Why Your Nonprofit Shouldn’t Operate Like A For-Profit Business

Charlotte thought she knew everything about running a not-for-profit community hospital. So the CEO was shocked when the IRS contacted her hospital about potentially losing its tax-exempt status. The IRS mentioned several issues, including the hospital’s increasingly wide operating margins and its extensive use of advertising. As the dispute proceeded to litigation, Charlotte learned that the hospital had tripped over the commerciality doctrine.

This is a fictitious example. But the commerciality doctrine can be all too real.

Exception to the rule

The commerciality doctrine, along with the operational test, was created to address concerns over nonprofits competing at an unfair tax advantage with for-profit businesses. The operational test generally requires nonprofits to be both organized and operating exclusively to accomplish their exempt purpose. The test also mandates that no more than an “insubstantial part” of an organization’s activities further a nonexempt purpose.

What this means for your nonprofit is that you can operate a business as a substantial part of your activities so long as the business furthers your exempt purpose. However, under the commerciality doctrine, courts have ruled that the otherwise exempt activities of some organizations are substantially the same as those of commercial entities. As a result, the entities are not tax exempt.

Don’t operate like a business

No single factor is decisive, but courts and the IRS consider several issues when evaluating whether an organization fails the commerciality doctrine. In general, you risk your exempt status if you operate like a for-profit business. So, for example, has your nonprofit set prices to maximize profits or has it accumulated unreasonable reserves?

Other potential pitfalls include providing fewer lower cost services than your nonprofit peers and advertising your services to the general public. Also consider the extent to which your organization relies on charitable gifts. Donations should be a significant percentage of your nonprofit’s total support.

The UBIT threat

There’s another risk for nonprofits operating a business. Even if you pass muster under the commerciality doctrine and retain your tax-exempt status, your organization could end up liable for unrelated business income tax (UBIT). Revenue generated from a regularly conducted trade or business that isn’t substantially related to furthering an organization’s tax-exempt purpose often is subject to this tax.

Determining UBIT liability or, worse, whether you could lose your exempt status under the commerciality doctrine, can be complex. Contact us to discuss the many factors that go into these determinations and for help avoiding missteps.