consider forming a for-profit subsidiary once unrelated business income regularly begins to equal 20-25% of gross income. Once an organization has upward of 40% or more of unrelated income, it becomes difficult to show that it is organized exclusively for charitable purposes.
The overall point in this area, however, often gets lost, and that is: There are any number of business forms, including limited liability companies and partnerships, that allow nonprofits to delve into the widest variety of business endeavors while retaining their tax exemption.
Automatic Revocation of Tax-Exempt Status for Failure to File IRS Form 990
In 2006 Congress passed the Pension Protection Act which included a requirement that all exempt entities, regardless of size, file an informational return with the IRS. In addition, organizations that fail to file for 3 consecutive years will automatically lose their tax-exempt status.
Since passage of the Pension Protection Act, the IRS has revoked the tax-exempt status of hundreds of thousands of organizations for failure to file Form 990. While many – if not most – of these organizations were defunct prior to revocation, there are still many active nonprofit organization that, for one reason or another, fail to file their return for three consecutive years. The good news is that there is a prescribed method by which a nonprofit may re-apply for federal tax-exempt status. In 2014 the IRS released Revenue Procedure 2014-11 which describes this step-by-step process. In some cases, organizations may be eligible for retroactive reinstatement which can be crucial to avoiding any possible tax liabilities. To learn more about the reinstatement process, please refer to our article “Reinstatement of Tax-Exempt Status” by Attorney Anne Rosenthal.
In order to avoid loss of tax-exempt status in the first place, boards of directors should make a regular habit of reviewing their compliance requirements – at both the state and federal level. The IRS now provides for an automatic 6-month extension for filing of Form 990 and 990-EZ. An organization simply needs to file IRS Form 8868 on or before the filing deadline for the Form 990/990-EZ (4 ½ months after an organization’s fiscal year end). Similarly, many state agencies will also grant an extension for their charitable and state tax filing requirements.