I get a lot of interesting phone calls from people with creative ideas for nonprofits. One common misunderstanding is that you can run an ordinary business, turn the profits over to charity, and qualify as a tax-exempt organization under Section 501(c)(3). Unfortunately, turning over profits to charity does not qualify a business activity as charitable. This is what the IRS refers to as a Feeder Organization.
Code Section 502 provides that an organization operated for the primary purpose of carrying on a trade or business for profit does not qualify for exemption under Code Section 501(c)(3) on the ground that all of its profits are payable to charitable organizations.
The prohibition on exemption for feeder organizations originated in a series of cases that held that several organizations whose sole activity was engaging in commercial business qualified for exemption even though the only basis for exemption was the obligation to distribute their profits to specified exempt organizations.
Famously, one of the companies involved had as its sole activity the operation of a macaroni factory and subsequent distribution of its profits to its tax-exempt parent. These cases permitted feeder organizations to compete with for-profit businesses and not pay any income tax. Code Section 502 was designed to level the playing field.
The idea behind Code Section 502’s prohibition on exemption for Feeder Organizations is that one cannot convert a for-profit business into a charity simply by contributing all of the profits to charitable organizations. The policy rationale is that permitting businesses to operate on a tax-free basis just because they donate their proceeds to charity permits unfair competition in the marketplace.
Therefore, to qualify for exemption under Code Section 501(c)(3), an organization’s activities must be inherently charitable, educational, religious, literary, or scientific. For example, a restaurant that wishes to turn all of its profits over to charity cannot qualify as charitable on that basis alone.
However, a restaurant that is operated as a work-force development operation to provide training and employment to a charitable class, such as the disabled, may qualify under Code Section 501(c)(3).
As with all tax rules, there are exceptions. The exceptions include:
- The deriving of rents which would be excluded under section 512(b)(3), if section 512 applied to the organization,
- Any trade or business in which substantially all the work in carrying on such trade or business is performed for the organization without compensation, or
- Any trade or business which is the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions.
So, if your nonprofit business plan is mostly business, with a donation tacked on at the end, you most likely have a feeder organization that is better structured as a taxable for-profit.
 See Roche’s Beach, Inc. v. Commissioner, 96 F. 2d 776 (1938); C. F. Mueller Company v. Commissioner, 190 F. 2d 120 (1951).