Tax-exempt status isn’t necessarily forever. It may not happen frequently, but the IRS does revoke the status when nonprofits engage in substantial disqualifying or nonexempt activities. In fact, the agency recently updated the audit guidance for its examiners regarding such tax-exempt status violations. If your organization is venturing into business activities these days, know what the IRS is looking for.
A 501(c)(3) nonprofit must be both “organized” and “operated” exclusively for an exempt purpose. The new guidance focuses largely on the second factor, the so-called operational test.
When applying the operational test, the IRS will examine an organization’s activities and how they further exempt purposes. No more than an “insubstantial part” of its activities may further a nonexempt purpose. The IRS will look at your Form 990 and review your mission and activities, employees, volunteers, changes in programs, and any unrelated business income. The IRS also will scrutinize your financial information to determine if income, expenses and assets are appropriate for your exempt functions — or if they indicate a nonexempt trade or business.
The IRS will scrutinize an organization’s financial information to determine if the income, expenses and assets are appropriate for the exempt functions.
Although the tax code requires tax-exempt organizations to be organized for exempt purposes, it does allow them to conduct some activities similar to those of a trade or business — that is, activities conducted to produce income from the sale of goods or the performance of services. But if these activities aren’t substantially related to your organization’s exempt purpose, they might jeopardize its exempt status under the operational test.
This is where the fragmentation rule comes into play. This rule recognizes that an activity doesn’t lose its identity as a trade or business simply because it’s conducted:
- Within a larger aggregate of similar activities, or
- Within a larger complex of other activities that may or may not be related to your organization’s exempt purpose.
As a result, the IRS will separately analyze each trade or business activity as to whether it furthers an exempt purpose, even when it’s engaged in alongside similar exempt activities.
The commerciality doctrine is relevant to the operational test, too. Under the doctrine, an organization can be found to have operated for nonexempt commercial purposes because of the commercial manner by which it conducted activities.
The IRS has reasoned that a nonprofit operating in a commercial manner has commercial activity as its primary purpose, making the commercial activity substantial and unrelated to exempt purposes. In recent years, for example, the IRS denied tax-exempt status to a community coffeehouse because it was operating for a substantial nonexempt commercial purpose, rather than an exempt purpose.
The IRS will consider the extent and degree of below-cost services provided (nonprofits generally should price at below-cost, rather than at fair market value or cost), as well as the extent of charitable donations (donations should represent a significant percentage of a nonprofit’s total support). It also examines whether the business sells to the general public, rather than to a discrete charitable class (for example, other nonprofits or a disadvantaged population). Other factors relevant to the commerciality evaluation include:
- Competition with for-profit commercial entities,
- 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 employees, and
- Whether unprofitable programs are discontinued. No single factor is determinative.
Better safe than sorry
If your organization has begun conducting business activities and you’re uncertain about the impact on your tax-exempt status, check with your CPA. We can help ensure you stay on the right side of the IRS.