earned income 101 for nonprofits
DESCRIPTION
Many nonprofits use earned income as a source of revenue generation. For example, it was estimated in 2008 that nearly 70% of the $1.4 trillion generated by nonprofits came from the sale of goods and services. However, despite its long-standing, common use in the nonprofit sector, the area of earned income for nonprofits is often wrought with misconceptions and misunderstandings which can lead to untapped sources of revenue or unknowingly jeopardizing the organization’s exempt status. Especially in light of current economic challenges facing the nonprofit sector, nonprofits should become familiar with the basic principles related to earned income to best help their organizations more effectively further their missionsTRANSCRIPT
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Earned Income 101 for Nonprofit
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January 18, 2012
Presented by: Gene Takagi and Emily Chan
Earned Income 101 for
Nonprofits
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Examples
• Let’s start a new business!!!
• Let’s buy an existing business!!
• Let’s partner with a for-profit!
• Let’s start charging
for our services.
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What Have You Got?
• Marketable value of ORG’s assets
• ORG’s capacity to develop and operate the Venture
• Money
• Market
• Management/Staff
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First Considerations
• Mission-consistency
• Board duties
• Prudent investment
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Mission – 501(c)(3) – Charitable Trust
• IRC § 501(c)(3)
• Operational Test
• No private inurement
• No private benefit
• Articles of incorporation – purpose restriction?
• Bases for exempt status – incompatible activities?
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Board’s Duties
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Duty of Care
• Ordinary prudent person standard
• Reasonable inquiry (investigation)
• Independent judgment
• Issues:
• Reliance
• Delegation
– Limit authority
– Reporting
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Duty of Loyalty
• In good faith
• In the best interests of the corporation
• Issues:
• Conflict of interest
• Corporate opportunity
• Confidentiality
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Prudent Investment
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Portfolio Theory
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Fiduciary Duties and Investments
• Lessons from Madoff
• Use care
• Understand what you invest in
• Diversify across asset classes (portfolio theory)
• Rely on appropriate advisors with due care
• Consider strict conflict of interest provisions
• Jeopardizing investment rules for Private Foundations
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Next Considerations
• Employees
• Licenses, Permits
• Leases
• Insurance
• Trademarks
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Tax Considerations
Tax-exemption relates to income tax
Business activities okay
BUT: Is all business income nontaxable? No.
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IRS – Tax Perspective
Related
• Generally exempt income
Unrelated
• May be subject to corporate taxes
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Related Business
Advances the organization’s charitable purposes
irrespective of profits.
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Unrelated Business
1. A trade or business;
2. Regularly carried on; and
3. Not substantially related to furthering the exempt
purpose of the organization.
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UBIT: Trade or Business
• Any activity carried on for the production of
income from selling goods or performing services.
• Even if carried on within a larger framework of
other activities that may, or may not, be related to
the organization's exempt purposes.
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UBIT: Regularly Carried On
• Activities that show a frequency and continuity,
and are pursued in a manner similar to,
comparable commercial activities of nonexempt
organizations.
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UBIT: Not Substantially Related
• Substantially related when the conduct of the business activities has a substantial causal relationship to achieving exempt purposes (other than through the production of income).
• The activities that generate the income must contribute importantly to accomplishing the organization's exempt purposes to be substantially related.
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Substantially related?
IRS considers factors such as:
• Nature and size of business
• Fees
• Who is served
• Business operations
For each activity!
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“Charitable”
• Relief of the poor, distressed or underprivileged (low income, minority, elderly, disabled, other 501(c)(3) organizations, or similarly situated persons)
• Promotion of social welfare by lessening neighborhood tensions, eliminating prejudice and discrimination, defending human and civil rights, and combating community deterioration and juvenile delinquency
• Lessening the burdens of government
• Promotion of health
• Advancement of education
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Earned Income Examples
• One-time: Woodland Park Zoo Doo
• Business activity: Girl Scouts
• Social Enterprise: Goodwill Industries
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Exclusions & Modifications
Including:
• Volunteer workforce
• Convenience of members
• Selling donated merchandise
• Passive income*
* debt-financed property exception not addressed here
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Application of the Rule
Unrelated Business?
(facts & circumstances)
Exclusion? Modification?
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Example: Museum Cafe
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Café Open to Public
- Street entrance
- Open to the public
- UBIT?
Rooftop Coffee Bar
- Accessible through museum
- Must have museum admission ticket
- UBIT?
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Fragmentation Rules Examples
• Dual-use facility
• Sale of various merchandise
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Example: Museum Theater Auditorium
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• Museum has a program of public education in arts and sciences
• Theater designed for showing educational films
• Operation while museum is open to the public – UBIT?
• Operation as a motion picture theater for public when museum is closed – UBIT?
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Example: Museum Gift Shop
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Unrelated Business Activities & Commerciality
• Unrelated business income tax?
• Jeopardize 501(c)(3) status?
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Substantiality Test
• How much unrelated business activity is too much?
• Factors:
• Relationship of the business activity to the overall activities of ORG in terms of time, effort and dollar income
• Relationship between business activity and the exempt function of ORG (commensurate test)
• Reason that ORG conducts the particular business activity
• Methods of operation and the control exercised by the board over the business operations
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Business Considerations/Risks
• Loss of money
• Overburdened staff
• Mission creep
• Private benefit (actual or perceived)
• Adverse PR/marketing
• Culture compatibility
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Legal Form Considerations
• In-house
• Subsidiary
• Other social enterprises
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In-house
• IRC § 501(c)(3) Rules
• Articles of incorporation – restriction?
• Basis for exempt status – incompatible?
• Capacity?
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Subsidiaries
Tax-exempt or taxable subsidiary
Considerations
• Business
• Legal
• Tax
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Subsidiaries
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Nonprofit For-profit
c3
c3
c3
FP
Affiliation Ownership
Investment lawsBusiness w/ different risk profile
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Taxable Subsidiaries
Nonprofit subsidiary
• ORG is sole member
For-profit subsidiary
• ORG is sole shareholder
The key is separateness
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Separateness
• Boards, directors, officers
• Meetings
• Books, accounts
• Filings
• Stationary, marketing materials
• Phone numbers
• Parent does not participate in day-to-day management of Sub
• Helpful facts:
• Majority of Sub’s Board independent of Parent
• CEO of Sub is neither an Officer nor Director of Parent
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Considerations regarding a Subsidiary
• If unrelated business, and substantial activity:
• Form subsidiary
• Liability
• Subsidiary may provide limited liability protection, but there are limitations:
• ORG guarantees Sub’s obligations
• Veil piercing (failure to observe formalities, inadequate capitalization)
• Financing
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Taxation
• Dividend from a taxable subsidiary
- Not taxable income to ORG
• Payment of interest, annuity, royalty or rent from a subsidiary (controlled entity)
- ORG may exclude such payments if they do not exceed FMV (excess is subject to UBIT plus 20% penalty)
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Collaborations with For-Profits
• Contractual Relationships / Sponsorships
• Joint Ventures
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Sponsorships
• Sponsorship payments to ORG not UBTI if sponsor does not receive any substantial return benefit (Qualified Sponsorship Payment or QSP)
• The use or acknowledgment of sponsor
• Insubstantial benefits - FMV does not exceed 2% of sponsorship payment
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Use or Acknowledgement of Sponsor
• Grant of exclusive sponsorship in an activity to a for-profit
• Use of logos and slogans that do not contain qualitative or comparative descriptions of sponsor’s products, services, facilities or company
• Use of a list of sponsor’s locations, telephone numbers or internet addresses
• Use of value-neutral descriptions, including displays or visual depictions of sponsor’s product line or services
• Use of sponsor’s brand or trade names and product or service listing
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Qualified Sponsorship Payment – Yes or No?
• “Ride for Life” sponsored by ABC Company
• “Buy ABC Widgets”
• “ABC Company – for the finest widgets”
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Nonprofit – For-profit Joint Ventures
• NP Hospitals + Physicians
- Ambulatory surgical center
• Developer + Nonprofit
- Low-income housing
• University + Health System
- Distance learning
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Joint Ventures – Motivating Factors
(Nonprofit)
• Additional opportunities to further its charitable
purposes
• Greater access to capital and expertise
• Possibility of capital appreciation
• Flexibility in operation
• Protection from liability
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Joint Ventures – Motivating Factors
(For-profit)
• Enhanced good will
• Increased marketing opportunities
• Access to expertise and political capital
• Availability of financial opportunities
- Low-Income Housing Tax Credits
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Two-Prong Test
1. Whether participation in JV furthers a charitable purpose
2. Whether JV permits the nonprofit to act exclusively in
furtherance of its exempt purpose and only incidentally
for the benefit of its limited partners
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Vehicles for JVs: Social Enterprise Entities
• Certified “B” Corporation
• L3C
• Benefit corporation
• Flexible purpose corporation
• Nonprofit – for-profit joint ventures
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Disclaimer
The information contained in this presentation has been prepared by NEO Law
Group and is not intended to constitute legal advice. NEO Law Group has used
reasonable efforts in collecting, preparing, and providing this information, but
does not guarantee its accuracy, completeness, adequacy, or currency. The
publication and distribution of this presentation are not intended to create, and
receipt does not constitute, an attorney-client relationship.
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