Being in the business of making the world a better place often requires nonprofit organizations to become politically active. The IRS rules prohibit 501(c)(3) charities from engaging in certain kinds of political activities, but there are a lot of political activities that charities can (and should) engage in to further their exempt purpose and mission.
Fundraising is an important activity of most charities. Without fundraising, many charities would not be able to carry out their exempt purpose. How an organization raises funds, however, is regulated by the IRS, and there are important tax implications that organizations need to consider before beginning a new fundraising campaign.
Types of fund-raisers
While there are always new ways to fund raise, they generally fall into one of four buckets: direct solicitation, grants, in-kind, and events or sales.
Direct solicitation is familiar. If you have ever received a phone call or letter from your alma matter requesting a donation, then you have been directly solicited. Direct solicitation can happen in person, over the phone, by mail or email, or by any other means of direct communication. It is a “straight up ask” — no need to attend an event or buy a product.
Grants are another common method for raising funds. Grants can be given from the government (think scientific research) or from nonprofit foundations. In either case, the applications are often lengthy, and require oversight. Different foundations or government branches will target their grant-making toward different problems or causes. Additionally, nearly all domestic grant-makers require that the grant recipient have 501(c)(3) status, which makes it nearly impossible for smaller clubs and organizations to rely on grant monies.
In-kind donations are another common fundraising strategy. Instead of paying for a service (for example, website design or manual labor to clear a park), individuals (or businesses) will donate their time and expertise for free. This is usually a net gain for everyone, as the individuals or businesses can write-off the donation on their taxes, while the nonprofit receives the benefit of the donation without having to pay for it.
Lastly, events and sales are common ways for organizations to fund raise. Events include things like auctions or carnivals, and sales include everything from candy bars and bake-sales to t-shirts and hats with the organization’s logo or motto.
Pitfalls
The first pitfall that organizations should watch out for is Unrelated Business Income. Unrelated Business Income (abbreviated UBI) is a complicated topic, but basically it includes any income that comes from activities not related to the exempt purpose of the organization. And it’s taxable.
There’s a three-part test for determining whether income is UBI:
1. Is the income from a trade or business? If someone could do the same thing without being part of the nonprofit (for example, for-profit businesses also sell t-shirts), then it is income from a trade or business.
2. Is it regularly carried on? To use the t-shirt example again, if your nonprofit sells shirts once a year, then it is NOT regularly carried on. But if the t-shirts are always available for purchase, year-round, then it IS regularly carried on.
3. Is the activity substantially related to the exempt purpose of the organization? Or, if it isn’t, is the activity taking up more time and effort than the exempt purpose of the organization? For most nonprofits, selling t-shirts is not substantially related to their exempt purpose. However, one example of an organization where selling t-shirts is substantially related to their exempt purpose is Goodwill. Their purpose is to provide employment placement services and job training, and specifically retail sales training, to individuals with barriers to employment. In this specific case, they cannot provide retail sales training without selling a t-shirt. Their purpose isn’t to sell t-shirts, but they cannot do their purpose without selling t-shirts either.
Tax law also has some specific exemptions for UBI. First, activities conducted by volunteers, like an all-volunteer bake sale, will probably be exempted.
Second, businesses that are carried on for the primary benefit of the organization’s members are exempted. A typical example is a school cafeteria.
Third, any trade or business selling merchandise, substantially all of which is donated to the organization, is not taxed. Many thrift shop operations of exempt organizations would meet this exception.
Also, just because an activity creates UBI and may result in a tax liability does not mean that the organization has to discontinue the activity. It's only when unrelated activities are substantial compared to all of the organization's exempt activities, that those activities could jeopardize an organization's tax-exempt status.
UBI is a complicated topic, but I hope this has provided a framework to begin thinking about how your organization solicits donations. For more details and the reporting requirements, go to IRS.gov and download or order Publication 598, Tax on Unrelated Business Income of Exempt Organizations.
