Engaging in a Trade or Business

Engaging in a Trade or Business as a 501(c)(3) Organization

Many nonprofit organizations engage in a trade or business as a significant part of their activities, or as a means of supplementing their funding. Many are also legitimately concerned that by doing so, they are putting their tax-exempt status at risk. The main questions for a nonprofit to ask itself in this situation are:

  1. is the trade or business substantially related to the accomplishment of the organization’s exempt purpose,
  2. does it look and smell like a commercial, rather than a nonprofit, activity, and
  3. does the non-exempt trade or business constitute a substantial part of the organization’s activities?


The 501(c)(3) Operational Test
To qualify or maintain tax-exempt status under section 501(c)(3) of the Internal Revenue Code, an organization must be operated exclusively for one or more tax-exempt purposes. Despite the use of the term “exclusively” in the law, the Internal Revenue Service, through regulation, has clarified that an organization can meet this operational test if it engages primarily in activities that accomplish one or more of the 501(c)(3) purposes. Activities that are not in furtherance of an exempt purpose must constitute only “insubstantial part” of the organization’s activities

You can engage in a trade or business!
The mere fact of engaging in a trade or business in a substantial way does not mean that an organization fails the operational test. The Treasury regulations state that:

An organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization’s exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513.

So your organization can engage in a trade or business so long as it furthers the organization’s tax-exempt purpose and, if it does not, so long as it does not constitute the primary purpose of the organization.

The Questions

(1) Is the trade or business substantially related to the exempt purpose?

Section 513 of the Internal Revenue Code Trade uses the term “unrelated trade or business” to refer to a trade or business that is not substantially related to the exercise of an organization’s tax exempt purposes. Generally income from an unrelated trade or business regularly conducted by a 501(c)(3) is subject to the “unrelated business income tax”. As noted, when an unrelated trade or business constitutes the primary purpose of a 501(c)(3) organization, its tax-exempt status is jeopardized.

In evaluating whether a trade or business is “substantially related”, the IRS examines whether the business activities contribute importantly to accomplishment of exempt purposes. There is no bright line rule as to what it means to contribute importantly. Instead, the IRS looks at the facts and circumstances of the particular business and organization.

Treasury Regulation 1.513-1 provides the following additional guidance: “In determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function that they intend to serve. For example, to the extent an activity is conducted on a scale larger than is reasonably necessary to perform an exempt purpose, it does not contribute importantly to the accomplishment of the exempt purpose. The part of the activity that is more than needed to accomplish the exempt purpose is an unrelated trade or business.”

Useful examples, including sales of advertising space, book publishing and travel tours, are described here in the Publication 598 and here in the Internal Revenue Manual.

(2) Does it look and smell like a commercial, rather than nonprofit, business?

Even if it seems clear that the trade or business contributes importantly to your exempt purpose, the IRS and courts may still find it to be “unrelated” if it doesn’t pass the commercial sniff test. The “commerciality doctrine” focuses more on the nature of the activity, rather than on its relationship to an exempt purpose, in examining whether the organization’s trade or business has a “commercial hue”.  Better Business Bureau v. U.S., 326 U.S. 279 (1945).

Again there is not a bright line rule, but the courts and the IRS have looked at the following factors in the context of this doctrine:

  • Pricing margins: Whether the fees charged for the product or service are substantially below cost, for example 75% to 85%.
  • Competition with for-profits: Whether the activity competes with similar activities by for-profit entities.
  • Accumulated profits: Whether the organization accumulates large reserves through the trade or business without a clear view of their intended future use.
  • Business and marketing practices: Whether the organization pays a trained professional staff or instead uses volunteers. Whether it uses advertising and promotions to market the product or service to the general public.
  • Customer base: Whether the organization sells the product or service to charitable organizations or to non exempt entities.
  • Donations: Whether the organization relies on charitable contributions, or instead on fee income or sales revenue, to support its exempt purpose.

The theoretical concern with 501(c)(3) organizations that engage in trade or business is their unfair tax advantage with for-profit competitors. For this reason, an organization whose primary activity is a trade or business that is in direct competition with a for-profit, sells products or services above cost (although below market rate) and relies heavily on fees and sales to stay in the black will likely not get or maintain tax-exempt status, even if the product or service furthers a charitable purpose.

(3) Do non-exempt activities constitute a substantial part of the organization’s activities?

Assuming that an organization engages in an unrelated trade or business, the next analysis is whether the unrelated business constitutes the primary purpose, or a substantial part of, the organization’s activities.

Unfortunately there is no bright line percentage rule to measure what constitutes a “substantial part”. Logic would dictate that if a majority of the time and effort is dedicated to, or alternatively a majority of the gross income of the organization comes from, the unrelated trade or business, then it constitutes a substantial part. Not so. Instead, again the specific facts and circumstances of each case may result in different outcomes. Many attorneys and CPAs advise that 20% or more gross income from an unrelated trade or business may constitute a “substantial part”. But some organizations that have gotten the vast majority of their gross income from unrelated business have retained their tax-exempt status after IRS scrutiny.

The IRS has used a “commensurate in scope” test to evaluate whether the non-exempt activities play too great a role. Under this test, an exempt organization may receive a substantial amount of income from an unrelated trade or business so long as it carries out charitable programs that are commensurate with its financial resources. Again a variety of factors come into play, including how time, effort and resources are spent on the exempt versus non-exempt activities, how great of an impact the exempt activities have, and how the organization presents itself to the general public.

In short, if it looks like the time, energy and resources of your organization are increasingly spent on a non-exempt purpose, you should consider re-evaluating your structure and potentially splitting off that part into a separate structure, such as a for-profit subsidiary or stand alone corporation.

Written by Cameron Holland.