Spring 2006 issue of Horizons

INDUSTRY

NOT-FOR-PROFIT

Entrepreneurship and Not-For-Profit Organizations

Judy Murphy, CPA Jeff Person, CPA

Many not-for-profit organizations are looking for additional sources of revenue either out of necessity or of a desire to grow. For some types of not-for-profits there are, from a tax perspective, relatively clear guidelines compared to other types of organizations: Social clubs may generally have a maximum of 15 percent of gross income from on-premise nonmember revenues. There are established procedures for tracking what constitutes non- member revenue. Furthermore, there are severe restrictions on any receipts for off-premise consumption. Revenue from activities such as carry-out sales must be minimal. Trade associations must have more than 50 percent of their revenue from exempt function sources such as dues and related educational programs. While it is a gross oversimplification, there is quite a bit of truth in the proposition that for social clubs and trade associ- ations, the main source of revenue allowable under the Internal Revenue Code is the collection of dues from members. For 501(c)(3) organizations, there is no bright-line test. It has been a rule of thumb that unrelated business income receipts in the range of 10 percent to 20 percent might be acceptable, but ultimately it may be a facts and circumstances test with the ensuing uncertainties. There is no percentage test per se, and there are other considerations. Such considerations include avoiding private inurement, relationship to an exempt purpose, and the relative scope of the activities. Sometimes the technique of choice to protect the exempt status of a 501(c)(3) organization is to establish a taxable corporation as a subsidiary. This allows the organization to maintain control over the activity; however, tax will be paid at the subsidiary level and the parent organization receives dividends to the extent available. Under current Internal Revenue Service (IRS) instructions, a single member limited liability company (LLC) will be treated as a part of the organization (i.e., the entity is disregarded as a separate taxpayer). So while a sin- gle member LLC might provide protections under state laws, there is no tax effect unless the organization timely files an election to treat the LLC as a corporation or additional mem- bers are admitted.

responsibility for separately reporting to tax-exempt partners their share of income, deduction and credit items that may affect the tax liability of each partner. Under federal tax def- initions, the term partnership generally includes an LLC with more than one member. There are different sets of issues depending on who the other partners are. If a partnership consists of partners who are all tax-exempt entities, there may still be issues of whether the partners' share of income is unrelated business income (UBI) and thus taxable. The first issue to be addressed is whether the activity of the part- nership is substantially related to the exempt purpose of the organization. Secondly, the allocation of income, deductions and gains or losses must bear a rational relationship to the organization's participation in the partnership. There general- ly cannot be a shifting of profits for tax purposes compared to the way in which the activities of the partners generated such profits without the issue of whether taxable income arises (even for a partnership consisting solely of not-for-profit part- ners). Thus, as a general rule, an organization could not con- duct an activity in a partnership and arrive at a different result than if it conducted the activity on its own. When for-profit and not-for-profit entities form a partnership, extensive scrutiny by the IRS should be expected. This is an evolving area of the tax law. It has only been since the early 1980s when the IRS lost a court case that the government began to consider the possibility that this kind of partnership might be permissible for a tax-exempt entity to form. The IRS devised a two-part test. First, the partnership must further a charitable or other exempt purpose. Second, the partnership must operate for the benefit of the not-for-profit partner(s) and not use the assets of the not-for-profit to benefit the for- profit partners. Put another way, the nonprofit organization may not impermissibly serve private interests. This standard is different than whether the not-for-profit is acting in a com- mercially reasonable or arms-length manner. For example, the general partner of a real estate partnership often will make various guarantees to induce limited partners to invest in the partnership. The IRS may view some of these guaran- tees unfavorably when made for the benefit of private inter- ests by a not-for-profit general partner even though these are the typical guarantees made in the marketplace. If a transac- tion gives impermissible benefits to private parties, there may be sanctions or loss of exempt status. While not all benefits to private parties are impermissible, this can involve complex and even uncertain areas of the tax law.

PARTNERSHIPS

When a tax-exempt organization joins a partnership, the activities of the partnership are attributed to the organization because of the flow-through characteristics of partnerships for tax purposes. However, the partnership has the primary

37 • spring 2006 issue