The 501(c)(3) Dilemma: How Can a Tax-Exempt, Nonprofit Organization Legally Generate Revenue?

Many tax-exempt, nonprofit organizations (TENPs) that focus on creating a just food system through urban agriculture are in what I like to refer as the “501(c)(3) dilemma.” On one hand, TENPs are often under pressure from traditional funders, such as large foundations, to make their operations more financially sustainable. To become more financially sustainable, TENPs are encouraged to figure out ways to generate revenue while carrying out a charitable purpose. On the other hand is the Internal Revenue Service (IRS). The IRS is often very skeptical of TENPs conducting a business activity that generates revenue. It closely examines revenue generating activity to determine whether it is an activity that is related to the organization’s charitable or educational purpose and, if it determines that it is unrelated, the TENP may risk being subject to additional tax liability and even may risk its tax-exempt status. To make matters worse, the application how the IRS examines revenue generating activity conducted by TENPs has often been inconsistent, which has created a lot of uncertainty in this area of the law.

This blog post will address revenue generation restrictions contained within the Internal Revenue Code that all TENPs should be aware of. It will also address how the IRS has treated urban agriculture focused TENPs that have conducted revenue generation activities, and tips to avoid additional tax liability and revocation of your organization’s tax-exempt status.

When nonprofit organizations talk about being “tax-exempt” the tax that is being referred to is the corporate income tax. The federal corporate income tax is governed by the Internal Revenue Code. Pursuant to 26 U.S.C. § 11, all corporations, including nonprofit corporations, are subject to a federal tax on all income. The federal corporate income tax is assessed yearly and varies from 15% to 35% depending on the income for the corporation in a given year.

However, many nonprofit corporations are exempt from the federal income tax described above pursuant to 26 U.S.C. § 501. Section 501(a) states that an organization that is exempt under section 501(c) “shall be exempt from taxation” under the Internal Revenue Code. Section 501(c) contains several categories of exemption, but section 501(c)(3) is by far the most popular. The popularity of the 501(c)(3) exemption stems from two additional advantages bestowed upon 501(c)(3) beyond tax-exemption. First, donations made to 501(c)(3) organizations are eligible for a tax deduction. Tax deductions operate to reduce the real costs of charitable gifts by providing donors with tax savings that correspond with the donor’s income level and the amount of the donation. Second, 501(c)(3) organizations are typically favored by private foundations, such as the Kresge Foundation, for distributions of financial resources. Private foundations are obligated by the Internal Revenue Code to distribute most of their funds to other charitable organizations, and this is typically done by providing grant funding to 501(c)(3) organizations.

Despite the two additional advantages of 501(c)(3) organizations, it is also the most restrictive tax-exempt status contained within section 501(c). According to regulations contained in 26 C.F.R. § 1.501(c)(3), in order for a nonprofit corporation to qualify for 501(c)(3) status, it must pass both an “organizational test” and an “operational test.” The “organizational” test relates to a 501(c)(3) organization’s Articles of Incorporation and mandates that the nonprofit organization be organized exclusively for one or more exempt purposes as described in 26 U.S.C. § 501(c)(3).  The “operational” test relates to how an organization that has been granted 501(c)(3) actually operates and, as such, is slightly more complex. The “operational” test requires 501(c)(3) organizations to “engage primarily in activities which accomplish one or more of the exempt purposes specified in 501(c)(3).” Most urban agriculture organizations qualify for 501(c)(3) status by focusing on either a charitable or educational purpose.

On top of the organizational and operational restrictions, all tax-exempt organizations also

must comply with revenue generation restrictions. In general, revenue generation activities of 501(c)(3) organizations are divided into two categories: business related to the organization’s exempt purpose and business unrelated to the organization’s exempt purpose. According to 26 U.S.C. § 511, the income of an organization will be subject to an unrelated business income tax (UBIT) if:

1.) The income is from a trade or business,

2.) Such trade or business is regularly carried on by the organization, and;

3.) The conduct of such trade or business is not substantially related (other than through the production of funds) to the organization’s performance of its exempt functions

In general, before any 501(c)(3) nonprofit organization conducts revenue generation activity on a regular basis, it should assess whether the business activity will be regarded as “unrelated business activity” and therefore subject to the “unrelated business activity tax.” It should also assess whether the business activity may cause the organization to run afoul of the “operational test” and jeopardize the organization’s tax-exempt status. These two issues should be assessed separately; while the rules regarding unrelated business income and the operational test do interact with one another, it is currently unclear exactly how they interact.

In regards to revenue generation activity, it is generally helpful to first analyze whether or not it would be regarded by the IRS as an unrelated business activity. Of the three factors listed above, the last is the most important. Unfortunately, the IRS has typically taken a hard line against tax-exempt organizations selling food. In a recent private letter ruling, the IRS denied 501(c)(3) status for a nonprofit corporation that sought to operate a local farmers’ in an economically depressed neighborhood in order to provide local farmers’ with a market for direct sales and local residents with a source of high-quality, locally grown products. The IRS stated that by operating the farmers’ market, the nonprofit organization was engaged “in substantial non-exempt activity similar to a commercial enterprise and marketing service.” The IRS also stated that providing a venue for the sale of items for the benefit of private individuals does not qualify as a tax-exempt activity under 501(c)(3).

Based on the private letter ruling described above, the sale of produce grown by the organization or by other organizations or individuals would likely be regarded as unrelated business activity and thus any income generated by that activity would be subject to the unrelated business income  tax. However, that is not all. The an organization conducting produce sale operations should also be concerned about jeopardizing its tax-exempt status. To be safe, most organization’s like to be sure that at least 51% of their activities and financial resources are dedicated to their tax-exempt purpose. Therefore, if your produce sale operations start to become a predominant part of your operations, your organization may be at risk of having its tax-exempt status revoked.

While the IRS has typically treated produce sales operations that sell food indiscriminately to the public as business activity that is unrelated to a tax-exempt purpose, there are ways that a 501(c)(3) urban agriculture organization can structure its produce sale operations to comply with tax laws and regulations.

One possible way may be to restrict produce sales almost exclusively to low-income individuals at costs that are below market. In regards to 501(c)(3) organizations focused on developing and selling affordable housing, the IRS has regarded such sales as for an exempt purpose if the sales are made to low-income individuals and families at prices well below the market rate. This option would entail carefully documenting the income of individuals to whom produce is sold and ensuring that prices are low enough that the organization doesn’t produce any profit.  It should be noted that many urban agriculture organizations may feel uncomfortable with asking for and documenting the income levels of its customers.

Another possible way to alter produce sales operations to avoid violating tax laws and regulations is to tie your produce sales operations to another exempt purpose. Typically, this is done by either making your farming operations part of a job-training program for at-risk, underemployed, or unemployed individuals. However, the IRS closely scrutinizes such operations to make sure that the business activity is not conducted on a scale that is larger than necessary to support the tax-exempt job-training program.

Both of the above options above involve crafting your produce sale operations to comply with federal tax laws and regulations. However, it is important to reiterate that this area of law is uncertain. It is incredibly important to talk with a lawyer to determine how to structure your revenue generation operations to make sure it does not subject your organization to tax liability and possibly jeopardize the organization’s tax-exempt status.

Rather than deal with the risks that come with uncertainty, many organizations that regularly operate a revenue generation activity have chosen to free themselves of the restrictions placed upon tax-exempt organizations by starting a for-profit entity to house its business activity. This can be done by either transitioning the entire TENP to a for-profit entity or by creating a for-profit subsidiary of the TENP. The next post will discuss some of the for-profit entity options for mission-driven businesses.