CAN A NONPROFIT ORGANIZATION BE TAXED ON UNRELATED BUSINESS INCOME?
Nonprofit organization often retain an Attorney to provide an opinion on whether the corporation will be engaging in unrelated business activities that may be taxable.
To note, the activities of a nonprofit organization can still be considered charitable even though they generate profits. However, the primary purpose must be charitable and not income generation. A for-profit business generates income on a regular basis; whereas, a non-profit organization engages in fundraising not on a regular basis. Factors that are considered in determining if the organization is charitable include:
- How the income is derived, not how the surplus will be used;
- The nature and size of the business – is it affordable, below cost?
- Does it serve a charitable class – i.e. low-income, minority, elderly, disabled, other 501(c)(3) organizations; and
- Does the nonprofit operate in a commercial manner and compete against private business?
A charitable corporation can engage in a limited amount of non-charitable unrelated business activity and still qualify for section 501(c)(3) status. As a general rule, not more than 15% of the income can be non-charitable.
A section 501(c)(3) nonprofit organization will be subjected to tax on the net income derived from activities that are not substantially related to the exempt purposes. The organization must submit additional State and Federal tax returns for its unrelated business income – IRS Form 990T and California FTB Form 109. An exception from tax exists for the passive income, such as rent from real property, interest on dividends, and royalties. However, if the activity is financed with debt the exception does not apply and the net income is taxed.
If too much of the organization’s activity is non-charitable, the 501(c)(3) status will be lost. For this reason, many charitable corporations will form a for-profit subsidiary to conduct the unrelated business activity, allowing the charitable corporation to retain control by electing the directors of the subsidiary and the funds can be transferred back to the 501(c)(3) pursuant to a services contract or as after-tax dividends. If the nonprofit corporation controls any subsidiary nonprofit or for-profit corporations, it is important that it monitors the performance and compliance with corporate formalities.
An activity may still be considered charitable even though it is partly supported by grants and also partly by income, such as a sliding scale fee based on ability to pay. In such situations, the income received is used to subsidize those who pay less than cost and the grants make up the difference.
NONPROFIT RESIDENTIAL REAL ESTATE ACTIVITIES AND LOW INCOME HOUSING PROJECTS
Residential real estate activities may be charitable and qualify for 501(c)(3) status if the purpose is for the relief of the poor and distressed. Pursuant to IRS Revenue Procedure 96-32, entitled Low Income Housing Guidelines, at least 75% of the units in a real estate project must be for recipients who earn 80% or less of the median income in the area. Furthermore, either 20% of those units must be for families earning 50% or less of the area median income, or 40% of those units must for families earning 60% or less of the area median income. The remaining units may be provided at the market rate.
Another method for residential real estate to qualify for 501(c)(3) status is based on the facts and circumstances. For example, evidence may be introduced to show that the persons aided by the project could not otherwise obtain housing (i.e. housing for those who have very high medical expenses); or the project participates in a government housing program; or the project contains provisions for social services; or the project has a community-based board of directors and allows for community involvement in making operation decisions.
In addition, the residential real estate project may qualify for 501(c)(3) status by aiming to combat community deterioration. For example, the project may aim to rehabilitate or provide new construction in a blighted area designated by the Government or the facts and circumstances show that the area is blighted. Evidence of blight includes: studies showing that the area is old and deteriorated, the area has lower median income as compared to other neighboring areas, the area has few recreational facilities, declining property values, high abandonment and vacancies, high crime and drug rates, and many housing code violations.
The residential real estate project may also qualify for 501(c)(3) status by eliminating prejudice and discrimination. The project may aim to provide housing to minorities who have historically been unable to obtain housing due to discrimination. The project may also aim to provide specialized housing for the elderly and handicapped.
NONPROFIT COMMERCIAL REAL ESTATE ACTIVITIES
Pursuant to IRS Revenue Rulings, commercial real estate activities may be considered charitable when:
- The property is used as office space for the nonprofit organization’s own use;
- The property is rented out to other 501(c)(3) organizations at the lowest feasible rate;
- The property is rented to poor and minority business owners particularly in blighted areas;
- The property includes lease provisions requiring job training and employment of residents in a disadvantaged area;
- The rental income is used to make grants to other 501(c)(3) organizations; or
- The rental income is used to lessen the rent of other 501(c)(3) organization tenants of the property.