Your RLG Legal Update: Do We Have to Pay Taxes on That?

Increasingly, nonprofit organizations, including churches, engage in business activities usually reserved for the for-profit sector. For example, several churches rent out facilities as commercial landlords or operate coffee shops as part of the church’s ministry strategy.

Often, the leaders of these nonprofit organizations ask whether engaging in such endeavors puts the organization’s tax-exempt status at risk. Unfortunately, there is not a cut and dried answer to that question. If the tax-exempt organization derives excessive income from an unrelated business endeavor, then its tax-exempt status can be at risk. However, the Internal Revenue Service has not set a percentage of the organization’s income that would be considered excessive. At the extreme, it is very likely that receiving over 50% of a nonprofit’s income from an unrelated business endeavor would be considered excessive. To be sure, it’s likely that the percentage would likely be much lower to trigger the IRS’s interest in reviewing an organizations’ nonprofit status. If a nonprofit is receiving more than 10%- 15% of its income from an unrelated business activity, the organization may want to consider its options with a qualified tax attorney or certified public accountant.

However, an additional question that should be asked is whether the nonprofit is required to pay unrelated business income on the revenue. There are three requirements for a nonprofit’s income to be subject to federal income tax if the nonprofit receives over $1,000.00 in unrelated business income.

First, the organization must carry on a trade or business. 

Here, trade or business involves the sale of goods or services in exchange for money or something else of value for the purpose of making a profit.

Second, the trade or business must be regularly carried on. 

This means it takes place frequently or on a continual basis similar to the way the activity would be carried on by a for-profit business. For example, one client was regularly harvesting timber on its property, while this only happened every few years, it did occur at the same regular interval as it would have in a for-profit context and was, therefore, regularly carried on. Another client sold Christmas trees each year to the public. While this activity was seasonal, it was regularly carried on at the same time as a for-profit company would conduct the business.

Third, the trade or business must not be substantially related to the organization’s exempt purposes. 

In other words, the activity must not contribute importantly to accomplishing the organization’s exempt purposes. What are its exempt purposes? Just because the income from the business may be used for nonprofit purposes, does not mean the business is substantially related to the nonprofit’s purposes. In other words, just because the profits of the Christmas tree sales go to youth ministry does not mean that the business is substantially related to the nonprofit’s exempt purposes. However, an example of related business would be a nonprofit symphony selling tickets to its events. The concert and the tickets are clearly related to the symphony’s purpose of conducting concerts and engaging in the arts.

There are exceptions to the rule. For example, if the business is carried on for the convenience of members(i.e., a coffee shop only open during worship services, a college-owned laundry operated for students, etc.) or if the business is substantially completed by a volunteer workforce, the profit from those endeavors are exempt from unrelated business income tax. There are other more complicated exceptions. To learn more, contact your attorney or tax professional. In addition, IRS Publication 598 is helpful in providing more details about this increasingly common issue for churches and nonprofits.

If you would like more information about how Reynolds Law Group, PLLC can help your non-profit or church call 757.219.2500 or send us an email to asssistant@reynoldslawgroup.com to set up a FREE consultation.

Also, for more information take a look at our blog, “Top Three Reasons Churches End up in Court” here!