May a Section 501(c)(3) nonprofit engage in business operations to generate revenue? Such organizations often brainstorm creative solutions to accomplish their charitable purposes and ensure revenue is sufficient to support their charitable endeavors, including business-related ideas. These activities may blur the lines between a nonprofit organization engaging in permissible commercial activity, on the one hand, and a de facto for-profit business with charitable overtones. How does a Section 501(c)(3) stay tax-exempt within applicable IRS constraints, and yet carry on a profit-generating business? The “Newman’s Own” exception provides a fascinating example of charity mixed with business, within the broader context of other more common and far less complex nonprofit operational models.
Following in Paul Newman’s Footsteps: Private Foundation Plus a Business
The “Newman’s Own” exception was recently codified in the federal Bipartisan Budget Act of 2018. This Act was signed into law in the wake of the historic Tax Cuts and Jobs Act (as it is commonly known). Among other provisions, the Bipartisan Budget Act amended Section 4943 of the Internal Revenue Code (“Code”) to include a narrow exception allowing Section 501(c)(3) private foundations to own for-profit businesses under certain circumstances – as the famous food label Newman’s Own has done for years. At first glance, the Newman’s Own exception is an appealing model, but it is a difficult fit for most organizations – particularly given its fundamental requirements for a private foundation with fairly distanced control from its related business entity.
A private foundation is an organization formed under Section 501(c)(3) of the Code that typically receives its funding from a single donor or a very small group of donors (e.g., a family foundation). The foundation’s assets are typically invested and the income from such investments is used to further the foundation’s tax-exempt purpose. The creator of a private foundation has significant flexibility with respect the creator’s control over the long-term purpose for which the foundation’s assets are used, the initial appointment of directors, and the requirements for electing future directors.
The downside of establishing a private foundation is that it is subject to significant excise taxes that do not apply to its public charity counterparts, including excise taxes on certain prohibited transactions between the foundation and certain “insiders” of the foundation, on certain investments made by the foundation that jeopardize its exempt purposes, and on excess business holdings.
The Newman’s Own exception relates to one of these excise tax provisions, excess business holdings. Section 4943 of the Code generally imposes excise taxes on a private foundation’s business holdings of more than 20% of the company’s voting stock. The Bipartisan Budget Act, however, provides a narrow exception to this rule, the Newman’s Own exception, which allows a private foundation (e.g., Newman’s Own Foundation) to own all of the voting stock of a particular business entity (e.g., Newman’s Own, Inc.) when the following requirements are met:
- Ownership: (1) the private foundation owns 100% of the voting stock in the business enterprise; and (2) such ownership interests were acquired by means other than purchase.
- Distribution of Net Operating Income: the business enterprise’s net operating income is distributed to the private foundation within 120 days after the close of the taxable year.
- Operational Independence: (1) no substantial contributor to the foundation or substantial contributor’s family member serves as a director, officer, trustee, manager, employee, or contractor to the business enterprise; (2) at least a majority of the private foundation’s board of directors must not be directors or officers of the business enterprise or family members of a substantial contributor to the private foundation; and (3) no outstanding loan exists from the business enterprise to a substantial contributor to the private foundation or a substantial contributor’s family member.
The obvious example here is Newman’s Own Foundation, which was established by Paul Newman as a tax-exempt private foundation created for philanthropic purposes. The Foundation’s funding is entirely made up of profits and royalties generated from food and beverage sales made by Newman’s Own, Inc., a for-profit business enterprise.
This model has been extremely successful for Newman’s Own Foundation but may be less appealing for the creator of a private foundation who wishes to maintain overlapping control over the foundation and business enterprise. The Newman’s Own business model appears to be most effective as an estate planning tool when the owner of a profitable closely-held business wishes to leave ownership of the business to the owner’s private foundation but does not plan to have family members controlling the private foundation and involved in running the business. Due to the complexity of this model—especially with respect to structuring the board of directors and officers of both entities—the “Newman’s Own” model is unlikely to apply to most organizations.
A More Common Option: Directly Operating Related or Insubstantial Business Activity
A much more common option is a Section 501(c)(3) organizations carrying out related business activities or “insubstantial” unrelated business activities. An organization is considered a tax-exempt organization under Section 501(c)(3) of the Code when it is organized and operated exclusively for the enumerated exempt purposes in Section 501(c)(3). In other words, an organization may engage in profit-making activities without jeopardizing its tax-exempt status so long as a substantial amount of its activities are focused on accomplishing its exempt purposes.
Related Business Income
Consider a nonprofit museum that sells items related to its educational exhibits, or a youth entrepreneurship program that focuses on teaching kids job skills through making and selling handmade jewelry. In both cases, the nonprofit has a tax-exempt mission, and the nonprofit’s sales are directly related to the nonprofit’s tax-exempt mission. The resulting income therefore should not result in either taxable income or potential loss of tax-exempt status. (For further guidance on potential taxable income, see our blog here.)
Unrelated Business Income
If a 501(c)(3) organization regularly engages in an unrelated trade or business—business activities that are carried on for a profit and are unrelated to accomplishing the charity’s exempt purpose—the charity may maintain its tax-exempt status so long as such activities are insubstantial. Depending on the amount of income generated from the unrelated trade or business, the charity may be subject to unrelated business income tax on such activities, which mirrors the federal corporate tax rate of 21%. But if the unrelated trade or business activities become more than insubstantial, the organization’s tax-exempt status may be at risk. “[T]he presence of a single [nonexempt] purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt] purposes.” Better Business Bureau of Washington, D.C., Inc. v. Commissioner, 326 U.S. 279, 283 (1945).
Going back to the examples above, imagine the nonprofit museum found that selling food to tourists was more profitable than showing educational exhibits, and the youth entrepreneurs became crackerjack jewelry makers who did not need any further teaching. While both types of sales would help each nonprofits’ revenues, they would be profit-making activities that are unrelated because the activity itself does not contribute importantly to furthering the organization’s exempt purposes. If the level of unrelated business activity eclipses the nonprofit’s other exempt activities (i.e. substantial), the organization’s tax-exempt is jeopardized. (See our previous blog article here).
Consequently, it is essential for any nonprofit engaging in business activities to carefully consider (a) the extent to which such activities may properly be “related”, and (b) the extent to which any “unrelated” activities have rendered the organization too commercial for continued tax-exempt status.
Other Appetizing Alternatives: Venturing into Other Structural Arrangements
Given the above serious considerations, a nonprofit organization that anticipates significant unrelated business activities should consider creating a separate taxable business entity to carry on such unrelated business activities, or in other scenarios, a joint venture with for-profit entities may be the most appropriate arrangement. (For an overview of the latter structure, see our blog here).
As an example of a separate taxable business, consider a church that is organized and operated exclusively for religious purposes under Section 501(c)(3) of the Code. The church is passionate about reaching its local community and desires to start a large commercially operated coffee and book shop business for the neighborhood. If the church decides to directly operate the shop itself, it will put its tax-exempt status at risk due to the substantial, non-exempt commercial activities in which it would be engaging. Instead, the church should consider forming a single-member LLC which operate as a taxable subsidiary to own and operate the shop. The church will hold all ownership interests in the taxable LLC and fund the project. The LLC will pay income taxes at the state and federal level, similar to any other commercially operated coffee and book shop. The LLC, however, can distribute dividends to the church, which would be tax-exempt income for the church. By “siloing” this business activity into a separate taxable entity, the church protects its own tax-exempt status.
The Cherry on Top
Creative fundraising ideas should be encouraged and applauded. But if your Section 501(c)(3) organization is considering engaging in commercial activities, the leadership should consider carefully evaluate the nature and extent of such activities and the best organizational model to protect its tax-exempt status, in addition to other very significant practical considerations. Good intentions to fund the nonprofit’s operations through business revenues are not enough to maintain and protect tax-exempt status. Indeed, a seemingly benign activity may significantly affect the organization’s tax liability. With proper planning and procedures, whether to the scale of Newman’s Own or something more plain vanilla, a nonprofit may well generate business revenues as part of developing its support and accomplishing its mission.
 In Better Business Bureau, the United States Supreme Court found that the promotion of a “profitable business community” gave the organization a “commercial hue” and lead to the unavailability of tax-exempt status, despite the organization’s truly educational activities.