With the market volatility of the last six months, funding sources and non-profits alike may be uneasy given memories of the 2008 recession. Although predicting future macro-economic forces may be impossible, it is always a good idea for 501(c)(3) non-profit corporations to seek to diversify revenue streams to prepare for shifts in funding. Tax-exempt corporations can creatively act like a business, to an extent, to diversify their revenue streams.
Benefits of Business Income. One possible helpful revenue stream may be the creative varieties of business revenue (earned income) that can help support a non-profit’s mission. Although some non-profits—such as the Girl Scouts with the sale of cookies—have long relied upon such income streams, business revenue may be an underutilized strategy for many non-profits. However, 501(c)(3) should understand the regulations concerning the taxation of such revenue, and instances in which such revenue may jeopardize tax-exempt status.
Permissible and Impermissible Business Activity. In general, non-profits are free to sell goods or services for income to support their mission. However, if the business is regularly carried on and unrelated to the non-profit’s mission, it will generally be subject to unrelated business income tax (UBIT). In short, income from the sale of goods or services that are closely related to the non-profit’s mission is not taxable, while business transactions unrelated to the mission are taxable. For example, revenues from the sale of baked goods from a non-profit bakery that performs job training for the unemployed would not be taxable, as the bakery sales are part of the organization’s workforce development mission. In contrast, a food business run with the aim to raise money for charity will be subject to UBIT because just making money is not an inherently charitable activity and is not related to the organization’s core mission.
UBIT Test. The test to determine whether revenue is taxable (federal and state tax) unrelated business revenue is whether such activity is: 1) a trade or business activity (selling goods or services); and 2) regularly carried on; and 3) not substantially related to furthering the exempt purposes of the organization. If an activity does not meet one of these three criteria, it is not taxable.
Exceptions. There are also business activities that are specifically exempt from taxation by the IRS. Such activities include: 1) bingo or other gambling activities; 2) activities facilitated for the convenience of those served by a non-profit (e.g., a laundry run by a college for students); 3) convention or trade show activities; 4) activities facilitated by volunteers (volunteer bake sales are safe); and 5) the sale of donated merchandise (such as thrift shops). Moreover, purely passive rental income from the lease of real property by a non-profit usually is not taxable.
Impact on Tax-exempt Status. While unrelated business income is allowed, it should be one element of a diversified revenue portfolio, and non-profits should not rely upon such income for a majority of its revenue, or it can jeopardize its nonprofit status. To minimize such risk, a non-profit should keep its business income under 20 percent of its total annual revenue. Once an activity approaches this threshold, the organization should consider moving this activity to a taxable subsidiary.
Reporting. Business income can be a vital source of income for non-profits, but boards of directors and non-profit administrators should consult their tax advisor to ensure they understand whether such income is taxable. If more than $1,000 of unrelated business income is earned in any year by a non-profit, it will be taxed at the state and federal level on the amount over $500, and it must file an IRS Form 990-T.
With careful planning and expert advice, it is possible to incorporate sustainable business income into a tax-exempt organization’s overall funding plan. Although the general categorization of non-profit business revenue by the IRS is straightforward, some nuances can catch nonprofits off-guard. Tax-exempt organizations should review IRS Publication 598 before embarking upon a business revenue strategy, and consult an attorney before implementing a business income strategy.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, PC. To contact Ellis, call 602-456-0071 or email us at firstname.lastname@example.org.