Earned Income 101 for Nonprofits

Earned Income 101 for Nonprofit

Gene Takagi & Emily Chan
January 18, 2012

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Today’s Speakers

Gene Takagi Emily Chan
Managing Attorney Associate Attorney
NEO Law Group NEO Law Group

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A Service
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Earned Income 101 for
Nonprofits
Nonprofit Webinars
January 18, 2012

Presented by: Gene Takagi and Emily Chan

Copyright © 2012 NEO Law Group. All rights reserved.

Examples

• Let’s start a new business!!!

• Let’s buy an existing business!!

• Let’s partner with a for-profit!

• Let’s start charging
for our services.


What Have You Got?

• Marketable value of ORG’s assets

• ORG’s capacity to develop and operate the Venture
• Money

• Market

• Management/Staff


First Considerations

• Mission-consistency

• Board duties

• Prudent investment


Mission – 501(c)(3) – Charitable Trust

• IRC § 501(c)(3)
• Operational Test
• No private inurement
• No private benefit

• Articles of incorporation – purpose restriction?
• Bases for exempt status – incompatible activities?


Board’s Duties


Duty of Care

• Ordinary prudent person standard
• Reasonable inquiry (investigation)

• Independent judgment

• Issues:
• Reliance

• Delegation
– Limit authority

– Reporting


Duty of Loyalty

• In good faith

• In the best interests of the corporation

• Issues:
• Conflict of interest

• Corporate opportunity

• Confidentiality


Prudent Investment

Portfolio Theory


Fiduciary Duties and Investments

• Lessons from Madoff
• Use care
• Understand what you invest in
• Diversify across asset classes (portfolio theory)
• Rely on appropriate advisors with due care
• Consider strict conflict of interest provisions
• Jeopardizing investment rules for Private Foundations


Next Considerations

• Employees

• Licenses, Permits

• Leases

• Insurance

• Trademarks


Tax Considerations

Tax-exemption relates to income tax

Business activities okay

BUT: Is all business income nontaxable? No.


IRS – Tax Perspective

Related Unrelated
• Generally exempt • May be subject to
income corporate taxes


Related Business

Advances the organization’s charitable purposes
irrespective of profits.


Unrelated Business

1. A trade or business;

2. Regularly carried on; and

3. Not substantially related to furthering the exempt
purpose of the organization.


UBIT: Trade or Business

• Any activity carried on for the production of
income from selling goods or performing services.

• Even if carried on within a larger framework of
other activities that may, or may not, be related to
the organization's exempt purposes.


UBIT: Regularly Carried On

• Activities that show a frequency and continuity,
and are pursued in a manner similar to,
comparable commercial activities of nonexempt
organizations.


UBIT: Not Substantially Related

• Substantially related when the conduct of the
business activities has a substantial causal
relationship to achieving exempt purposes (other
than through the production of income).
• The activities that generate the income must
contribute importantly to accomplishing the
organization's exempt purposes to be substantially
related.


Substantially related?

IRS considers factors such as:
• Nature and size of business

• Fees

• Who is served

• Business operations

For each activity!


“Charitable”

• Relief of the poor, distressed or underprivileged (low
income, minority, elderly, disabled, other 501(c)(3)
organizations, or similarly situated persons)
• Promotion of social welfare by lessening neighborhood
tensions, eliminating prejudice and discrimination,
defending human and civil rights, and combating
community deterioration and juvenile delinquency
• Lessening the burdens of government
• Promotion of health
• Advancement of education


Earned Income Examples

• One-time: Woodland Park Zoo Doo

• Business activity: Girl Scouts

• Social Enterprise: Goodwill Industries


Exclusions & Modifications

Including:
• Volunteer workforce

• Convenience of members

• Selling donated merchandise

• Passive income*
* debt-financed property exception not addressed here


Application of the Rule

Unrelated
Business?
Exclusion? Modification?
(facts &
circumstances)


Example: Museum Cafe

Café Open to Public Rooftop Coffee Bar
- Street entrance - Accessible through museum
- Open to the public - Must have museum admission
ticket
- UBIT?
- UBIT?

Fragmentation Rules Examples

• Dual-use facility

• Sale of various merchandise


Example: Museum Theater Auditorium

• Museum has a program of public
education in arts and sciences
• Theater designed for showing
educational films
• Operation while museum is open
to the public – UBIT?
• Operation as a motion picture
theater for public when museum
is closed – UBIT?


Example: Museum Gift Shop


Unrelated Business Activities & Commerciality

• Unrelated business income tax?

• Jeopardize 501(c)(3) status?


Substantiality Test

• How much unrelated business activity is too much?
• Factors:
• Relationship of the business activity to the overall
activities of ORG in terms of time, effort and dollar
income
• Relationship between business activity and the exempt
function of ORG (commensurate test)
• Reason that ORG conducts the particular business
activity
• Methods of operation and the control exercised by the
board over the business operations


Business Considerations/Risks

• Loss of money

• Overburdened staff

• Mission creep

• Private benefit (actual or perceived)

• Adverse PR/marketing

• Culture compatibility


Legal Form Considerations

• In-house

• Subsidiary

• Other social enterprises


In-house

• IRC § 501(c)(3) Rules

• Articles of incorporation – restriction?

• Basis for exempt status – incompatible?

• Capacity?


Subsidiaries

Tax-exempt or taxable subsidiary

Considerations
• Business

• Legal

• Tax


Subsidiaries

Nonprofit For-profit

c3 c3
Affiliation Ownership
c3 FP

Business w/ different risk profile Investment laws

Taxable Subsidiaries

Nonprofit subsidiary
• ORG is sole member

For-profit subsidiary
• ORG is sole shareholder

The key is separateness


Separateness

• Boards, directors, officers
• Meetings
• Books, accounts
• Filings
• Stationary, marketing materials
• Phone numbers
• Parent does not participate in day-to-day management of Sub
• Helpful facts:
• Majority of Sub’s Board independent of Parent
• CEO of Sub is neither an Officer nor Director of Parent


Considerations regarding a Subsidiary

• If unrelated business, and substantial activity:
• Form subsidiary
• Liability
• Subsidiary may provide limited liability protection,
but there are limitations:
• ORG guarantees Sub’s obligations
• Veil piercing (failure to observe formalities, inadequate
capitalization)

• Financing

Taxation

• Dividend from a taxable subsidiary

- Not taxable income to ORG

• Payment of interest, annuity, royalty or rent from a
subsidiary (controlled entity)

- ORG may exclude such payments if they do not
exceed FMV (excess is subject to UBIT plus 20%
penalty)


Collaborations with For-Profits

• Contractual Relationships / Sponsorships

• Joint Ventures


Sponsorships

• Sponsorship payments to ORG not UBTI if sponsor
does not receive any substantial return benefit
(Qualified Sponsorship Payment or QSP)
• The use or acknowledgment of sponsor
• Insubstantial benefits - FMV does not exceed 2% of
sponsorship payment


Use or Acknowledgement of Sponsor

• Grant of exclusive sponsorship in an activity to a for-
profit
• Use of logos and slogans that do not contain qualitative
or comparative descriptions of sponsor’s products,
services, facilities or company
• Use of a list of sponsor’s locations, telephone numbers
or internet addresses
• Use of value-neutral descriptions, including displays or
visual depictions of sponsor’s product line or services
• Use of sponsor’s brand or trade names and product or
service listing

Qualified Sponsorship Payment – Yes or No?

• “Ride for Life” sponsored by ABC Company

• “Buy ABC Widgets”

• “ABC Company – for the finest widgets”


Nonprofit – For-profit Joint Ventures

• NP Hospitals + Physicians
- Ambulatory surgical center

• Developer + Nonprofit
- Low-income housing

• University + Health System
- Distance learning


Joint Ventures – Motivating Factors
(Nonprofit)

• Additional opportunities to further its charitable
purposes

• Greater access to capital and expertise

• Possibility of capital appreciation

• Flexibility in operation

• Protection from liability


Joint Ventures – Motivating Factors
(For-profit)

• Enhanced good will

• Increased marketing opportunities

• Access to expertise and political capital

• Availability of financial opportunities
- Low-Income Housing Tax Credits


Two-Prong Test

1. Whether participation in JV furthers a charitable purpose

2. Whether JV permits the nonprofit to act exclusively in
furtherance of its exempt purpose and only incidentally
for the benefit of its limited partners


Vehicles for JVs: Social Enterprise Entities

• Certified “B” Corporation

• L3C

• Benefit corporation

• Flexible purpose corporation

• Nonprofit – for-profit joint ventures


Disclaimer

The information contained in this presentation has been prepared by NEO Law
Group and is not intended to constitute legal advice. NEO Law Group has used
reasonable efforts in collecting, preparing, and providing this information, but
does not guarantee its accuracy, completeness, adequacy, or currency. The
publication and distribution of this presentation are not intended to create, and
receipt does not constitute, an attorney-client relationship.
201 Spear St., Suite 1100
San Francisco, CA 94105
415.977.0558
www.NEOLawGroup.com
www.NonprofitLawBlog.com
gene@neolawgroup.com
twitter.com/gtak
emily@neolawgroup.com
twitter.com/emilychan


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