Just because you run a nonprofit, it doesn’t mean you can completely ignore taxes. You still have to file. In fact, if your nonprofit fails to file its annual federal return (Form 990) for three consecutive years, its tax-exempt status will be revoked automatically. The law surrounding this is clear. There are other areas in which a nonprofit may be subject to tax, however, that are not as straightforward. A nonprofit organization may find that it is subject to tax in the following circumstances.
Excise Tax on Executive Compensation
Nonprofits are subject to a 21 percent excise tax on executive compensation over $1 million paid to the five top-earning executives. This tax is paid by the nonprofit, not by the individual. Good planning may make it possible to mitigate the effects of this tax.
Local Lobbying Expenses
Section 501(c)(4), 501(c)(5) and 501(c)(6) organizations may no longer deduct their lobbying expenses. This has the potential to make them subject to a proxy tax.
Unrelated Business Income Tax
The distinctions between tax-exempt revenue and unrelated business income tax (UBIT) are not clear-cut. When nonprofits earn income through an activity that is unrelated to their exempt purposes (e.g., selling goods or services related to their mission) the revenue from the activity may be taxable. An important factor the IRS considers is the size and extent of the activities involved compared with the nature and extent of the entity’s mission.
Because it can sometimes be confusing to tell the difference between related and unrelated business income, the IRS clarified that the following activities aren’t subject to UBIT:
- The rental or exchange of mailing lists of donors or members
- Activities that are mostly done by volunteers
- Activities carried on primarily for the benefit of members, students, patients, officers or employees (such as a hospital gift shop for patients or employees)
- Sales of merchandise that has been mostly donated (e.g., at a hospital a thrift store)
- The distribution of token or insubstantial items as incentives for donating money (e.g., preprinted mailing labels)
- Activities carried out primarily for the convenience of the nonprofits members, students, patients, officers or employees (e.g., a school cafeteria)
- Certain bingo games
Nonprofits may be able to protect their tax-exempt status through multi-entity planning: The nonprofit organization can form a separate company through which it carries out its unrelated business activities, allowing it to avoid certain risks and liabilities.
Some newer nonprofits are organized as hybrid organizations, which are permitted to pursue both profit and nonprofit purposes. These low-profit limited liability corporations (LLCs), or L3Cs, are structured like LLCs. Although they must have a nonprofit purpose, the organization also may generate income.
To sort through the complexities of your nonprofit’s potential tax liabilities, contact an MCB Advisor at 703-218-3600 or click here. To review a summary of recent articles related to exempt organizations, click here. To review our tax news articles, click here. To learn more about MCB’s tax practice and our tax experts, click here.