Generally, charitable 501(c)(3) organizations are exempt from paying income tax because their fundamental mission is to benefit society. The majority of revenue generated by these organizations contributes significantly to the achievement of their exempt purposes. Yet many such organizations also operate retail ventures such as a museum gift shop or a hospital-run thrift shop. Organizations should be aware that doing so has pitfalls from a tax perspective.

While nonprofit organizations may receive an unlimited amount of income that is "substantially related to the pursuit of its exempt purpose" (generally not subject to income tax), charities that regularly engage in business activities unrelated to their exempt functions may be subject to tax on the net income from these activities. If this unrelated business activity becomes "substantial," the charity risks losing its exempt status. Therefore, it is vital that the organization not only demonstrate that its income-generating business activity is an appropriate method of achieving the organization's exempt purposes, but also show that there is no substantial non-exempt commercial purpose.

How Much Unrelated Business Taxable Income (UBTI) Can a Nonprofit Receive Without Jeopardizing Its Tax-Exempt Status?

Although charitable organizations must be both organized and operated exclusively for tax-exempt purposes, the word "exclusively" in this case means "primarily," not "solely." The IRS has inconsistent guidelines and, in turn, determinations are often subjective.

The IRS has frequently used what is sometimes referred to as the "commerciality doctrine" in its analysis of organizations' retail operations to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete.

In Airlie Foundation v. Internal Revenue Service, 283 F. Supp. 2d 58 (D.D.C., 2003), the District Court relied on the "commerciality doctrine" in applying the operational test. The operational test requires both that an organization engage "primarily" in activities that accomplish its exempt purpose and that not more than an "insubstantial part of its activities" further a non-exempt purpose. Because of the commercial manner in which the organization conducted its activities, the court found that it was operated for a non-exempt commercial purpose, rather than for a tax-exempt purpose. The court stated: "Among the major factors courts have considered in assessing commerciality are competition with for profit commercial entities; extent and degree of below cost services provided; pricing policies; and reasonableness of financial reserves. Additional factors include whether the organization uses commercial promotional methods (e.g., advertising) and the extent to which the organization receives charitable donations."

Assuming the organization itself is still considered by the IRS to be a nonprofit, the next step is to determine whether any income from retail ventures is UBTI. Each of the following criteria must be met in order for the IRS to consider such income to be UBTI:

• The activity producing the income must be a "trade or business," which means any activity carried out for the production of income from the sale of goods or the performance of services.
• The activity must be "regularly carried on," which is defined as an activity that shows frequency and continuity and is pursued in a manner similar to comparable commercial activities conducted by for-profit entities.
• The activity must not be substantially related to the nonprofit's exempt purpose.

For nonprofits, the IRS specifically excludes several types of income from classification as UBTI. These include:

• Income generated substantially by unpaid volunteers
• Income from the sale of merchandise donated to the nonprofit
• Dividend, interest and royalty income and gains from the sale of property
• Rental income from real property (unless the property is debt-financed)

Because the IRS does not provide specific, iron-clad guidelines for organizations to follow regarding Unrelated Business Income Tax (UBIT), they must instead use their own judgment to interpret IRS rulings made in cases similar to their own.

IRS regulations provide that a trade or business is "related" to an organization's exempt purposes only where the conduct of the business activities has a causal relationship to the achievement of exempt purposes, and is "substantially related." For the conduct of trade or business from which gross income is derived to be substantially related to exempt purposes, the production or distribution of the goods from which the gross income is derived must contribute importantly to the accomplishment of those purposes.

A connection between the items sold in a gift shop and accomplishing the organization's exempt purpose must be established before sales of the items can be considered substantially related within the meaning of section 513(a) of the Code.

Because each case is examined individually and a determination is based on the specific facts and circumstances involved, it is difficult to extrapolate from a prior ruling to your particular situation. Further complicating matters is the fact that the IRS explores not only the activity itself, but also compares the size and extent of the activity with the nature and extent of the exempt function it is said to serve.

What does this mean? In essence, it means that an organization that derives income from activities related to the performance of its exempt functions — which would normally render this income exempt from taxes — might not be out of the woods regarding UBIT. If those activities are conducted on a larger scale than the IRS considers "reasonably necessary" to perform the exempt functions, the income attributable to the excessive portion of the activities may be deemed UBTI and therefore taxable.

Here are a few examples:

• Reg. 1.513-2(a)(4) states that the operation of a wheat farm is substantially related to the exempt activity of an agricultural college if the wheat farm is operated as a part of the educational program of the college, and is not operated on a scale disproportionately large when compared to the educational program of the college.
  
  
• Rev. Rul. 73-104 held that the sale of greeting card reproductions of art works by an art museum exempt from tax under section 501(c)(3) does not constitute an unrelated trade or business. The rationale of Rev. Rul. 73-104 is that the card sales contribute importantly to the achievement of the museum's exempt educational purposes by stimulating and enhancing public awareness, interest, and appreciation of art. Rev. Rul. 73-104 also states that the fact that the cards are promoted and sold in a clearly commercial manner at a profit, and in competition with commercial greeting card publishers, does not alter the activities' relatedness to the museum's exempt purposes.
  
  
• Rev. Rul. 73-127 describes a nonprofit organization that was formed to operate a retail grocery store to sell food to residents of a high-poverty area at prices substantially lower than those charged by competing grocery stores, to provide free grocery delivery service to residents who needed it, to participate in the Federal food stamp program, and to provide job training for unemployed residents. The store was operated by a staff of employees experienced in the retail food industry and in a manner similar to profit-making businesses in the area, but had a smaller markup than the competing stores.

The IRS found the store was conducted on a scale larger than is reasonably necessary for the performance of the organization's training program and was not intended to, nor did in fact, serve solely as a vehicle for carrying out the training program of the organization. The IRS denied the organization recognition of exemption.

What Does All This Mean to Your Organization?

The takeaway is this: to avoid UBIT liabilities, nonprofit organizations must first ensure their income-generating activity is "substantially related to its exempt purpose," and then further demonstrate that the income-generating activities are conducted on an appropriate scale in proportion to the organization's charitable mission.

This is true whether the operation in question is a farm, gift or other type of retail shop, catering operation, or myriad other commercial-like enterprises run by nonprofits.

So when trying to determine whether you may have a UBIT liability, ask yourself the following types of questions:

• Is my organization's income-generating operation substantially related to its stated exempt purpose?
• Does this income contribute importantly to the accomplishment of my organization's exempt purpose?
• Do these activities generate more income than is needed to accomplish my organization's exempt purpose?
• Are retail sales pursued in a manner generally similar to comparable commercial activities? Does my organization compete directly with commercial businesses in this area?

Proceed with Caution

Expanding into new activities is a great way to grow your nonprofit organization, support its mission and take advantage of new opportunities. Proceed cautiously, however, because despite the fact that commercial-like activities can help generate after-tax income, straying too far into commercial territory can cause revocation of your exempt status.

If you have questions regarding UBTI, or would like assistance in determining whether your organization's retail activities might be subject to UBIT, please contact your local CBIZ MHM tax professional.

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