For most public charities and private foundations, fundraising is an integral activity in achieving the organizational mission. Even organizations that collect program fees to fund their activities, such as athletic organizations and theater groups, often rely on fundraising to meet operating expenses. While it seems like an easy way to defray the cost of programs, there are complex rules that nonprofit leaders must follow when soliciting contributions.
One of the most important concepts to understand is the commerciality doctrine, for that is the foundation for a complex set of rules that define Unrelated Business Income, or UBI.
The commerciality doctrine is an Internal Revenue Service principle that states, “Revenue from an activity, even one substantially related to the organization’s exempt purpose, cannot be exempt function income if it is conducted in a commercial manner.”
Plain and simple, the IRS wants to ensure that nonprofit organizations do not use their special tax-exempt status to compete, with this unfair tax advantage, against for-profit, taxpaying businesses. Additionally, while the federal government considers charitable giving a virtuous act and rewards taxpayers with a charitable contribution deduction, fundraising activities of the organization should never become an endeavor that is larger than the actual program activities supporting your mission. The UBI rules are one compliance tool the IRS employs to ensure responsible fundraising and deter unfair competition with for-profit businesses.
Why should organizations care about UBI? Because an organization is required to report and pay federal and state income taxes on UBI. This will require additional record-keeping, including the annual filing of federal and state Exempt Organization Income Tax Returns, and paying the associated tax at the regular corporate rates, on Unrelated Business Taxable Income.
So what is Unrelated Business Income (UBI)? An activity will generate UBI if it is a trade of business; regularly carried on; and not substantially related to the organization’s exempt purpose.
“A trade or business” means selling goods or services to generate income.
“Regularly carried on” means the activity shows frequency and continuity and that is conducted in the same way that a for-profit business would operate.
“Not substantially related” means that the activity is not important to furthering the exempt purpose of the organization.
Of course tax law can never be that simple, and thankfully so. Based on the above definition, fundraising activities often would create a taxable event. Exceptions (with examples) to the above definition include activities that are:
• Conducted substantially by a volunteer workforce (while not defined, “substantially” is generally considered to be 85 percent or more);
• Conducted for the convenience of members of the organization (the Little League concession stand);
• Involving the sale of donated merchandise (most thrift shops);
• Involving the distribution of low-cost articles (the pen or shopping bag you receive in return for your donation);
• Involving income from convention or trade show participation (vendor booths at a business expo);
• Involving income from qualified sponsorships (see my previous article); and
• Traditional bingo (but not “instant bingo” pull-tabs or other gambling).
This explanation has greatly simplified a very complex area of tax law. For local community-based nonprofits, fundraising is typically infrequent (held once a year) or carried on by substantially all volunteers and is therefore excepted from consideration as UBI. Nonprofit leaders must ensure that fundraising activities support programming but never outweigh the focus of the organization’s mission.
When in doubt, leaders should provide the organization’s accountant with complete information regarding fundraising concepts prior to the endeavor to avoid the UBI fundraising trap.
• Nancy Gonsiorek is a Certified Public Accountant providing audit, tax and consulting services to nonprofit organizations. Her firm, Nancy L. Gonsiorek, CPA, LLC is based in Crystal Lake. Reach her at 815-455-9462 or firstname.lastname@example.org.