Overcoming the Nonprofit Revenue Challenge
Nonprofit revenue is one of the toughest challenges for organizations. If you’ve worked at a nonprofit, then you’ve participated in one of the continual discussions to come up with something creative. But, if your nonprofit team is thinking about creating other income streams to increase your nonprofit revenue, you need to begin by understanding the commerciality doctrine.
In other words, you don’t want your good intentions to run afoul of the law or IRS regulations.
The Commerciality Doctrine
In a world of more fickle donors who are less inclined to maintain long-term support of nonprofits, some charities have
established businesses. However, these businesses can run afield of regulatory rules. So, what is the commerciality doctrine anyway?
In the simplest terms, the courts created the commerciality doctrine. Because nonprofits mostly operate with tax-exempt status, the courts wanted to ensure they didn’t have an advantage over for-profit businesses that do pay taxes. Therefore, the courts developed a “test.”
The test ensures that nonprofits are “both organized and operating to accomplish its exempt purpose. It also requires that no more than an “insubstantial part” of its activities further a nonexempt purpose. In other words, your organization can operate a business as a substantial part of its operations. But, it can only exist as long as the commercial enterprise furthers your exempt purpose.”
IRS and Regulators Checking?
As a matter of fact, they are paying attention. So, how could your group fail the commerciality doctrine test?
As an example, some years ago, a nonprofit claimed that they were going to
promote agricultural products in the restaurant and hospitality industries.
As a result, what they sought to do was to operate hubs throughout a state for patrons to purchase food. But they weren’t looking to make a profit. The clients for the charity were retailers, farmers and restaurants. And the idea of promoting the agriculture foods of the region—without obtaining a profit was one they thought would be a win for the nonprofit.
But the IRS didn’t see it that way. Although the nonprofit claimed it was not seeking to generate a profit but instead promote local agriculture, they failed the test. And in the ruling the IRS quoted from a 1972 decision, “an organization is not exempt merely because its operations are not conducted for the purpose of producing
Are Religious Groups Exempt?
Nope, groups organized to promote religion also have to be careful in any commercial activities.
In 2016, a case went to the court concerning a coffee shop where the IRS ruled (IRS Denial 201645017; UIL Code 501.30-00; released Nov. 4, 2016). The coffee shop claimed that they existed for religious reasons. For instance, they wanted to proselytize by proclaiming the Gospel and promoting the Bible. Also, they said that they would give 100% of its net operating revenue to ministries.
While all of that was well and good, the IRS stated that they operated a commercial business. Why? They stayed open for long hours and they had “only subtle, indirect efforts to promote religion.”
In other words, the IRS took the view that the group was too commercial, and religion was not their priority. But wait, nonprofit revenue from commercial businesses could bring more problems.
Unfortunately, nonprofits that choose to operate enterprises also have another consideration. Meaning, they can run afoul of the IRS and regulators for unrelated business income tax (UBIT).
What does this mean for your nonprofit? As a result of IRS regulations, if you don’t pay tax for UBIT, you can be held liable—even as a tax-exempt nonprofit. So, it’s essential that nonprofit revenue you’re obtaining through a business be substantially related to furthering the mission and tax-exempt purpose of your group.
Are you protecting yourself for the commerciality doctrine test and UBIT?
Those of us in the sector understand that generating healthy nonprofit revenue is a daily struggle. And, because of the intense competition coming from social enterprises and even for-profit businesses focusing on social good, nonprofits have to look harder to be creative.
Meaning, nonprofits are no longer the only place where people can support a good cause.
• Don’t compete with for-profit businesses.
• Don’t seek to maximize profits.
• Be careful about advertising.
• Ensure your nonprofit revenue is significantly coming from charitable donations.
So as to ensure that your nonprofit pays any unrelated business income tax, you can do some of the following things:
• Create a blocker corporation to protect your nonprofit from liability and also develop revenue-generating activities.
• If you have a commercial endeavor, such as a thrift store, ensure that unpaid volunteers staff it.
• Remember that passive income, such as rental income, interest and royalties, are not subject to UBIT.
If your charity is seeking to create new nonprofit revenue by establishing a commercially-driven enterprise, do yourself a favor: Speak to your legal and tax advisors to ensure that you’re complying with the IRS and your legal obligations.
Paul D’Alessandro, J.D., CFRE, is the author of "The Future of Fundraising: How Philanthropy’s Future is Here with Donors Dictating the Terms." He’s the founder and chairman of High Impact Nonprofit Advisors (HNA), and also D'Alessandro Inc. (DAI), which is a fundraising and strategic management consulting company with more than 30 years of experience in the philanthropic sector.
He has worked with hundreds of nonprofits to raise over a billion dollars for his clients in the U.S. and abroad. In addition, as a nonprofit and business expert — who is also a practicing attorney — Paul has worked with high-level global philanthropists, vetting and negotiating their strategic gifts to charitable causes. Paul understands that today's environment requires innovation and fresh thinking, which is why he launched HNA to train and coach leaders who want to make a difference in the world.