SUSTAINABILITY. That’s been the buzzword around the nonprofit space for over a decade. Organizations everywhere are looking for ways to build-in revenue streams to supplement, or even replace, traditional donations. The reality is, no matter how appealing the idea is, effective and compliant implementation is anything but easy.
The idea makes sense. Always asking for donations and planning for that annual golf tournament…again!…can get tiresome. And with “sustainability” being a constant theme, it can be very tempting for nonprofit leaders to look for ways to increase revenue through non-traditional means. This includes activities that look a lot like a commercial business, and in fact, they often are.
So what are some of the ways that nonprofits are mixing business and charity? Which ones could be more problematic than others? Let’s first take a quick look at the two primary categories of transactional revenue.
Program revenue is money earned from a nonprofit’s sale of goods and services, with the sales activity itself directly furthering the organization’s exempt purpose. This is, by far, the most common type of transactional revenue generated by nonprofits.
Examples of this include ticket sales to performances by a community theatre group, participation fees to play in a youth baseball league, college tuition, and a museum’s sale of art-related items in its gift shop.
Program revenue is an extremely common way for nonprofits to create an ongoing stream of non-donation revenue. For many organizations, revenue generated by programs is essential to their operational plans. The scenarios cited above are examples of that. For other groups, it may be a matter of looking for less obvious, creative ways to generate transactional revenue. Program revenue is a strategic way to increase income that is just as tax-exempt as that received through donations.
The key, however, is understanding that the sale of the particular goods or services involved must directly further the charity’s purpose. Clients often pitch us interesting ideas of revenue generation which would indeed raise a steady stream of cash. Because they intend to use every penny raised by the proposed sales activity to financially support their cause, they think it qualifies as program revenue.
Ongoing sales of goods and services that do NOT directly further the exempt purpose are called unrelated business income.
We’ve written about unrelated business income, or UBI, before, so be sure and follow the link above to get more specifics. UBI as a source of nonprofit revenue can be useful, but difficult to implement well for several reasons:
- It is a taxable stream of revenue. Because it is a commercially-equivalent activity not directly furthering the nonprofit’s purpose, any net profits from UBI is taxable at corporate tax rates, even though the organization is considered tax-exempt.
- The financial transactions must be accounted for on a separate set of books, preferably including a separate bank account.
- A separate tax return must be filed with the IRS, Form 990-T, along with the already required Form 990.
- UBI-generating activity, because it is not directly engaged with the nonprofit’s primary charitable mission, can be a distraction that drains time and resources from the organization’s main purpose.
- UBI income cannot be a large percentage of a 501(c)(3) organization’s overall revenue without jeopardizing their 501(c)(3) status. Although the IRS doesn’t explicitly give numbers here, we know from experience that UBI in excess of 20% of total revenue can be problematic.
There are others ways that nonprofits mix business and charity besides program revenue and UBI. These include the following:
The frequency in which clients propose this sort of thing may surprise you. It is not uncommon for someone to suggest setting up and operating an entirely separate business, one that is “owned” by the nonprofit, as a way of generating sustainable revenue for the charity. While this may sound good in theory, it isn’t easy to pull off.
First, it really doesn’t differ that much from other UBI-type endeavors in that it requires separate books and records, and maybe (probably) a separate staff. From a tax perspective, it usually amounts to the same thing as UBI also, given that the IRS is likely to “disregard” the entity because of it being wholly-owned. In our experience, these types of setups rarely produce a result that is worth the effort required by the complexity of it all.
Partnerships / Joint Ventures
This is a situation where a nonprofit partners with a for-profit company or a group of individuals for a joint venture to produce ongoing income. You often see charities partner with businesses for fundraising activity of a short-term nature, but this is different.
In many such situations, the charity and its partners will form a separate business entity, like an LLC, to conduct the activity. And while the IRS won’t disregard the entity for tax purposes since it isn’t a wholly-owned situation like we talked about above, some of the same UBI concerns are at play. With an LLC, any net revenue to the nonprofit from the joint venture is considered earned revenue reported on a K-1. Therefore, it must be reported as UBI and taxed accordingly. If the joint venture is a C corporation (which pays its own taxes), distributions could possibly be treated as investment earnings (dividends), which are typically not taxable to a public charity.
This is a very complicated topic, for which we do not have the space here to go into a lot of tax detail. The biggest takeaway here is to get professional guidance before jumping into any situation like this.
Generating a reliable revenue stream as a way of supplementing regular charitable support and fundraising is a great way of ensuring your nonprofit’s sustainability. But as demonstrated above, it can be complicated. Know what you’re getting into, and get the assistance you need up-front.
In an upcoming article, we’re going to dig into some very specific examples of how nonprofits can partner with business for revenue generation.
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