Nonprofit Law Jargon Buster – 501(c)(3) Organizations and the Commerciality Doctrine

Commerciality DoctrineThe well-meaning have been advising exempt organizations to “operate like a business” for years. If the organization is a Section 501(c)(3) organization, operating too much like a business can cost it its tax-exempt status. This concept is known as the “Commerciality Doctrine.”

The Commerciality Doctrine has evolved in the courts and is applied to determine whether an organization complies with Section 501(c)(3)'s requirement to operate exclusively for exempt purposes. A key factor indicating an organization is operating in an excessively commercial manner is that its activities are in competition with those of for-profit commercial entities. This concept is sometimes referred to as the “counterpart test.” Other factors evidencing a commercial purpose are as follows:

-          pricing to maximize profits;

-          generation and accumulation of unreasonable reserves;

-          use of commercial promotional methods, such as advertising;

-          sales and marketing to the general public;

-          high volume of sales;

-          the organization uses paid professional staff rather than volunteer labor;

-          the organization discontinues money losing programs; and

-          the organization does not receive significant charitable contributions.

Factors evidencing the absence of a commercial purpose include the following:

-          lack of competition with for-profit entities;

-          below market rate pricing;

-          relatively insubstantial reserves;

-          lack of commercial advertising practices;

-          the absence of sales to the general public;

-          low volume of sales;

-          use of volunteers and low-paid non-professional staff; and

-          significant charitable contributions.

The most frequently cited case illustrating the commerciality doctrine is a case involving the Airlie Foundation. The Airlie Foundation operates a conference center near Washington D.C.. The conference center was operated for the stated purpose of conducting scientific research by sponsoring meetings of scientists, administrators, scholars and others.

In 1988, the IRS revoked the foundation's status due to both private inurement to its founder and excessively commercial operations. Five years later, a district court upheld the IRS' determination solely on the basis of inurement. Later, the foundation reapplied for Code Section 501(c)(3) status. The IRS denied the application on the basis of excessively commercial purposes. The foundation filed for a declaratory judgment against the IRS.  IRS' decision was again upheld.

The foundation argued it did not operate in the same manner as the commercial conference facilities in its area. The foundation demonstrated that its profit margins were below those of its taxable competitors. To support its contention, it showed that it fully subsidized 4.75% of events and partially subsidized another 12.5%. However, the facts also showed that 30-40% of the events were of a private or corporate nature. Another 20% were held by government agencies and the balance by nonprofit or educational entities.

The court reasoned that the operational test requires the foundation to operate primarily to accomplish its exempt purposes. The commerciality doctrine provides that operating in a commercial manner will violate the operational test. The court applied the above factors to the foundation and found that while discounts were granted in more than 17% of the events, resulting in below-cost services, the balance of the events were priced in a commercial manner. Further, the foundation maintained a commercial website, paid significant advertising and promotional expenses and competed regularly with commercial conference centers in the area.

This case is a good illustration of the threat that commercial activities can pose to exempt organizations. It is not enough to price goods or services below the competition. To  operate in a noncommercial manner, exempt organizations must provide services at substantially below cost, preferably to charitable recipients, and should not advertise in a commercial manner or operate in a manner that indicates a purpose of maximizing profits. While nonprofits can charge, the operations must clearly demonstrate an exempt purpose.

Practically, the issue of commerciality usually arises when a tax-exempt organization engages in any endeavor for which a clear for-profit counterpart exists in the marketplace. Typical examples include publishing, consulting and sales of arts and crafts. Today, the Commerciality Doctrine is a threat to the increasingly popular movement toward social enterprises. Those that choose to organize as Section 501(c)(3) organizations should only do so after a thorough review of the Commerciality Doctrine.

3 thoughts on “Nonprofit Law Jargon Buster – 501(c)(3) Organizations and the Commerciality Doctrine

  1. in view of the growing tendency for income-generating, i.e. profit-making initiatives within NGOs, wouldn’t it make more sense to apply the criteria of the end of the profit making? If the above-mentioned foundation could have argued that it uses its “commercially made” income to fullfil its 501c(3) stated goals and mission, shouldn’t it get some benefits because of that???

  2. Ellis, this is such a good explanation! Such a confusing subject, yet you have made it understandable. I will refer my readers to this frequently. Thanks!

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