In a previous post, we introduced the concept of “nonprofit” vs. “charitable” under U.S. tax law. In this post, we will further expand on the definition of charitable, and will specifically focus on income-generating activities – a common source of confusion with respect to charitable activities.
Meeting charitability requirements
In order to be recognized as a charitable organization described in section 501(c)(3) of the Internal Revenue Code, an organization must be both organized and operated exclusively for one or more charitable purposes. The U.S. Treasury Regulations define "charitable" to include: relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency. “The term charitable is used in section 501(c)(3) in its generally accepted legal sense and is, therefore, not to be construed as limited by the separate enumeration in section 501(c)(3) of other tax-exempt purposes which may fall within the broad outlines of charity as developed by judicial decisions.” Treas. Reg. § 1.501(c)(3)-1(d)(2). While this definition provides an important framework for charitability, interpretation is varied, and the IRS has itself recognized that “[t]he concept of what is charitable is still evolving today.”
When is income generation charitable?
Many charitable organizations earn income primarily through grants or other donations from the general public. However, charities are permitted to, and often do, engage in income-generating activities of another nature – including payment-based program services, product sales, or other fee-based arrangements. An organization that operates a trade or business as a substantial part of its activities may still meet the organizational and operational requirements of section 501(c)(3) of the Internal Revenue Code if:
- the operation of such trade or business is in furtherance of the organization's charitable purpose or purposes; and
- the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business.
Treas. Reg. § 1.501(c)(3)-1.
Income earned from trade or business activities that are related to the organization’s charitable purposes are often referred to as “gross receipts from related activities,” and commonly include admissions, sales of merchandise, performance of services, or furnishing of facilities. The most common form of gross receipts earned in the performance of charitable activities are ticket earnings at museums, zoos, symphonies, operas, theaters, ballets, and similar institutions. Tuition fees are another typical kind of gross receipts from charitable activities.
Specific examples of income-generating activities conducted in furtherance of charitable purposes include selling books, pamphlets, or other literature related to the organization’s charitable programs or promoting or benefiting the organization’s beneficiary class; charging fees for admission to performances, concerts, lectures, or courses conducted in furtherance of an organization’s charitable purposes; or operating a business that serves to train and employ a beneficiary class (such as recently released felons, the homeless, or the indigent). See, e.g., Rev. Rul. 65-271, Rev. Rul. 69-267, and Rev. Rul. 76-94. For example, the IRS has held that an organization created to market the cooking and needlework of needy women was organized and operated exclusively for charitable purposes. The organization passed the organizational test because it was formed for the purpose of assisting needy women in earning income, and it passed the operational test because it provided necessary services to help “relieve the poor and distressed,” which is a recognized charitable purpose. See Rev. Rul. 68-167.
Notably, the fact that the income earned is applied toward charitable activities is not sufficient to make it “related.” The income-earning activity must itself further a charitable purpose. See Internal Revenue Code § 513.
Can a charitable organization engage in non-charitable income-generating activity?
While an organization is permitted to engage in non-charitable income generating activities, such activity must not be more than an insubstantial part of its activities, and, in the U.S., income from such activities is generally taxed as unrelated business income.
Applying the commerciality doctrine
Organizations that engage in substantial unrelated business activities will fail the operational test, despite the existence of legitimate charitable activities. Determining whether an organization is engaged in substantial unrelated business activities typically requires an analysis under a U.S. common law test known as the “commerciality doctrine.” The commerciality doctrine looks to a number of facts and circumstances to determine whether a charitable organization is conducting activities in a manner that resembles and competes with commercial organizations, such that it is operating for a substantial non-charitable purpose. The U.S. Supreme Court has stated that “the presence of a single non[charitable] purpose, if substantial in nature, will destroy the [charitable] exemption, regardless of the number or importance of truly [charitable] purposes.” Better Business Bureau v. U.S., 326 U.S. 279 (1945).
In Airlie Foundation v. Internal Revenue Service, the district court held that, even if an organization is operating in some respects in a charitable fashion, it will nonetheless be denied exemption as a charitable organization if it is operating with a “distinct commercial hue.” The court explained that
Among the major factors courts have considered in assessing commerciality are competition with for profit commercial entities; extent and degree of below cost services provided; pricing policies; and reasonableness of financial reserves. Additional factors include, inter alia, whether the organization uses commercial promotional methods (e.g., advertising) and the extent to which the organization receives charitable donations.
Airlie Foundation v. IRS, 283 F. Supp. 2d 58 (D.D.C. 2003). None of these factors is alone dispositive, and not all are required to indicate that an organization operates for a substantial commercial purpose.
Application to NGOsource
The issue of charitable income generating activities is a common source of confusion for charitable organizations, domestic and foreign alike. It can be particularly confusing for non-U.S. organizations that are subject to different charitability standards in their home countries. Equivalency Determination analyzes how a foreign organization is organized and operated to determine if it is consistent with charitability requirements under U.S. tax law. This includes a detailed analysis of an organization’s governing documents and supporting documentation, as well as an in-depth examination of its current and anticipated activities, including activities that generate income. While some non-U.S. jurisdictions treat all income-earning activities as “non-charitable,” it is important to remember that U.S. tax law does not draw as bright a line with respect to income generation.
The Profitable Side of Nonprofits – Part I: Earned Income, NEO Law Group
Legal Framework for Earned Income, Adler & Colvin
IRS Publication 598, Internal Revenue Service (2017)
Schedule A, Form 990 Instructions, Internal Revenue Service (2017)