Charlotte believed she knew everything about overseeing a non-profit community hospital. To her surprise, the CEO was taken aback when the IRS reached out to her hospital regarding the potential loss of its tax-exempt status. The IRS pointed out various concerns, such as the hospital’s expanding operating margins and its extensive reliance on advertising. As the disagreement progressed into legal proceedings, Charlotte discovered that the hospital had run afoul of the commerciality doctrine.
This is a fictitious example. But the commerciality doctrine can be all too real.
Exception To The Rule
The commerciality doctrine, along with the operational test, was created to address concerns over non-profits competing at an unfair tax advantage with for-profit businesses. The operational test generally requires non-profits to be both organized and operating exclusively to accomplish their exempt purpose. The test also mandates that no more than an ‘insubstantial part’ of an organization’s activities further a nonexempt purpose.
What this means for your non-profit is that you can operate a business as a substantial part of your activities so long as the business furthers your exempt purpose. However, under the commerciality doctrine, courts have ruled that the otherwise exempt activities of some organizations are substantially the same as those of commercial entities. As a result, the entities are not tax exempt.
Don’t Operate Like A Business
No single factor is decisive, but courts and the IRS consider several issues when evaluating whether an organization fails the commerciality doctrine. In general, you risk your exempt status if you operate like a for-profit business. So, for example, has your non-profit set prices to maximize profits or has it accumulated unreasonable reserves?
Other potential pitfalls include providing fewer lower cost services than your non-profit peers and advertising your services to the general public. Also consider the extent to which your organization relies on charitable gifts. Donations should be a significant percentage of your non-profit’s total support.
The UBIT Threat
There’s another risk for non-profits operating a business. Even if you pass muster under the commerciality doctrine and retain your tax-exempt status, your organization could end up liable for unrelated business income tax (UBIT). Revenue generated from a regularly conducted trade or business that isn’t substantially related to furthering an organization’s tax-exempt purpose often is subject to this tax.
Determining UBIT liability or, worse, whether you could lose your exempt status under the commerciality doctrine, can be complex. Contact us to discuss the many factors that go into these determinations and for help avoiding missteps.