Tuesday, April 12, 2011

IRS Focuses on Unrelated Business Income Taxes in Social Enterprise Audits

Two years ago, I read in the Wall Street Journal that the IRS was planning to audit more charities operating business ventures. “Hmm,” I thought to myself, “wouldn’t that be a lot of fun.”

A few weeks later, I received a letter from the IRS and the good times started rolling with our own nonprofit audit. I wasn’t worried because we pride ourselves in operating with the highest ethics and transparency. Sure enough, we passed with no deficiencies a few months later.

But the audit raised a couple of interesting issues for social enterprises and faith ventures. The IRS was most interested in collecting the Unrelated Business Income Tax which is required if the nonprofit is operating a business that is “not substantially related to furthering the exempt purpose of the organization.” Over and over, they asked us to show that our businesses served our social mission verses just being an unrelated income source.

My favorite moment was when the agent asked one of our project directors to prove that he hired ex-offenders.

“Well, first of all, I am one,” he replied, “And see that building next door, that is a community correction facility. We hire staff from there.” Issue resolved.

But the point I want to emphasize is that organizations need to satisfy the UBIT requirements or else they could be subject to some sizable penalties. And thrift stores operators need not panic. UBIT provides an automatic exemption for businesses that sell substantially all donated merchandise.

Secondly, don’t handle an audit without outside help from an accountant or attorney. Non-profit organizations are foolish to handle the rigors of an audit by themselves. Competent professional help goes a long way in settling issues without needing to be expensive. Many legal and accounting firms will be glad to donate services or provide discounts to worthy organizations.

Finally, the IRS seems to be getting aggressive with the commerciality doctrine with regard to new social enterprise businesses. If an activity is considered too “commercial” or similar to other existing for-profit businesses in the community, it is not eligible for tax exemption. This could be a huge deal killer for new organizations with a social enterprise approach hoping for nonprofit status.

But groups need to remember that social enterprises don’t always need to be non-profits to operate effectively. Some projects are successfully organized as for-profits.

And in my experience, if your mission is tightly congruent with your business, you can satisfy the commerciality doctrine. For instance, if you operate businesses that only hire ex-offenders in line with your mission statement, you should satisfy the test.

Even so, legislative reform is needed in this area as argued here by the Nonprofit Law Prof Blog.

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