By Dr. Fred Herzog
To the average person, the concept that a nonprofit organization can earn profits seems contradictory. In the case of a for-profit corporation, everyone understands the goal in that business entity is to make profit. In the 501(c)(3) nonprofit world, nonprofits do make “profits” and they are referred to as the margin or income over expense.
Nonprofit “profits,” described in this manner, sound reasonable. Nonprofit revenue margins, however, must follow IRS financial guidelines.
All nonprofits must seek sufficient revenue to sustain mission and purpose. Nonprofit revenue streams generally come from four main sources: membership dues, public donations, grants and earned income.
Many nonprofits have annual membership dues with one or more categories each with a different fee structure. Not all nonprofits have memberships and have to rely on other sources of financing their operation. For the most part, membership fees are usually the least of a nonprofits’ annual income stream.
Public donations to 501(c)(3) nonprofits are voluntary. This revenue directly supports many nonprofits and forms the basis of the publicly supported 501(c)(3) charitable, scientific, research, safety or athletic organizations. This group receives the most generous of tax exemptions from the IRS and state revenue departments with respect to federal income tax and sales tax exemptions.
The downside of this category is when donors begin to drop away. The burden to keep donations sufficient to keep the organization financially strong usually falls on board or committee members.
A grant request requires an application to a grant-making foundation. The application process is complicated and competitive. Grants generally represent large amounts of financial help and annual re-applications are required to continue support. Grant makers always expect certain goals to be met and outcomes documented with proof.
Close scrutiny by granting organizations has become more intense for grantees. There is always the chance a future grant may not be awarded. Foundations can be private or nonprofit 501(c)(3) foundations. The IRS has strict guidelines for this category regarding operational and financial activities. Grant-making foundations usually have large asset bases from which to award grants. The IRS does tax them on their income from investments.
Earned income has become the largest source of revenue for many nonprofits, basically, out of a financial necessity to survive. The sale of goods and services have offered nonprofits the capacity to cover the costs of maintaining mission and purpose. Earned income has become a great provider of financial stability for nonprofits. The National Center for Charitable Statistics estimated in 2008 nearly 70 percent of the $1.4 trillion generated by nonprofits nationally came from the sale of qualified goods and services. By the end of 2017, experts anticipate this number will witness a substantial increase. Nonprofits have the business of their mission to satisfy.
Earned income for goods and services is a primary goal in the for-profit sector. Businesses sell goods and services, incurring costs along the way. When income is greater than expenses, profit is realized, taxes are paid and owners and shareholders are rewarded by sharing in profits. Nonprofits follow a different set of rules with respect to earned income so as to remain exempt from tax.
When a nonprofit generates earned income from the sale of goods and services, a special set of criteria must be met to insure the revenue is exempt from federal income tax. When IRS criteria is not met, a tax called UBIT (unrelated business income tax) is imposed at current corporate rates. UBIT left disregarded or unpaid results in fines, penalties and organizational dissolution.
Many years ago, as history will confirm, the IRS set the rules regarding earned income for nonprofits. An IRS declaration stated nonprofits should not be allowed to compete directly with the taxpaying for-profit sector businesses while remaining tax free. From that decision forward, nonprofit leadership and relevant business professionals would be responsible to be aware of the importance of earned income that was, in fact, taxable, under the definition of UBIT.
Criteria and UBIT
IRS has set criterion that decides whether UBIT is applicable based on three questions. They appear simple, but are truly complicated, demonstrated by a large volume of legal thinking, briefs, court cases and individual legal opinions. Here are the questions asked during the analysis process:
n Does the nonprofit operate like a for-profit business?
n Is the income earning activities carried on a regular basis?
n Is the earned income substantially related to the exempt purpose of the organization?
Question No. 3 is probably the most controversial. In order for the exemption to be allowed, a substantial casual relationship must exist to the exempt purpose for which the exemption was granted. When an unpaid volunteer work force runs an activity that produces earned income, the IRS excludes the income from UBIT. This same is true when volunteers sell donated merchandise.
Examples when UBIT would apply are such as when a museum sells merchandise not related to the educational purposes of the museum, or when a nonprofit routinely engages in too many unrelated business activities. The IRS provides tax exemptions to publicly supported charitable nonprofits to work within the boundaries of why they were designated exempt.
Dr. Frederick J Herzog is founder and executive director of The NonProfit Resource Center in Citrus County. He can be reached at 847-899-9000 or firstname.lastname@example.org.