Charlotte thought she knew everything about running a not-for-profit community hospital. So the CEO was shocked when the IRS contacted her hospital about potentially losing its tax-exempt status. The IRS mentioned several issues, including the hospital’s increasingly wide operating margins and its extensive use of advertising. As the dispute proceeded to litigation, Charlotte learned that the hospital had tripped over 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 nonprofits competing at an unfair tax advantage with for-profit businesses. The operational test generally requires nonprofits 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 nonprofit 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 nonprofit set prices to maximize profits or has it accumulated unreasonable reserves?

Other potential pitfalls include providing fewer lower cost services than your nonprofit 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 nonprofit’s total support.

The UBIT threat

There’s another risk for nonprofits 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.

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Even when they’re nonprofits, trade associations and chambers of commerce generally qualify for a tax exemption under Section 501(c)(6) of the Internal Revenue Code, not Sec. 501(c)(3). And these “business leagues” (as the IRS terms them) must adhere to a different set of rules. In fact, if you haven’t looked at the rules recently, your organization may not be in compliance and could be risking its exempt status.

Potential business league violations

Business leagues exist to promote their members’ common interests and improve business conditions of “one or more lines of interest.” Typically, these groups get into trouble if they interpret terms such as “promote common interests” and “improve business conditions” too broadly. For example, your organization might provide customized sales training for only some of its members. That’s generally a no-no.

Another potential violation is engaging in business that’s normally carried out on a for-profit basis. And groups that are primarily social or that exist to promote a hobby usually don’t qualify for 501(c)(6) status.

Group vs. individuals

To avoid IRS scrutiny, you must be able to differentiate between qualified and nonqualified activities. For example, you’re typically allowed to attempt to influence legislation relating to the common business interests of your members. You can also test and certify products, establish industry standards and publish statistics on industry conditions to promote your group’s line of business. In addition, you’re allowed to research effective business practices to share with your members.

But you should limit activities that benefit specific members rather than your industry or profession as a whole. These might include:

• Selling advertising in member publications,
• Facilitating the purchase of supplies for members, and
• Providing workers’ compensation insurance to members.

The key is your association’s “primary purpose.” Most 501(c)(6) groups perform some activities that don’t primarily serve common interests. But these activities should be limited in scope and number.

Even when certain activities don’t threaten your exempt status, performing services for members can trigger unrelated business income tax (UBIT). Typically, members pay for such services directly, instead of through dues or other common assessments. Depending on the services your association provides and the revenues raised, additional reporting may be required and you may owe UBIT.

When to consider a for-profit offshoot

If you find your organization is performing more (or more substantial) services for individual members than is “safe,” you might consider forming a separate for-profit organization. Then any services that benefit individuals can be shifted under this taxable umbrella and you can preserve your association’s not-for-profit status. Contact us for information about how to establish a for-profit offshoot.

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Relatively high interest rates and tight lending standards are making it difficult for even for-profit businesses to apply and qualify for bank loans. But not-for-profits, which may lack adequate collateral or steady cash flow, generally face a greater uphill battle when it comes to obtaining financing.

If you’ve ruled out finding a grant or launching a capital campaign to fund your expansion or cover the cost of a large project, one of the following financing options may work for you.

Traditional lenders and products

Bank financing generally comes in two basic forms:

1. Line of credit. This is a negotiated amount that you can draw against as needed. If your goal is to smooth out cash flows over the year, it’s usually the best option. A maximum amount is available to you, but you use only what you need. Required monthly payments may be limited to interest expense and principal payments can be made any time. So you have flexibility in how much you repay each month.

2. Term loan. Here, you receive a lump sum, usually for a specific purchase. The application process is usually more complicated, and approval typically takes more time. Repayment is in installments, which means you’d make equal monthly payments consisting of interest and principal throughout the entire loan term.

Bank lenders usually look at an applicant’s financial statements, cash-flow predictability, management and governance, collateral, and repayment plan. But even if your nonprofit is approved for a loan, the interest rate may be prohibitive. Banks almost always charge higher rates for what they perceive as higher risk loans.

Credit unions may be more likely than traditional banks to take a chance on nonprofits. Because they’re also nonprofit entities and don’t pay income tax, they may extend loans with lower interest rates.

Other possibilities

Although credit cards usually are much easier to obtain than a loan, avoid using them to finance any large amount you can’t repay quickly because the interest will add up fast. If your project is relatively small, a crowdfunding campaign through GoFundMe, Donorbox or a similar online platform, may be a less expensive way to go — particularly if you already have a large online following.

Also take a look at nonprofit loan funds — such as the Nonprofit Finance Fund or Propel Nonprofits — that specialize in servicing charities. They may offer a range of products (including lines of credit and emergency and mortgage loans) at low to no interest and favorable terms.

A tax-exempt bond issued by your municipality, county or state government is another possible option. Tax-exempt interest rates generally are two to three percentage points lower than on loans from other sources and the Internal Revenue Code generally allows nonprofits to use the proceeds of a bond issue to further their stated charitable purpose.

However, the process can be lengthy, complicated and expensive. Bond issues usually involve stringent financial disclosure requirements and tighter overall scrutiny. A line of credit or term loan can be approved in a matter of weeks, but bond financing can take six months to a year before funds are received.

Don’t despair

If none of these options seem viable, don’t despair. We can help your nonprofit by preparing financial documentation for lender scrutiny and suggesting the best possible approaches for obtaining the financing you need.

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If a donor has never asked your not-for-profit to return a gift, it may only be a matter of time. Although uncommon, donors can change their minds. They may come to believe your organization is misusing or wasting donated funds or decide it’s no longer fulfilling its charitable mission. Although you’re probably inclined to cooperate with requests, doing so can be difficult if you’ve already spent the money or if other factors are in play. Let’s look at the problem — and a potential solution.

What the law says

In general, federal law doesn’t require nonprofits to return donations. Individual states have enacted various laws, but these generally are vague about returning contributions. They usually assume that a gift is no longer the property of a donor once a charity accepts it. And because nonprofits are expected to act in the public interest, state regulators may rule that returning a donation harms the public good.

However, to avoid potential lawsuits, some situations require you to return a donation. One such situation is the violation of a donation agreement. If, for example, a donor stipulates that money must go directly to hurricane relief and the funds are instead spent on mobile devices for staffers, the charity is legally obligated to return the donation. Another situation where donations should be returned is when a donor pays for a ticket to a fundraising or other event and the event is cancelled. At the very least, nonprofits should offer a refund for the canceled event, but can ask supporters to donate the amount.

As a gesture of goodwill, it’s usually best to return small donations when asked. Larger gifts may be harder to return. In such circumstances, talk to your attorney and financial advisor — and possibly your state’s nonprofit agency.

Heading off unwanted return requests

No nonprofit wants to return donated funds. Fortunately, you can head off unwanted return requests by adopting a written donation refund policy. State that most donations aren’t eligible for return and explicitly describe the circumstances under which a donation is eligible for return.

Also document large gifts using a standard agreement form that includes your return policy and consider including a “gift-over clause.” This permits a donor to request that a gift be transferred to another organization if the donor believes it has been misused. Finally, observe best fundraising practices. By adhering to the highest ethical standards, you may be able to avoid misunderstandings and conflicts that could result in refund requests.

Get to the bottom of it

Supporters can request the return of donations for many reasons. Try to get to the bottom of each case so you can prevent other donors from following suit. For instance, supporters may object to a recent decision or trend — or simply dislike how something was worded in your newsletter. In these circumstances, you may be able to smooth ruffled feathers and keep the donation. Just be certain you respond quickly to requests and enlist the help of advisors when there’s a threat of legal or financial repercussions.

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If your not-for-profit focuses all of its fundraising energy on the holiday season and end of the year, it’s not misguided. After all, 26% of charitable giving to nonprofits occurs in December, according to the 2023 M+R Benchmarks Study. But that means almost three quarters of annual donations need to be obtained during the rest of the year. Even if your December haul is much greater, you still risk experiencing cash shortfalls.

The best way to make fundraising an ongoing process with strategies you can use any time of the year is to build a fundraising plan.

It takes a team

The first step to a solid fundraising plan is to form a fundraising committee. This should consist of board members, your executive director and other key staffers. You may also want to include major donors and active community members.

Committee members need to start by reviewing past fundraising sources and approaches and weighing the advantages and disadvantages of each. Even if your overall fundraising efforts have been less than successful, some sources and approaches may still be worth keeping. Next, brainstorm new donation sources and methods and select those with the greatest fundraising potential.

As part of your plan, outline the roles you expect board members to play in fundraising efforts. For example, in addition to making their own donations, they can be crucial links to corporate and individual supporters.

A flexible plan

Once the committee has developed a plan for where to seek funds and how to ask for them, it’s time to create a fundraising budget that includes operating expenses, staff costs and volunteer projections. After the plan and budget have board approval, develop an action plan for achieving each objective and assign tasks to specific individuals.

Most important, once you’ve set your plan in motion, don’t let it sit on the shelf. Regularly evaluate the plan and be ready to adapt it to organizational changes and unexpected situations. Although you’ll want to give new fundraising initiatives time to succeed, don’t be afraid to cut your losses if it’s obvious an approach isn’t working.

Get going now

Perhaps you’re gearing up for your year-end campaign (most nonprofits start planning in September or October). That doesn’t mean you should wait until the new year to build a more comprehensive fundraising plan. Your organization’s cash flow depends on steady income, so the sooner you put a plan in place, the better. Contact us for more information.

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