Alternative Fundraising: What Every Nonprofit Should Know

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April 2009 Updated September 2015

In an effort to find new sources of revenue, for the organization. Generally, income some charitable organizations are turning to from a nonprofit will be taxed as unrelated “alternative fundraising” techniques. These business taxable income (“UBTI”) if three include increased commercial activities, gala requirements are met: events, joint ventures with for-profit entities, and the use of debt to produce cash flow to (i) The income is from a trade or fund operations and activities that can be business; extremely useful to organizations seeking to maintain or even increase their level of (ii) The trade or business is regularly services. carried on by the nonprofit; and

However, a nonprofit must carefully (iii) The conduct of the trade or consider these techniques, as they may result business is not substantially in taxable income to the nonprofit and the related to the organization’s prohibited use of the nonprofit’s assets to performance of its exempt benefit private individuals and for-profit functions. entities. Organizations considering commercial The following alert discusses issues that activities to raise funds—such as the sale of nonprofits should consider when planning goods—should therefore consider whether transactions or agreements and identifies those commercial activities will produce situations in which “alternative fundraising” unrelated business taxable income. An techniques may implicate certain tax rules activity constitutes a “trade or business” if it applicable to nonprofits. is carried on for the production of income from the sale of goods or performance of Unrelated Business Taxable Income services. Generally, a trade or business includes only those activities that are General Rules conducted with a profit motive. This includes activities carried on for a profit in Although many nonprofit organizations conjunction with similar activities that are enjoy tax-exempt status, certain activities related to the organization’s exempt may nonetheless give rise to taxable income purpose.

April 2009 Updated September 2015

For example, suppose a nonprofit provides income-producing activity to be computer training classes free of charge to substantially related to an organization’s low-income individuals in accordance with exempt purposes, the activity must its exempt purposes. If the nonprofit then contribute importantly to those exempt decides that it will also provide computer purposes. training classes to the general public at market rates, those classes may qualify as a Determining whether the activity contributes trade or business. importantly to an organization’s exempt purposes requires an analysis of all the facts This rule ensures that tax-exempt nonprofit and circumstances, including the size and organizations engaging in unrelated business extent of the activities in comparison to the activities are not placed at a competitive nature and extent of the exempt functions advantage over for-profit organizations that that they serve. are subject to tax. The Treasury Department has provided the The second UBTI requirement is that the following examples to distinguish between trade or business must be “regularly carried those activities that are substantially related on.” If an activity is carried on with the and those that are not: same frequency and continuity as a similar activity conducted by a for-profit  A nonprofit operates a school for organization, the activity will likely be training children in the performing arts. considered “regularly carried on” by the It presents performances by its students nonprofit. Certain intermittent or seasonal and derives gross income from activities may not amount to a regular trade admission charges for the or business by the organization if a for-profit performances. The student entity would carry out those activities performances are an essential part of consistently throughout the year. their training, and as a result, the income realized from the performances For example, a charitable organization that contributes importantly to the operates a sandwich stand at a state fair for organization’s exempt purposes. only two weeks out of the year would not be Accordingly, the income generated regularly carrying on that business, as from the performances does not commercial sandwich providers would carry constitute UBTI. on that business throughout the year.  A tax-exempt museum has a theater Because determinations about whether auditorium that is specifically designed activities are regularly carried on depend and equipped for showing educational largely on the specific facts of the activity, films in connection with its program of nonprofits should consult a competent tax public education in the arts and advisor before making conclusions on their sciences. The theater is a principal own. feature of the museum and is in continuous operation during the hours Finally, UBTI arises only when the conduct the museum is open to the public. In of the trade or business is not “substantially addition, the organization operates the related” to the organization’s performance theater as an ordinary motion picture of its exempt functions. In order for an theater for public entertainment during

April 2009 Updated September 2015

the evening hours when the museum is point at which these donor closed. The income generated from acknowledgements cross the line and result this after-hours operation is unrelated in the sale of goods and services to the business taxable income. “donor.”

As noted above, these examples are based In order to bring clarity to this area, on the facts and circumstances of each Congress added a section to the tax code for specific organization. As a result, a “qualified sponsorship payments,” which nonprofit should discuss its specific sets forth guidelines outlining the amount circumstances with a competent tax advisor and type of recognition that a nonprofit may to determine whether an activity is give to its donors. substantially related to its exempt functions. The Treasury Regulations define a Unrelated Business Taxable Income: “qualified sponsorship payment” as a Corporate Sponsorship Payments and payment made by anyone engaged in a trade Advertising or business with respect to which there is no arrangement or expectation that the person Two activities that frequently present UBTI will receive any “substantial return benefit” concerns are corporate sponsorships for from the nonprofit in exchange for the nonprofit organizations and advertising. payment. The nonprofit’s use or The Internal Revenue Code specifically acknowledgement of the name, logo, or excludes “qualified sponsorship payments” product line of the person’s trade or business from the definition of an unrelated trade or in connection with the exempt business, but the exclusion does not extend organization’s activities does not amount to to activities that are considered a substantial return benefit. “advertising.” Examples of permitted uses or Historically, the Internal Revenue Code acknowledgements include publishing: treated the sale of advertising space in the nonprofit’s newsletter or other publication  The sponsor’s logos and slogans, as as an unrelated trade or business, and thus, long as they do not contain any income from the sale of such advertising qualitative or comparative would be taxable. The IRS took the position descriptions of the sponsor’s that the sale of such space was in direct products or services; competition with for-profit businesses.  A list of the sponsor’s locations, In contrast, nonprofits generally are allowed contact information or website to acknowledge the support of their donors address; and in places such as their website or in a gala program. Over the years, however, these  Value-neutral displays or depictions acknowledgements have come to more of the sponsor’s product line. closely resemble advertisements. Moreover, nonprofits, at the behest of their donors, Organizations holding gala events in which have been providing perquisites in corporate sponsors are given space in an recognition for their donations. As a result, event program should be mindful of whether Congress and the IRS began to question the those arrangements represent “sponsorship

April 2009 Updated September 2015 payments” that are exempted from UBTI or The following examples illustrate the “advertising” that would constitute UBTI. differences between qualified sponsorship The inclusion of a page in a nonprofit’s gala payments and advertising. program that merely thanks a sponsor for  A local charity organizes a marathon contributing to the gala and provides the and walkathon at which it serves sponsor’s name and contact information participants drinks and other would be a “qualified sponsorship payment” refreshments provided free of charge excludable from UBTI. by a national corporation. The corporation also gives the charity prizes Advertising, by contrast, is not considered a to be awarded to winners of the event. “use or acknowledgement” of the sponsor’s The charity recognizes the assistance of payment and results in a substantial return the corporation by listing the benefit to the sponsor. A page in the gala corporation's name in promotional program exclaiming a particular sponsor’s fliers, in newspaper advertisements of products to be superior to others would thus the event and on T-shirts worn by be an “advertisement,” and payments the participants. The charity changes the nonprofit organization receives from the name of its event to include the name sponsor would be subject to tax. of the corporation. The charity’s activities constitute acknowledgment of Other categories of return benefits that will the sponsorship. The drinks, subject a sponsorship payment to tax refreshments and prizes provided by include: the corporation are a qualified sponsorship payment, and not income  Exclusive provider arrangements, from an unrelated trade or business. such as a college permitting a soft drink company to be the exclusive  A noncommercial broadcast station airs supplier of soft drinks on campus; a program funded by a local music store. In exchange for the funding, the  Goods, facilities, services or other station broadcasts the following privileges, such as tickets to a charity message: “This program has been golf tournament or a dinner; and brought to you by the Music Shop, located at 123 Main Street. For your  Rights to use an intangible asset of music needs, give them a call today at the exempt organization. 555-1234. This station is proud to have the Music Shop as a sponsor.” Because Applicable Treasury Regulations, however, this single broadcast message contains provide a limited exception for benefits both advertising (“For your music below a certain value: if the fair market needs, give them a call today”) and an value of the return benefit the sponsor acknowledgment, the entire message is receives in exchange for the sponsorship advertising. If the fair market value of payment is not more than 2% of the amount the advertising exceeds 2% of the total of the sponsorship payment, then it is payment, the advertising is a substantial disregarded. return benefit, none of the payment is a qualified sponsorship payment, and the payment will be subject to UBTI.

April 2009 Updated September 2015

Because there are a number of factual faculty members compensated by the school situations that may fall within the grey area were working at the sale. between advertising and qualified sponsorship payments, exempt organizations For purposes of both these exceptions, the should consult a competent tax advisor to term “substantially all” is usually interpreted determine whether their specific activities to mean at least 85%. generate UBTI. Certain “passive” income is expressly Unrelated Business Taxable Income: excluded from the calculation of UBTI, such Exceptions as dividends; interest; annuities; payments with respect to securities loans; royalties; Further complicating an already complex and certain rents. area of law, the Internal Revenue Code identifies numerous exceptions to the Each of these exceptions has specific general unrelated business income tax rules. requirements that must be met before the item can be excluded from UBTI. Rental One such exception—known as the income from real property, for example, is volunteer exception—allows exempt excluded from the UBTI calculation but organizations to engage in an unrelated trade rental income from personal property is or business if substantially all the work in generally not excluded. A nonprofit’s carrying on the trade or business is income from leasing out space in its performed by uncompensated volunteers. building is generally excluded from UBTI, As an example, a tax-exempt orphanage that but income from renting out vehicles is not. operates a retail store selling merchandise to the general public would ordinarily meet all As with all of the rules described above, the three requirements of the UBTI test actual application of the exceptions to UBTI identified above. The store, however, would involves far greater complexity than can not be an unrelated trade or business whose adequately be described in this alert. income is subject to tax if all of the work Nonprofits considering transactions or was performed by volunteers who received activities that potentially implicate the UBTI no compensation. rules or the exceptions thereto should seek the advice of a competent tax advisor. The “thrift store” exception similarly excludes from the definition of an unrelated Unrelated Debt-Financed Income trade or business a trade or business that consists of selling merchandise, Facing cash shortfalls, some nonprofits may substantially all of which was received by consider using debt to provide cash flow to the organization as gifts or contributions. fund activities and operations, to purchase Thus, a high school that collects used facilities, or as part of investments. clothing and household items from its Nonprofits, however, must be mindful that students and faculty members and then sells the use of property held subject to those items to the general public could indebtedness may create “unrelated debt- exclude from UBTI any income it received financed income” that is taxable in a manner from those sales. Note, however, that this similar to UBTI. activity would not qualify under the “volunteer exception” described above if

April 2009 Updated September 2015

The Internal Revenue Code imposes a tax on the building, calculated as described above, “unrelated debt-financed income,” defined is therefore subject to the tax on unrelated as income earned from “debt-financed debt-financed income. property.” Such property—subject to certain exceptions—is any property that is: Because of the complexity of the debt financing rules, including the potential (i) Held to produce income, applicability of various exceptions to those including rents, royalties, rules not discussed here, organizations that interest, and dividends; and are considering transactions or investments that involve the use of debt should first (ii) Is held subject to a mortgage or consult with a competent tax advisor. other indebtedness used directly or indirectly for the acquisition of the property. Participation in Joint Ventures

A significant exception to this definition is Nonprofits may also consider participation that if at least 85% of a property is used for in “joint-venture” activities and transactions activities that are substantially related to the with for-profit entities and individuals to organization’s charitable purpose (see the generate additional revenues. general discussion of substantially related activities, above) then the property is not Joint ventures are enterprises in which two “debt-financed property.” or more parties contribute assets or expertise to a project with the expectation that the If, after taking certain deductions, a parties will share in the proceeds of the nonprofit has net income from a debt- endeavor. Joint ventures are common in the financed property, then the organization for-profit world, as multiple parties often must add a percentage to its UBTI collaborate when making investments or calculated by comparing the amount of the participate in joint projects. When joint debt and the organization’s “adjusted basis” ventures involve the participation of in the property of that income. This is the nonprofits, however, special care must be case even if the income that is earned would taken to ensure that: otherwise be excluded from UBTI under one of the exceptions described above. (i) Joint-venture activities do not impermissibly interfere with a For example, assume a nonprofit owns a nonprofit’s obligation to operate four-story office building subject to a exclusively for charitable mortgage. The organization uses the lower purposes; and two stories to house computers that the organization uses for administrative (ii) The nonprofit does not purposes; the organization rents the top two impermissibly confer any private stories to a third party. Because the building benefits on the for-profit business is held subject to a mortgage, and because through the joint venture. only 50% of the property is used for charitable purposes, the building is “debt- The IRS has published little guidance for financed property.” A portion of the rental nonprofits entering into joint ventures. income received from the top two stories of There are, however, three general principles

April 2009 Updated September 2015 that nonprofits should keep in mind when least 50% voting control over the joint considering joint ventures: venture.

 If the nonprofit invests in a partnership To further prevent a nonprofit’s assets from or other entity that is taxed the same as being used for the benefit of private parties, a partnership, any joint venture thereby conferring impermissible private activities that are not related to the benefits, the nonprofit must also ensure that organization’s charitable purpose will all transactions with for-profit entities or be treated as if carried out by the private parties are on arm’s-length terms, nonprofit directly; with the organization receiving a fair-market value price for any goods, services, or rights  A nonprofit must retain control over all it provides. assets that it contributes to the joint venture; and For example, the IRS dealt with the case of a university that formed a joint venture with a  The organization must not allow its for-profit corporation that specialized in assets to be used for the benefit of conducting interactive video training private parties. programs that was treated as a partnership for federal tax purposes. The joint venture arranged and conducted video teacher If a nonprofit does not keep these general training seminars using the university’s principles in mind when planning a joint curriculum and the for-profit corporation’s venture, the income it receives from the joint expertise in interactive video technology. venture may include UBTI. Even worse, The IRS concluded that the joint venture did the organization may risk losing its tax- not affect the university’s tax-exempt status, exempt status. noting four primary factors:

If activities of the joint venture are attributed  The university’s activities relating to to the nonprofit participant and they are not the joint venture were not substantial; substantially related to the organization’s charitable purpose, income from the joint  The joint venture’s activities were venture may be UBTI to the organization. substantially related to the university’s Moreover, if the activities of the joint educational mission and thus did not venture are unrelated to the organization’s give rise to UBTI for the university; charitable purpose and those activities are “substantial,” then the organization risks  The university held a 50% voting losing its tax-exempt status. interest in the joint venture through the appointment of half of the company’s Nonprofits entering into joint ventures must directors; and also ensure that the organization retains control of the assets it contributes to the  The joint venture’s organizational joint venture and that those assets are not documents required that all contracts used for private gain. To maintain and transactions entered into “be at appropriate control over the joint venture arm’s length and that all contract and and any assets a nonprofit has contributed to transaction prices be at fair market that enterprise, the nonprofit must retain at value determined by reference to the

April 2009 Updated September 2015

prices for comparable goods or services.”

Because these determinations are very fact- specific, and given the complexity inherent in this area of the law, nonprofits considering participation in a joint venture should consult a competent tax advisor before moving forward.

Additional Resources

For additional information, please see IRS Publication 598 at: http://www.irs.gov/pub/irs-pdf/p598.pdf

This communication is provided by the D.C. Bar Pro Bono Center and Miller & Chevalier Chartered, as a public service solely for informational purposes, without any representation that it is accurate or complete. It does not constitute legal advice and should not be construed as such. It does not create an attorney-client relationship between the recipient and any other person, or an offer to create such a relationship. This communication contains information that is based, in whole or in part, on the laws of the District of Columbia and is current as of the date it is written. However, laws vary from state to state and may change from time to time. As a result, the information may not be appropriate for anyone operating outside the District of Columbia and may no longer be timely. Consult an attorney if you have questions regarding the contents of this communication.