Nonprofits have traditionally relied on large donations from multiple sources in order to maintain their livelihood. In an effort to decrease their reliance on donations, some have opted to find other sources of financial assistance. One way they have sought financial freedom is by opening their own business, yet this is not fail-proof because the commerciality doctrine often negates federal tax-exempt status.
Don’t let the “commerciality doctrine” trip you up
If there’s one thing many nonprofits have learned in the past decade, it’s the danger of becoming overly dependent on donations to sustain operations. That lesson has prompted some organizations to look for other revenue sources, including opening their own businesses. But even business activities related to your exempt purpose could fall prey to the commerciality doctrine, resulting in the potential loss of your exempt status.
What defines commerciality?
The commerciality doctrine is a court-created outgrowth of the operational test. Both were formulated to address concerns over nonprofits competing with for-profit businesses that shoulder a tax burden nonprofits can avoid. The operational test generally requires that a nonprofit be both organized and operating exclusively to accomplish its exempt purpose. It also requires that no more than an “insubstantial part” of its activities further a nonexempt purpose. An organization can operate a business as a substantial part of its activities as long as the business furthers the organization’s exempt purpose.
Courts developed the commerciality doctrine while applying the operational test. They have ruled that organizations were operated for nonexempt commercial purposes based on the commercial manner by which they conducted their activities. In other words, the organizations’ activities were substantially the same as those of commercial entities.
The IRS or the courts consider several factors when evaluating commerciality, including whether the nonprofit is competing with for-profit commercial entities. They also examine how the organization has established pricing policies: It shouldn’t set prices to maximize profits. And they look at the extent and degree of below-cost services provided, rather than at fair market value or cost.
Other factors include:
- Reasonableness of financial reserves (nonprofits shouldn’t accumulate unreasonable reserves),
- Use of commercial promotional methods such as advertising,
- Whether the business is staffed by volunteers or paid staff,
- Whether unprofitable programs are discontinued,
- Whether the business sells to the general public, rather than to a discrete charitable class (for example, other nonprofits or a disadvantaged population), and
- The extent of charitable donations. (Donations should represent a significant percentage of a nonprofit’s total support.)
No single factor is decisive. Courts and the IRS weigh all of the relevant circumstances when making their determinations.
The doctrine at work
The commerciality doctrine isn’t merely an obscure tax principle that rarely comes into play. The IRS has been closely scrutinizing nonprofits’ commercial activities in recent years as more organizations have dipped their toes into social enterprises.
Just last year, the IRS denied a marine science organization’s application for exemption because it didn’t operate for an exempt purpose. The agency found that the organization neither solicited nor received voluntary contributions from the public and that a substantial amount of its income came from fees paid for services.
The IRS concluded that the organization operated in a commercial manner. By operating in such a manner, the organization furthered a substantial nonexempt purpose. Therefore, the IRS ruled, the organization wasn’t operated for an exempt purpose and wasn’t entitled to tax-exempt status.
What about UBIT issues?
Of course, loss or denial of your organization’s exempt status isn’t the only risk when you open a business. You could pass muster under the commerciality doctrine but end up liable for unrelated business income tax (UBIT). Much depends on how significant the business activities are to your organization as a whole.
Revenue that a nonprofit generates from a regularly conducted trade or business that isn’t substantially related to furthering the organization’s tax-exempt purpose may be subject to UBIT. Several exceptions apply, though.
Proceed with caution
As the 2017 case demonstrates, the commerciality doctrine is alive and well. If you’re thinking about launching a new business to drum up additional revenues, consult with your CPA to reduce the risk of running into potential exemption and tax issues.