For nonprofits, certain activities and property uses may subject otherwise tax-exempt entities to taxation, something that often comes as a surprise to nonprofit leaders.
“Because they are exempt from federal income taxes, they’re often surprised that, as they expand their operations, they run into issues that create federal and state tax liabilities,” says Nathan M. Fulmer, an Associate at Buckingham, Doolittle & Burroughs, LLC. “And sometimes they learn this when they get a notice from the IRS or other taxing authority.”
Smart Business spoke with Fulmer about the ways tax-exempt organizations can trigger a tax event.
How might a nonprofit get taxed despite being tax exempt?
Tax exempt generally means exempt from federal income taxes. A tax-exempt organization is an entity that applies to the federal government and receives tax exempt status. And because these entities technically have no owners, the people who control the charity don’t have any taxable income from the activities of the nonprofit.
These organizations can engage in some taxable activities without risking or jeopardizing their tax-exempt status. However, if they generate revenue from activities that are outside of their core, tax-exempt mission, those activities could be subject to taxation — referred to as unrelated business income tax, or UBIT.
Unrelated business income (UBI) is generally triggered when exempt organizations derive income from business activities that are unrelated to their exempt purposes. For example, a museum running a gift shop that sells merchandise unrelated to its exhibits generates unrelated business tax since such gifts are unrelated to its primary exempt mission.
Another potential activity that creates UBI is providing services that may be unrelated to the organization’s core mission. When organizations have revenue from providing insurance for their members, that generates UBI because providing those services aren’t related to their exempt mission.
Charities may also be subject to county real property taxes if their property is not used for charitable purposes. A common practice that leads to property being subject to taxation is leasing out property to others for profit. A church that has a gymnasium it rents to club sports teams, for example, could trigger unrelated business taxable income. Also, a charity that rents or leases property to for-profit or private individuals may face taxes on that property.
While it’s incredibly rare that a nonprofit would lose its tax-exempt status over small levels of non-exempt activities, there are cases where organizations, over a period of years, have substantial non-exempt activities that eventually lead to an audit and examination. That’s when the IRS could conclude that the organization is no longer a tax-exempt organization. It’s a grave risk, even if the possibility is remote.
How can nonprofits be sure to avoid unexpected taxes?
Tax-exempt nonprofits will always have some tax exposure — they pay payroll taxes, for instance. But these UBITs and state-level property taxes can pop up if an organization is not thoughtfully planning. If they engage in an activity — develop a capital project, for example, or lease their property — they could unknowingly create tax liabilities. That’s why it’s important to have regular check-in calls with advisers. Nonprofit leaders should talk with their legal team — quarterly, or at least annually — to discuss what’s been going on and what may be coming up. That allows the legal team to ask questions about certain activities to ensure the organization doesn’t unknowingly stumble into any taxable activities.
Keep legal and financial advisers in the loop as plans are discussed. If possible, have those advisers train board members and officers so they can recognize these types of issues in the early discussion stages. Then, as the organization develops projects, key members are thinking about the potential tax implications.
Alternatively, nonprofits could have a lawyer who specializes in this area on the board so they can be regularly consulted on any significant projects that the organization is about to engage in, or a new income stream that’s being looked into. They’ll be in the best position to advise on anything they see that might lead to a taxable event. ●
INSIGHTS Legal Affairs is brought to you by Buckingham, Doolittle & Burroughs, LLC.
