Nonprofit Tax Risks
Nonprofits are looking for ways to increase their income. While there are many ways to augment charitable donations for fees for services, it is crucial to be aware of tax triggers that can be imposed even though nonprofit organizations are thought to be tax exempt.
Most commonly nonprofits look to generate revenue by renting their building space when it is not in use or accepting donations of real estate in hopes to sell for a profit. Some of the tax issues that nonprofits should take into consideration when owning and/or operating a building is 1.) Will there be taxable income? 2.) Is there a risk of losing the nonprofit exempt status? and 3.) For real estate transactions will there be property tax? This paper will explore the different tax triggers and ways in which your organization can hedge against these risks.
Unrelated Business Income Tax (UBIT)
Unrelated business income tax can be triggered by income which is derived from a trade or business that is either carried on regularly or is not substantially related to the performance of the nonprofit organization; meaning it does not contribute to the important achievements or purpose of the mission. All of the mention criteria must be present in order for UBIT to incur. (http://media.umassp.edu/massedu/treasurer/UBIT.pdf)
For nonprofits that have their own building, an obvious way to augment their income is to rent out the space when not in use. For example, schools can rent out their gym or classrooms to other organizations during after school hours. These utilization fees are acceptable but there will come a certain quantitative threshold that triggers unrelated business income tax.
Generally, nonprofits that acquire rent through a real owned property are not subject to UBIT. However, this line can often become blurred and open your organization to risks. If the business of renting is considered unrelated to your mission, and comprises too large of an activity percentage then your exempt status could be jeopardized. An important exclusion from unrelated income is revenue generated in a passive manner. Incomes that may be considered to be passive include rent from real properties, revenue that results from a sale of property, royalty payment, dividends and interest earned. A rule of thumb is to consider the percentage of income, staff time and other resources in which activity is devoted and consult a legal professional to ensure the quantitative threshold is not met. Section 511 of the Internal Revenue Code goes more in depth and defines taxable income.
This quantitative threshold is not easily identified within the IRS codes. Practitioners may want to follow a 20% guideline rule. If unrelated business income surpasses 20% of your gross receipts, then the legal repercussions and guidelines should be researched and carefully monitored. Once a 50% level is reached it difficult to convince the IRS that income should remain tax exempt and legal actions may take place.
Selling merchandise is another way to increase your revenue and for many nonprofits this can be as much as 40% to 50% of their income. Particularly museums and arts groups rely on ticket sales as a significant part of their income.
The key to avoiding UBIT is to focus it on your mission. Note that UBIT is triggered by those activities that are unrelated to your mission. There are a few examples of organizations that have successfully created fees for service model and yet still remained within the scope of their mission. One of the most prominent examples is the Christo Rey schools; whose story is told in the book More Than a Dream. This is a story of how one Jesuit school system succeeded. But examples such as these are rare.
Usage Fees Versus Revenue
When reflecting revenue earned from rental income it is strongly recommended to use the term usage fees. Often time’s nonprofits categorize revenue as gross receipts which include donations and income from activities that relate to the organization’s mission.
The IRS often monitors frequency of revenue generating activities among nonprofits. As long as this revenue appears to be sporadic and not extremely uniform, usually it can be justified and categorized in a manner which will not trigger UBIT. That is why it is suggested to use terms such as usage fees when other organizations use our space and gross receipts when receiving donations. Revenue is often more associated with taxpaying businesses.
Sales Tax and Property Tax
Nonprofits are tax-exempt from income tax, sales tax and property taxes. Each state has different laws that need to be followed in order to be considered nonprofit. Where the line of property tax and sales tax is often blurred is when a nonprofit organization engages in activity from its business, property, or services that generate a profit. Whether this profit is by the organization itself or not, does not matter; if the property generates profits, then the issue of property tax is triggered.
Risks associated with these include accepting in-kind donations because a lot of donors have reduced cash flow these days they often want to help by donating property, stock etc. At what point do those trigger tax? If the property is flipped or sold for a profit or used to engage in profit generated activities, most likely property tax and sales tax will come into play.
There are ways in which a nonprofit can avoid these taxes. First, all transactions have to be carefully and clearly documented. If it shows that the sale was in lieu of fundraising efforts, or is used to generate revenue for a specific reason or project that directly relates to the mission then it may not appear as profit because it is in a sense “reinvested” into the nonprofit.
Overall, the issue of paying sales or property tax is tricky because it widely varies depending on the state and local regulations that monitor nonprofits. Researching within your jurisdiction is strongly recommended because often times the answer can depend on the type of organization, the types of goods being sold, etc.
Finally some nonprofits have taken to start a for profit business that runs alongside the nonprofit. Here are the dangers not as much in the taxes because it is clear from day one that
you will be paying taxes. The danger here is the distraction from your mission. Most nonprofit Executive Directors underestimate what it will take to start and run a for profit business.
Risk of Losing Your Tax Exempt Status
If a nonprofit reached unrelated business income that is defined as “substantial” in the eyes of the IRS, loss of tax exemption status may be set in motion. However, in some rare cases, organizations have exceeded a 75% to 25% ratio of unrelated income versus earned revenue and managed to remain a tax exempt organization, but this is a risky action.
In such circumstances that a nonprofit reaches a substantial portion of unrelated business income, creating a taxable subsidiary may be a creative way in which an organization can freely engage in commercial activity while avoiding the loss of exemption to the parent.
For example, if an organization experiences a large volume of unrelated business income, to hedge against the loss of tax exemption the parent organization can establish a for-profit subsidiary in which they have full control over. The parent would need to enter a lease with the subsidiary for a fixed rental amount equally nearly 100% of its after expense net income. Deducting the rental payments to the parent from gross income allows the subsidiary to incur almost no tax liability. The exempt parent through the simple device of creating a subsidiary would defeat the restraints that are imposed on an exempt organization. However, straying from the nonprofits mission is a risky tradeoff that needs to be considered along with professional consultation. (Treasury Regulations Section 1.501(c)(3)- 1(e)(1)).
The real focus of a nonprofit should be on mission. The donors that you have and the success that you have had can be directly attributed to how well you have carried out the mission and how faithful you have been in succeeding through the years. Efforts to increase your income through earned revenue as opposed to donated revenue can often times lead to taking your eye off the ball of those things that you are specially suited to do. Often the answer is re-doubling your efforts in the fundraising arena, learning new skills, and adopting best practices so that your charitable contributions remain at the level needed to carry out your mission.
Even through the economic hardships that have evolved over the years, nonprofits are still able to perceiver, and continue operations. It may result in both the donors and the organizations getting creative in fundraising and development strategies.
NOTE: The Giersch Group offers General Executive Counsel to help leaders in nonprofit organizations manage from their financial statements, stay on track and keep their organization strong and growing. This service involves a monthly meeting that addresses financials, operations, and fundraising concerns an affordable price. For more information, please visit http://www.gierschgroup.com/NonprofitServices
For more information, please visit the Giersch Group at www.gierschgroup.com or contact us at prosper@gierschgroup.com.
