The past decade has been marked by the increasing commercialization of the non-profit sector. Faced with cutbacks in government funding and foundation grants, as well as dwindling private donations in the wake of the 2008 recession, non-profits have looked to other sources of revenue to make up the difference. These factors, combined with the influence of the "social entrepreneurship" movement, have led non-profits to seek innovative models of philanthropy that increasingly resemble commercial enterprises.
"Fee-for-service" (an informal term of art the non-profit community uses to describe revenue generated from the sale of goods or services) has thus become an important and perhaps necessary source of revenue for many non-profits. Fee-for-service activities can include everything from simple bake sales to complex endorsement and license agreements with insurance companies. Additionally, many non-profits use their expertise to provide various consulting and administrative services to other non-profits for a fee.
This type of business revenue is attractive for several reasons. First, it diversifies an organization's revenue sources. Having a steady source of business revenue can protect an organization in the event donations and grants wane. Second, a business that taps into a real market need can produce revenue that is more reliable than donations and grants, which are subject to change at the whim of the donor. Importantly, fee-for-service revenue is also a source of "unrestricted funds," which can fund crucial overheard expenses without limitation.
However, the fee-for-service model raises tricky legal and operational issues, especially for non-profits that have relied on more traditional approaches to philanthropy. Organizations should bear in mind these six considerations before engaging in business activities.
1. The Commerciality Doctrine
Under the "commerciality doctrine," the IRS deems fee-for-service activities inconsistent with 501(c)(3) status if such activities are carried out in a manner too similar to for-profit businesses. This can potentially lead to the loss of tax-exempt status. Organizations should take steps to differentiate their operations from for-profit counterparts, such as by limiting their customer base, offering below-market prices, and/or supplementing fee-for-service revenue with more traditional fundraising activities.
2. Unrelated Business Income Tax
An organization may be subject to "unrelated business income tax" on its fee-for-service revenue if these activities are not considered "related" to the organization's mission. Importantly, the use of fee-for-service revenue to pay for charitable programs does not make the activity "related." Rather, the nature of the activity itself must directly further an organization's mission. Organizations should become familiar with the unrelated business income tax rules, including the many nuances, exceptions and modifications, before launching fee-for-service activities.
3. Public Charity Status
There are two types of 501(c)(3) organizations: public charities and private foundations. A 501(c)(3) organization must generally show that its revenue comes from a wide variety of sources to avoid being classified as a private foundation, thereby becoming subject to the very burdensome private foundation rules. Having large amounts of unrelated business revenue can make it harder to satisfy these tests.
4. Charitable Solicitation Registration
Charging for goods or services can potentially make an organization subject to charitable solicitation registration requirements in various states. If the name or mission of the organization is invoked as an inducement for the purchase, registration may be required in states in which the business is conducted or advertised.
5. Contract Drafting
Many non-profits find themselves ill-prepared to draft, review, negotiate and monitor business contracts. This can put an organization at a disadvantage, especially when dealing with sophisticated for-profit companies that are well versed in complex boilerplate language. At a minimum, an organization must be absolutely sure that it fully understands how and when each party is expected to perform, the term length of the contract (including the timing of cancellations and renewals), and the consequences of a breach. Of course, an attorney should be consulted to advise on trickier issues such as indemnification, insurance requirements, representations and warranties, and other complex but essential details.
Non-profits entering into new business activities should contact their insurance broker to ensure that their activities are adequately covered. A basic Directors & Officers Insurance policy only protects directors and officers against alleged breaches of fiduciary duty, and does not protect the organization from tort, contract and other liability risks inherent in business activities. Organizations should look into Comprehensive General Liability and/or Errors & Omissions policies, or if they already have these policies, make sure that the organization's business activities are covered.
This blog was written by Benjamin Takis, Academy for Nonprofit Excellence instructor. He is the founder and principal attorney at Tax Exempt Solutions, PLLC., a law firm specializing in tax, corporate governance, employment issues and business transactions for non-profit organizations and social entrepreneurs.