THE LEGAL OVERVIEW
C. The corporate subsidiary may be an “S” corporation for tax purposes (a nonprofit, tax-exempt entity is a qualified “S” shareholder).
5. What are the most common legal mistakes made by nonprofit organizations as they work on planning and implementing for-profit ventures?
A. Poorly structured nonprofit organization
B. Mission and objectives not well defined
C. Poorly functioning board of directors
D. Too much reliance upon free counsel (typically from professionals who do not specialize in nonprofit matters), or counsel from friends-of-the-board who are not specialists in nonprofit legal and accounting matters.
E. Assuming the organization cannot do it (“it’s illegal,” meaning that the activity may generate taxable income)
F. Assuming the organization can do anything (and “get away with it”) because it’s a nonprofit organization
G. Lack of control or supervision
H. Conflicts of interest
I. Poor bookkeeping and accounting records
J. Poor financial controls
6. What legal risks does the nonprofit organization face when venturing out to form a for-profit business under its umbrella?
A. Loss of tax-exempt status
B. Generating taxable income
C. Application of state and federal employment laws
7. What resources are available for nonprofit executives to learn more about the legal aspects of establishing a for-profit business?
A. Lawyers specializing in nonprofit organizations (ask other nonprofit executive directors for referrals; ask the large foundation directors for referrals, call the large law firms in town for lawyers (some of which have nonprofit specialists)
B. Accountants specializing in nonprofit organizations (ask other nonprofit executive directors for referrals; ask the large foundation directors for referrals, call the large accounting firms in town for accountants (some of which have nonprofit specialists)
www.nonprofit-startup.com;www.aristotle.net/~nonprofit; www.volunteercenter.org; go to google.com or other search engines and type in “UBI” or “unrelated business income”. Many other resources are available online.
In an era where nonprofit organizations are scrambling for what seems like an increasingly shrinking donor pool of available funds, or facing increasing competition for the same funds, many organizations are looking at revenue producing activities or ventures to supplement shrinking revenues.
Common fund-raising events include raffles (new rules go into effect in California July 1, 2004), golf tournaments, silent auctions, and dinners with entertainment and speakers who are well-known in the organization’s area of focus. Less common but well known are business enterprises such as thrift stores, bookstores connected to churches or mail-order book, tape and related-product sales by religious radio broadcasters, and so on. Some nonprofits get into marketing and selling products unrelated to their mission, licensing their tradename for use on services or products, and other activities that generate revenues. Some receive donations of rental properties and lease these out for profit. Others own (through subsidiary corporations) own and operate totally unrelated for-profit businesses.
These activities raise many legal, accounting and tax issues, and potentially run the risk of jeopardizing the organization’s tax-exempt status if handled improperly. Such enterprises or activities also raise issues of conflicts of interest (do board members, founders, officers (or their family members or other close relatives own interests in or receive compensation from vendors providing products or services to the venture, or receive other direct or indirect benefit from the activity), duties of loyalty (what is in the best interests of the organization), and related issues.
Just as important and relevant, though seldom mentioned in the literature on the subject, are issues such as whether entering into business enterprises or other income-producing activities result in shifting the organization’s focus away from the principal mission and objectives to such an extent that the organization’s principal focus is diluted and misdirected more towards fund-raising than achieving the organization’s objectives. Perhaps hiring experienced grant writers and professional fund raisers would be a better method of raising additional funds, and just as remunerative in the end, with fewer problems, than tackling a separate money-making enterprise.
However, many organizations hold successful fundraising events each year that do not result in a misdirection of focus and mission, become a regular part of the organizations annual programs, and that do not realize unrelated business income or risk loss of tax-exempt status.
A common misconception is that nonprofit organizations cannot run programs or small business ventures that “make a profit” in the accounting or tax sense, or that a nonprofit organization is prohibited from owning a for-profit business, or operating a business from which it derives income that will inure to the benefit of the organization. These are, generally speaking, both incorrect assumptions, but the ownership and operation of a for-profit business does raise a number of legal and tax issues that must be understood and carefully reviewed with legal and tax counsel, and conducted with care to avoid problems.
Another common misconception is that unrelated business income tax is ‘bad’ and to be avoided at all costs, and will jeopardize the organization’s tax exempt status. First, a nonprofit organization certainly can “make a profit” from a strict income minus expenses bookkeeping standpoint, and suffer no tax or legal consequences with respect to activities that are substantially related to the organization’s charitable purposes. Secondly, while operating a business activity that is not substantially related to the organization’s charitable purposes can in fact jeopardize an organization’s tax exempt status if operated by the nonprofit organization and not through a for-profit subsidiary, that risk can be avoided with proper legal and accounting counsel. Furthermore, as long as the corporate income tax rate is not 100%, and the for-profit subsidiary can in fact make a profit for accounting and tax purposes, the business activity may be a perfectly fine one to conduct. What’s more, the activity, even if “substantial,” may not in fact generate unrelated business income tax, as discussed below, if the activity falls in one or more of the three principal exceptions to the general rule.
Generally, income from activities that have no direct relationship to the exempt purpose of a nonprofit organization is “unrelated business income” (UBI). Specifically, an unrelated trade or business is one that is regularly carried on by the nonprofit organization and is not substantially related to the organization’s exempt purpose. IRC §512(a).
Where a tax-exempt organization engages in an unrelated activities (e.g. activities that generate UBI that is subject to tax), if the activities are substantial as compared to its exempt activities, the tax-exempt status of the entity is jeopardized. When unrelated activities become substantial (e.g. if revenues, expenses or employee time devoted to unrelated activities approaches or exceeds 15%), a tax-exempt organization must consider transferring those activities to a for-profit subsidiary so that its exempt status will not be jeopardized.
There are a number of ways to channel revenue from a for-profit subsidiary to its tax-exempt parent. For example, because the staff and other resources of the for-profit subsidiary are often the same as those of its tax-exempt parent, the taxable subsidiary can—and should—reimburse the exempt organization parent for the subsidiary’s occupancy costs, allocable share of employee time, and use of the parent’s equipment and supplies. The tax –exempt parent might lend money to it subsidiary, with the loan bearing a fair market rate of interest and other commercially reasonable terms (payment, duration of loan, secured perhaps). The parent can also license the use of its name or log to a for-profit subsidiary that sells products or services, so the subsidiary pays a royalty to the parent. The subsidiary may also distribute its earnings and profits to the parent in the form of dividends. Under the UBI rules, passive income, such as dividends, interest and royalties, is generally exempt from the unrelated business income tax provided that the distribution is not deductible by the subsidiary.
What are the General Rules?
An activity is an unrelated business (and subject to UBIT) if it meets three requirements:
There are, however, a number of exclusions and modifications to this general rule.
The term “trade or business” generally includes any activity carried on for the production of income from selling goods or performing services. It is not limited to integrated aggregates of assets, activities, and goodwill that comprise businesses for purposes of certain other provisions of the Internal Revenue Code. Activities of producing or distributing goods or performing services from which gross income is derived do not lose their identity as trades or businesses merely because they are carried on within a larger framework of other activities that may, or may not, be related to the organization’s exempt purposes.
Business activities of an exempt organization ordinarily are considered “regularly carried on” if they show a frequency and continuity, and are pursued in a manner similar to, comparable commercial activities of nonexempt organizations.
To determine if a business activity is “substantially related” requires examining the relationship between the activities that generate income and the accomplishment of the organization’s exempt purpose. Trade or business is related to exempt purposes, in the statutory sense, only when the conduct of the business activities has causal relationship to achieving exempt purposes (other than through the production of income). The causal relationship must be substantial. The activities that generate the income must contribute importantly to accomplishing the organization’s exempt purposes to be substantially related.
The Internal Revenue Code contains a number of modifications, exclusions, and exceptions to unrelated business income. For example, dividends, interest, certain other investment income, royalties, certain rental income, certain income from research activities, and gains or losses from the disposition of property are excluded when computing unrelated business income. In addition, the following activities are specifically excluded from the definition of unrelated trade or business:
Examples of For-Profit Activities Operated by Nonprofit Organizations
Another area in which there is not current guidance from the IRS or Regs relates to hyperlinks, where a charity’s website contains a sponsor’s logo and a link to the sponsor’s website. The mere display of the sponsor’s logo arguably meets the requirements for “qualified sponsorship payments.” But if the linked sponsor’s site contains comparative or qualitative statements about the sponsor or its products, the risk of a sponsorship payment as being view as UBI substantially increases. In the most recent cases, the IRS seems to take the position that merely maintaining a passive link to a sponsor’s website may not generate UBI, where a sponsor’s banner that moves across the non-profit organization’s website is more likely to be considered advertising.
A non-profit organization that establishes an online gift shop faces the same UBI issues as any other non-profit that operates a retail gift shop: are the items sold substantially related to the organization’s exempt function?
The IRS has not taken a definitive position on the tax consequences of a charity’s website that contains a link to a sponsor’s site, where the internet user can buy products on the sponsor’s site and the charity receives a percentage of the sponsor’s profits. If the payment is characterized as a “royalty,” the payment to the charity by the sponsor is exempt from UBIT. If the payment is characterized as a “referral fee,” then the question may relate to whether the referrals (to the sponsor’s site) significantly further the exempt mission of the charity (referrals by a local bar association to lawyers may further the organization’s purpose of providing “the best information, advice, and legal services possible to every citizen in the community.” (PLR 8432003).
Charity mall sites permit an individual to link from a charity’s website to a variety of online stores and with which an independent third party (“charity mall operator”) has an agreement. The individual makes a purchase, and a portion of the purchase price is donated to the charity selected by the buyer, at no additional cost to the buyer. In this context, it is less likely that the charity will be characterized as conducting a business, so payments to the charity will look more like a royalty from the mall operator.
The summary and overview given in the previous ten pages is by no means complete or exhaustive, and generalizes many topics which have numerous unmentioned exceptions or nuances, and does not mention many exceptions or other matters which may be pertinent to the examples given or a reader’s specific circumstances. The IRS, the tax and appellate courts are considering and reconsidering these issues all the time, and the subject needs the constant attention of and counsel from competent legal and tax professionals, as well as others. The summary above is not, must not be construed to be, and must not be relied upon as legal advice, nor is any attorney-client relationship established by the publication of this material. A nonprofit organization that is considering the start-up or acquisition of a for-profit venture must seek competent legal and accounting/tax advice from professionals that specialize in the nonprofit arena on a regular basis.
The foregoing summary was provided by Paul S. Nash, an attorney in Irvine, California. Mr. Nash has been practicing law for 27 years, and specializes in representing nonprofit and for-profit organizations. He serves as general counsel to about thirty nonprofit organizations, serves on the boards of several, and regularly consults with nonprofit boards on matters of board governance, operating issues, conducts “legal audits” of nonprofit organizations, and consults on matters of Bylaw revisions, formulation and adoption of key operating policies, foreign grant-making issues and issues, and so on.