Many tax-exempt organizations are moving into the realm of social enterprise as a way to increase top-line revenue. However, the tax implications of engaging in new activities must be considered before jumping in blindly.
The first question is whether the new activity fits within the tax-exempt organization’s exempt purposes. The tax-exempt organization must not only consider its exempt purposes as set forth in its Articles of Incorporation and its request for exemption filed with the Internal Revenue Service, but must also consider how it plans to operate the social enterprise. For example, the Internal Revenue Service (IRS) has held that activities are outside of an organization’s exempt purposes if the activities are greater in scope and scale than is required for the organization to fulfill its exempt purposes. In general, the more the activities are operated on substantially the same scale and scope as a commercial endeavor, the less likely the IRS will consider the activity within an organization’s exempt purposes. Consider the organization in Revenue Ruling 73-127, which operated a retail grocery store to sell food to residents of a poverty-stricken area and to provide training to unemployed individuals from the area. The organization hired some unemployed individuals as part of its training program, but most of the organization’s employees had grocery store experience. The IRS found that the organization’s grocery store activities were conducted on a scale larger than necessary for the performance of training.
If the activity does not fit within the organization’s exempt purposes, the organization must consider the applicability of the dreaded unrelated business taxable income. Unrelated business taxable income is generally defined as income derived from a trade or business, regularly carried on by the tax-exempt organization, which is not substantially related to its exempt functions. A number of exceptions and modifications exist, which should be carefully considered.
We often tell our clients that unrelated business taxable income is not a terrible thing, so long as the organization understands that it will pay income tax on such income and so long as the organization is not generating too much unrelated business taxable income. If an organization’s unrelated business taxable income is substantial as compared to its other gross revenue, the organization’s tax-exempt status is potentially at risk. Although the exact threshold is not entirely clear, most practitioners agree that if an organization is generating unrelated business taxable income equal to or greater than 20% or more of its gross revenue, the organization is putting its tax-exempt status at risk. Hence the reason that tax-exempt organizations must carefully consider the tax effects of engaging in a new social enterprise.