Nonprofit leaders often think creatively about entrepreneurially-minded activities and new ways to expand their scope. The IRS, however, may scrutinize a nonprofit’s more creative entrepreneurial endeavors under the judicially developed “commerciality” doctrine, which addresses the key question, “When do an organization’s operations become too commercial for Section 501(c)(3) tax-exempt qualification?” Nonprofit leaders thus need to structure their organizations and operations for optimal tax-exempt treatment of business activities. A new IRS ruling rejecting a coffee shop ministry’s tax-exemption application provides many insights.
The Coffee Shop Case
According to this newly issued IRS decision (IRS Denial 201645017; UIL Code 501.30-00; released Nov. 4, 2016), the coffee shop asserted it was formed for religious purposes, for example, to proclaim the Christian gospel, promote Bible study and prayer, provide a non-church forum for dialogue with non-believers, and to give away 100% of its net profits to other ministries. So far, so good for tax-exempt status.
As the IRS viewed the ministry, however, it operated mostly as a commercial business, with an ideal location for good sales, long hours of operation, and only “subtle, indirect” efforts to promote religion. From the ministry’s perspective, this soft-touch approach was strategic – to draw in many participants for exposure to Christianity. But from the IRS’s perspective, the heavier emphasis was clearly – and too commercially – on selling coffee, which was fatal to tax-exempt qualification.
The IRS’s analysis began with the foundational principle that for Section 501(c)(3) qualification, an organization must be both organized and operated exclusively – that is primarily, and not secondarily – for tax-exempt purposes such as religion, education, and/or charity. Selling coffee, itself, falls outside these purposes. The IRS then reviewed several tax decisions demonstrating that while it can sometimes be challenging to discern the line between tax-exempt qualification and too much commerciality, an applicant engaged in both business and tax-exempt activities must primarily devote itself to tax-exempt activities as described in Section 501(c)(3). As a bedrock tax principle, “the presence of a single non-exempt purpose, if substantial in nature, will destroy a claim for exemption regardless of the number or importance of truly exempt purposes.” (citing Better Business Bureau of Washington, D.C. Inc. v. United States, 326 U.S. 279 (1945)).
Too Much Commerciality?
The question is thus whether a commercially-oriented business activity within a nonprofit is too “substantial” for the organization’s tax-exempt qualification. The answer lies within a contextually rich, very fact-specific evaluation of numerous factors, all focusing on the extent of “commercial” versus charitable, religious, or educational activities. As set forth in the recent coffee shop case as well as other IRS rulings, these factors include the following:
1. Whether the totality of the organization’s activities looks more like a business than a charitable, religious, or educational organization (e.g., sales of mostly advisory publications for fees, although educational in nature, disqualified organization for tax-exempt status);
2. Whether the organization’s primary activity is characteristic of a trade or business that is ordinarily carried on by a for-profit commercial business (e.g., consulting services were held to be too commercial;
3. Whether the activity’s primary purpose is clearly commercial (e.g., operating health food stores for substantially commercial purposes, albeit with underlying religious purposes, was held to be too commercial);
4. Whether the activity competes with commercial business (e.g., operating a for-profit conference center, with only incidental charitable and educational functions, was primarily commercial);
5. The extent of the activities’ “commercial hue”;
6. The existence and amount of annual and accumulated profits (i.e., commercial);
7. The extent to which the organization advertises its business activities to the general public (i.e., commercial);
8. The extent of free and/or below-cost provision of goods or services (a good fact supporting tax-exempt qualification);
9. The extent to which the organization relies on volunteers for its business activities (another good fact);
10. The extent to which the organization relies on donated goods or services for its business activities (yet another good fact);
11. Other sources of goods for sale, such as fair trade artisans or people with disabilities (also evidencing non-commerciality);
12. The extent to which supposedly public benefits are limited to customers (commercial);
13. Any former attempts to run the operations as a for-profit business (again, commercial); and
14. The extent of the organization’s other non-commercial activities (of potentially critical importance).
In the coffee shop case, the IRS applied many of these factors to conclude that the organization’s primary activity was to operate a coffee shop in a commercial, for-profit manner, with the religious aspects only secondary. In particular, the IRS noted that the coffee shop operations were extensive, fee-based, and otherwise well suited for commercial success. The operations utilized mostly paid staff, with no donated goods for sale. In addition, the organization did not itself conduct any religious or other tax-exempt activities. It focused on selling coffee commercially, while other organizations engaged in ministry at the coffee shop and then only to a limited extent. The coffee shop also funded its operations through its sales revenues, and such revenues were not yet sufficient for donations to other organizations (as originally envisioned).
Lessons and Opportunities for Nonprofit Business Activities (Not an Oxymoron, By the Way!)
Many nonprofit leaders today are striving toward social enterprise models and innovative approaches to help others. What can entrepreneurially-minded nonprofit leaders learn from this coffee shop case and other IRS guidance involving the commerciality doctrine? This question is particularly of concern given the multitude of applicable factors, along with the sobering reality that the IRS cannot necessarily be expected to apply this inherently vague test well.
Remember that commercial activities may constitute a legitimate part of a nonprofit’s tax-exempt activities. But any commercial activities must be secondary in importance to the organization’s tax-exempt objectives, and pursued only as a means to such tax-exempt objectives. A key question to ask is whether the organization’s business purpose is incidental to its tax-exempt purpose, or vice versa.
Consider a Section 501(c)(3) charitable organization, “Up and Better,” that focuses on helping at-risk youth in inner-city neighborhoods to flourish, break free of poverty, and pursue educational goals. As part of its charitable programs, Up and Better provides entrepreneurial opportunities for program participants to learn t-shirt and hat embroidery, sell the resulting products, and develop business skills. Up and Better devotes much more of its resources to helping the kids with their homework, providing nourishing meals, taking kids on service trips, and helping them apply to college. Up and Better’s business program produces revenues, but not enough to fund all of its operations. The organization therefore depends on charitable contributions for this activity, and volunteers are extensively needed for both the business and the charitable operations.
Given these favorable facts, it seems clear that Up and Better’s primary focus is charitable, with its business program only incidental to its overall operations. The organization’s tax-exempt status should remain well protected. In addition, given Up and Better’s focus on helping youth, revenues proceeding from the sale of t-shirts and embroidery may well qualify for exemption from “unrelated business income tax” (UBIT), since the activity is directly “related” to the organization’s mission. (This is a highly notable point but beyond this article’s scope for in-depth treatment.)
Now what if Up and Better’s business activity becomes more business-like, with more production than training and more sales than learning, and with steadily increasing growth? The resulting revenues may become subject to UBIT as “unrelated” to Up and Better’s charitable purposes. If this UBIT activity is incidental in comparison to Up and Better’s other charitable programs, the commerciality question and potential disqualification for tax-exemption under Section 501(c)(3) are not at issue. But if the nonexempt business activity becomes more than incidental, then Up and Better’s leaders must take steps to either curtail the non-exempt business activity or transition the business into a separate taxable structure. Taking these additional measures to structure the entity as a business, apart from Up and Better, will protect Up and Better’s tax-exempt status.
These considerations apply with equal force for a new Section 501(c)(3) tax-exempt organization. Leaders will need to think carefully about whether they can develop the nonprofit as primarily operated for tax-exempt purposes, how much commerciality is envisioned, and how its operations will look through the IRS’s multi-factor prism. Perhaps the enterprise is best suited for a separate LLC, whether disregarded as a similar nonprofit or entirely separate as a for-profit business.
How much commerciality is too much for tax-exempt qualification? Depending on the facts, the answer may be uncertain and therefore less than satisfying. For nonprofit leaders seeking optimal clarity and Section 501(c)(3) tax qualification, the clear lesson is to make an organization’s charitable, religious, or educational nature strongly evident as its “primary” focus, with its “commercial hue” only secondary to the organization’s overall tax-exempt purpose, and preferably with extensive tax-exempt activities (the more, the better!).
