We’re speaking with Anthony Mancuso, an expert on corporations, business forms, and nonprofits, and the author of, “How to Form a Nonprofit Corporation.” We’re going to speak with Tony today about the ability of a nonprofit corporation to earn income.
NOLO: Tony, most people understand that nonprofits get special tax breaks, but one thing that’s not clear about nonprofits is whether they can actually make a profit. Perhaps you can start out by defining the word “profit,” and then explaining whether a nonprofit corporation can actually make a profit.
TONY MACUSO: Well, it’s interesting, because the common meaning of profit is basically, you take in more than you spend, and you end up having a margin or a profit related to your activities that isn’t really what it is meant under the nonprofit statues. Basically, they don’t want you to be a commercial profit-making business; they don’t want the end that you’re trying to achieve to be the making of money. So, it’s not really in an accounting sense, it’s more of a common sense definition that has to do with your motives, your reasons for operating a nonprofit. They don’t want a substantial purpose to be simply to make money. It’s okay to make money, but they don’t want that to be your overriding interest, so it’s rather fuzzy and vague, the standard, but that’s really why they look very closely at your operations when you apply for tax exemption; they want to see your overall purposes of your program. If they feel, for instance, that you’re going into a publishing business simply to sell books to make money and not for any other reason, they’ll say, “Well, you’re a profit-making business; you really don’t qualify as a 501 (c) 3 educational nonprofit.” On the other hand, if you’re selling books that do the public good, that are clearly focused on benefiting the public and educating them in a certain way, then you can qualify, and you can make money from your sales.
NOLO: If a nonprofit can make a profit, then what can’t it do with this profit?
TONY MANCUSO: The big thing you can’t do, the major prohibition, is against self-inurement; you can’t help out anyone individually in their individual capacity associated with your nonprofit. So, you couldn’t take the money you made and simply pay it out as some kind of benefit to your CEO, and say, “Thanks a lot; we’re so happy you’re with us, here’s the extra profits.” In other words, give someone a participating profit interest in your nonprofit. Now, obviously, people try and get around that sometimes, but the whole point is, you’re not supposed to be their to benefit anyone in their individual capacity; you’re supposed to be benefiting the public at large, or a segment of the community. So, you can spend your money in any way you want to help that purpose, to help your nonprofit purposes, but once you start paying people simply to pay them, to kind of thank them, to incentivize them… basically, the nonprofits statutes and regulations say that’s not a valid nonprofit way to spend your money.
NOLO: You used the term “self-inurement?”
TONY MANCUSO: It’s an old-fashioned term, inurement, and it basically means a self-benefit. So, we’ve heard in the news over the last several years, there’ve been some scandals regarding some fairly well-known nonprofits where that’s exactly what they did; they bought yachts for their executive officers or had them available for them. So, spending money in that way, to benefit someone personally, is self-inurement, and it’s prohibited.
NOLO: You provided an example in your book, where Friends of the Library Nonprofit gets a lot of donations for its book sale, but after its sale, there are a lot of books left over, so the nonprofit sets up a way to re-sell these books using outside dealers. You write in your book that this can lead to problem, because it’s “unrelated income.” What’s the difference between related and unrelated income, and how can a nonprofit know when it has crossed that line from one to the other?
TONY MANCUSO: Well, again, as in many areas of nonprofit law and practice, it’s a fuzzy line, and it takes a bit of analysis, and it’s hard to predict all the time how the IRS or a court will decide the issue, but, basically, common sense is your best guide. So, if a group is clearly just getting rid of surplus books as a very, very small part of their overall operations, then perhaps it’s not a problem. But if you start looking more and more like a commercial bookseller, making more and more money from purposes that are not strictly related to your tax-exempt purposes, in other words, you’re no longer trying to educate people through the sale of books but rather you’re trying to make money in any way you can, then the IRS can quite justifiably say, “You’re engaging in purposes unrelated to your stated nonprofit tax-exempt purposes.” So, again, there’s no bright-line test for that type of income or activities, but common sense can be a helpful guide. I can give an example: I believe at one point I had heard of – and I don’t know how accurate this is, but it serves as a good example – a builder’s center who had the purpose of helping people produce environmentally sound and environmentally friendly homes, and they did quite well at selling the kits, and it served a valid nonprofit purpose, but they branched out and more and more became a more commercial operation, and I believe the IRS questioned them about it, and said, “You know, you’re really starting to look like a homebuilder,” and so they split off that part of their operations from their nonprofit to satisfy the IRS; so, it’s not always going to be the worst thing; it’s not always going to be the demise of the nonprofit all the time. As you get more and more successful with sidelines and certain commercial activities, you can spend them off perhaps, if you’re doing well at them, but you’ll need to separate them sometimes from your nonprofit activities.
NOLO: So the IRS is always the final arbiter of that line between related and unrelated income?
TONY MANCUSO: Generally that’s true.
NOLO: Some nonprofits earn income from royalty-generating sources. For example, the author of Winnie the Pooh donated all royalties to a nonprofit. How is this royalty income characterized?
TONY MANCUSO: Royalty income is basically unrelated income, in many ways, so if you’re getting that type of income, it gets a little bit technical, depending on the type of nonprofit that receives it. Nolo’s nonprofit books, the ones I’ve written for Nolo, deal with 501 (c) 3 public charities. They don’t have to worry about the strict rules about passive income usually; it’s more the 501 (c) 3 private foundations, which are a very special type of nonprofit that we don’t deal with. Rich families and well-to-do companies often set up foundations to receive passive income, and they have a lot of stringent rules about dealing with the income – recording it, spending it, how you spend it, and they have some fairly strict taxes and penalties that apply if you don’t do it the right way. So, passive income can present problems, but generally, if you get contributions and you’re a 501 (c) 3 engaging in your tax-exempt purposes, you generally don’t have to worry about it. I think the more important point for nonprofits, the kind we talk about, has to do with, if you’re going into a book-related field as a nonprofit, the IRS sometimes wants your authors to assign the copyrights to the publisher. I’ve had that happen when I’ve applied for nonprofit status on behalf of some clients that were in the book business or publishing books that they thought would help people, or educational materials. They wanted the nonprofit to own the copyright. They didn’t want the nonprofit to essentially be a conduit, to be helping out an author who had a proprietary interest in the material. That was the issue for them, so the one you cited is a little bit different; it’s on the other side of things, where they’re receiving income from a successful author. Oftentimes, the IRS, generally, it arises in a different context; they want the nonprofit to own the book; they don’t want the nonprofit basically to be a selling agent on behalf of an individual.
NOLO: You used the term “passive income.” Just so we’re clear, passive income is…?
TONY MANCUSO: As opposed to actively doing something to get it, they consider receiving rents or royalty income, and other types of investment income as passive income, and so there are some technical rules about it, but usually a small or medium-sized nonprofit engaging in an active nonprofit program doesn’t have to worry too much about it.
NOLO: So, that’s three types of income for nonprofits: related income, unrelated income, and passive income?
TONY MANCUSO: Passive income can be unrelated income; in many cases, it is.
NOLO: Let’s review the rules you’ve talked about for a second. Let’s say I want to create a nonprofit that furthers environmental awareness. Tell me how the following activities will affect the nonprofit status: the nonprofit starts a book store that sells only environmental books.
TONY MANCUSO: If you clearly have an environmentally-friendly mission, and you couch it that way in your tax-exemption application, you have a good chance of being classified as a 501 (c) 3 educational group.
NOLO: Okay, now the environmental book store decides to sell not just environmental books, but other types of books as well.
TONY MANCUSO: You have less of a chance.
NOLO: Okay, now the environmental book store offers a lecture series on environmental topics.
TONY MANCUSO: Lectures of any kind that are educational in nature, you can charge admission; just think of all the nonprofit schools and universities; they can teach almost anything they want. The requirement having to do with educational involving 501 (c) 3 is that you have a balanced perspective. So, you can’t limit, in a way, you can’t limit the type of educational materials, you can’t strictly say, “We’re only going to teach this,” I mean, we’ll present a balanced view of things; they can object on that basis. But, generally, charging tuition or charging admission for a lecture series is completely above board, and a very standard educational activity under 501 (c) 3.
NOLO: Okay, so, back to that environmental company, the book store that sells environmental books. It also out rates a web-based book store that sells environmental book.
TONY MANCUSO: The environmental site, if they limited themselves to that and made it clear that that’s really their mission, that’s probably okay. Again, though, the more it starts looking something like a commercial bookseller, the less of a chance it has of that activity being subsumed in its 501 (c) 3 nonprofit. So, the IRS, for instance, if you disclosed that on your exemption application and said, “We want to sell all types of books on our website,” they may say, “Well, you have a valid 501 (c) 3, but we feel that your website does not qualify, so that’ll have to be a separate activity.”
NOLO: Okay, now the environmental nonprofit is doing so well, they decide to become a publisher of environmental books. That is, the bookstore begins publishing its own books.
TONY MANCUSO: I don’t think becoming a publisher as opposed to simply a retailer is critical; I think that’s fine, being a publisher. Again, the despositive issue might be, what are you publishing, and how does it benefit the public?
NOLO: Back to the bookstore now for one more question. If you’re operating a bookstore in furtherance of your nonprofit goals, can everyone who shops there claim a tax deduction when they buy something? In other words, is making a purchase similar to making a donation?
TONY MANCUSO: Well, generally, charitable contributions are only to the extent that you don’t get value for what you pay; so, if you buy a $30 book, and pay $100, maybe you’re entitled to a $70 deduction, but if you’re paying market value for your book, there’s no amount that qualifies as a contribution.
NOLO: Let’s shift gears a little bit and talk about director liability. One purpose in forming a nonprofit corporation is to shield the members and directors from personal liability. As an example, if the nonprofit bookstore violates rules regarding earning money, will the corporate shield for liability disappear?
TONY MANCUSO: No, the tax statute is separate from the state corporate law statutes, so, you may lose your tax exemption, but your corporate entity is intact. It’s kind of a distinction without a difference, because a nonprofit corporation that isn’t tax-exempt is not a very helpful entity; essentially, if you lose your tax exemption, it probably makes sense to dissolve your corporate entity; nonprofits really only make sense if they have a tax exemption. There are some types that can operate fine without a tax exemption, but really, in the real world of 501 (c) 3-type nonprofits, you need both. Technically, it doesn’t destroy your Limited Liability status; that can happen if you don’t operate your corporation properly and keep minutes, and if you kind of play fast and loose with corporate formalities, but the tax statutes are separate, really.
NOLO: How much of a salary can a nonprofit member or owner receive? Are there limits established under the tax law?
TONY MANCUSO: Well, that’s a really good question, and it’s a very timely one, because there have been a number of scandals in the nonprofit world; some very well-known, reputable nonprofits have had trouble recently because of the amount of compensation they’ve paid their directors and executive officers, and the kind of lavish benefits they’ve given them, so the IRS has become very concerned about this and issued very complex and lengthy excess benefit regulations that they want nonprofits to comply with; it’s not required, but they’re strongly suggesting you do that. In fact, to help implement them, they’ve changed their tax-exemption application to lead you to disclose how you might comply with these excess benefit rules, and you don’t have to, but really what they’re saying is, if you don’t, you’re going to have a harder time obtaining your 501 (c) 3 tax exemption. So, the Nolo books have incorporated these new regulations into our corporate bylaws, and into our tax-exemption application responses to help people comply and understand the significance. It’s very important these days to try and satisfy the IRS from the start, so you don’t plan to excessively benefit anyone. Now, what does that mean? Again, there’s no bright-line test for this; it’s a fact-based determination the IRS makes, but think about how difficult it is to determine what excess compensation is. Symphony orchestras now are paying their conductors, nonprofits, at least 2 million dollars a year or more, so how can you say that a highly-paid executive officer of another nonprofit is getting too much money when the IRS kind of believes that a symphony conductor should get a lot? Well, the truth is that in certain fields you can get away with it, you can pay a lot of money, and in others you can’t, and it depends on the market rate; that really is what drives it. So, if you’re compensating your people in a way that is fair generally, given the kind of work they do, and the kind of organization you have, then you’re probably fine. But if you’ve gone out of your way to overpay somebody, if they’re really getting a golden deal that they could only get at your organization, then you probably are paying them excessively. Now, there’s a lot of safe-harbor rules you can get into, and the book talks about them, and how you can help satisfy yourself ahead of time, that you’re paying people fairly, and basically it has to do with taking a look at the data in your field, and getting some sample data and recording it in your minutes to show that the amount that you’re paying your people, your directors and executive officers, is comparable to what they would get in other organizations; that’s really the test.
NOLO: So, it’s really a matter of comparability.
TONY MANCUSO: It really is, and now they really want you to go out and look before you decide how much to pay somebody.