Commerciality Doctrine

Posted on Wednesday, August 18, 2021

Has your organization added a new revenue stream recently?  The challenges brought on by the pandemic have caused some nonprofits to come up with new ideas to generate revenue.  You should be aware that sometimes these new ideas may lead to potential risks for the organization.

An activity that is carried on in a manner similar to a commercial business may be considered a trade or business (the commerciality doctrine).  The IRS uses this doctrine in determining whether an organization qualifies for tax-exempt status and also for organizations that have already received their tax-exempt status to make sure that they are following the requirements to remain tax-exempt.

According to the commerciality doctrine, revenue from an activity, even one that is substantially related to the nonprofit's exempt purpose, cannot be exempt function income if the activity is conducted in a commercial manner.  Factors used to determine commerciality are as follows:

• The manner in which the activities are conducted,
• the commercial nature of the activities,
• the existence and amount of profits,
• competition with for-profit commercial entities,
• the extent and degree of below-cost services provided,
• pricing policies,
• the reasonableness of financial reserves, 
• whether the organization uses commercial promotional methods (advertising), and
• the extent to which the organization receives charitable donations.

If it looks like a commercial business, then it likely is. 

The commerciality doctrine is an extension of the unrelated business income (UBI) test.  An activity is an unrelated business if all three of the following conditions exist.

• Trade or business.  The organization is conducting a trade or business for the production of income from selling goods or performing services.
• Regularly carried on.  The trade or business is regularly carried on.
• Unrelated to an exempt purpose.  The activity is "not substantially related" to the carrying out of the organization's exempt purpose.

What the organization uses the income for has no impact on determining whether the income is UBI.  It only matters how the income was generated.  Some UBI is allowable; however, the operation of unrelated business activity may jeopardize the organization's exempt purpose if it becomes substantial.  Even if the UBI is not substantial, a nonprofit must pay unrelated business income tax (UBIT) on the income and file Form 990-T with the IRS to report the activities.  

If your organization is considering taking on a new business endeavor and it is not substantial to your operations, then management should determine whether the additional cost of UBIT is worth the additional revenue, which it may be.  Just be sure that the activity does not become a substantial part of your operations and risk losing your exempt status. 

Contributed by: Carrie Minnich, CPA, MAcct | Director | DWD CPAs & Advisors 

Posted in Mission Minded Nonprofits

Disclaimer: The information contained in Dulin, Ward & DeWald’s blog is provided for general educational purposes only and should not be construed as financial or legal advice on any subject matter. Before taking any action based on this information, we strongly encourage you to consult competent legal, accounting or other professional advice about your specific situation. Questions on blog posts may be submitted to your DWD representative.