Photo by Harvey Made

This will be the first of two articles discussing the important issues that should be considered by anyone starting a nonprofit organization. If you are planning to start an organization that creates a social impact or has a charitable purpose, you can likely form that organization as a nonprofit. There are a number of benefits to forming your organization as a nonprofit, one of the biggest being tax-exempt status. However, it is important to remember that being tax-exempt comes with certain regulations. This article will be part one of two installments examining the regulations nonprofits must comply with to avoid losing tax-exempt status.

01 | Private Inurement Prohibition
A fundamental element of operating a nonprofit is that the organization serves a public, rather than private benefit. A nonprofit is prohibited from using its funds to unreasonably benefit an individual who is closely related to or can influence the organization. If a nonprofit’s funds are used to benefit a private individual, the nonprofit risks losing its tax-exempt status or having other sanctions imposed.

There are a number of both direct and indirect ways a nonprofit’s funds can be deemed to have benefited a private individual. The most common form of prohibited benefit is unreasonable compensation paid to insiders of the nonprofit. Other forms of private benefit could include the sale of assets to an insider, the purchase of assets from an insider, lending money to an insider, gifts, or other unreasonable compensation agreements. An organization is not necessarily prohibited from providing compensation to or engaging in business transactions with insiders. However, there are two very important points of consideration when conducting deals with insiders. First, compensation must be reasonable; second, business transactions must be done at arms length.

02 | Reasonable Compensation
There is no clearly defined method of calculating reasonableness. However, the amount of compensation should be directly related to the amount of services provided, and should be consistent with the going rate for workers of the same job description in the area. If a concern ever arises with the IRS or Attorney General, the organization will have to provide clear evidence demonstrating the reasonableness of the compensation. All nonprofits should keep detailed notes, time cards, job descriptions, etc. showing that compensation was reasonable and justified.

03 | Business Dealings
An issue can also occur through business dealings, such as sales or lending, with insiders. The important consideration with these dealings is that they must be done at arms length. An organization can buy or sell assets with an insider, but the fair market value must be paid. If the sale is substantially over or under fair market value, red flags will be raised and the organization will risk losing tax-exempt status.

04 | Unrelated Business Income Tax (“UBIT”).
A nonprofit is allowed to earn profits from business activities that are not substantially related to its charitable purpose. However, these profits are likely subject to UBIT, imposed by the IRS, and will require filing tax returns. These profits are generally taxed at the corporate tax rate.

An example of when UBIT became an issue is an organization that defined its charitable purpose as an effort to stimulate and foster public interest in the fine arts by promoting art exhibits, sponsoring cultural events, and supplying information about fine arts to the public. This organization also conducted business activities in which they leased studio apartments to artist tenants and ran a dining hall for these tenants. The leasing and dining hall activities were not substantially related to the charitable purpose of fostering public interest in the fine arts, and were thus subject to UBIT.

When forming a nonprofit, a clear charitable purpose should be articulated, and the primary activities of the nonprofit should serve that purpose. If there is any doubt about whether the nonprofit is generating profits from business activities that are “unrelated” to the purpose of the nonprofit, an attorney should be consulted to ensure compliance with any federal tax requirements.

What Does All This Mean For Your Nonprofit?
When managing your nonprofit, every decision and action should be made with a focus on the charitable purpose of your organization. Any compensation agreement for a member of your nonprofit must be made with an awareness that the organization and its employees and members work for the benefit of the public. When organizing business activities for your nonprofit, you must consider whether the activities fall within the scope of your charitable purpose. It is always wise to consult with an attorney regarding these issues and to keep detailed records regarding employment duties and history, as well as records regarding the activities of your organization.

Next month, part two to this article will further discuss the need to create and act within the scope of your nonprofit’s charitable purpose, by exploring the political and lobbying restrictions imposed on nonprofits.

Disclaimer: The information in this article is presented for informational purposes only, and should not be taken as legal advice. Before acting on any information presented in this article, you should consult an attorney regarding the facts of your specific situation. We would love to hear from you, so please feel free to contact Wilkinson Mazzeo for a consultation.

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