For people interested in local, authentic economies, nonprofits are one of the most attractive features of the local institutional environment. Across the nation, around 1.5 million of them pay 9.2 percent of the wages in the country and account for 5.3 percent of the GDP. (National Center for Charitable Statistics). At least one mission-driven entrepreneur a month comes to my office to talk about a service or good they want to provide differently than how it is provided in a more profit focused way. It can be hard, sometimes, to give these clients an answer because they pass the basic, well-known tests for nonprofit status (like not “profiting”), but may fail to receive exemption because of the commerciality doctrine. This post explains briefly why some of these organizations will not qualify as exempt organizations and give some of their options for achieving tax exemption by organizing as a cooperative.
Courts developed the commerciality doctrine over time in opinions interpreting exempt organization tax law. Underlying it is an assumption of US capitalism that for-profit businesses are the default and nonprofit entities are gap-fillers. Nonprofits, according to the doctrine, should not be allowed to unfairly compete with for profit entities serving the same purpose. (Bruce Hopkins. The Law of Tax Exempt Organizations. Pg 114. 2016). The commerciality doctrine is, in short, that if an organization looks like a for-profit, and acts like a for-profit, then it probably is for-profit.
Some entities whose revenues come entirely from fee for service payments can qualify for nonprofit status, even 501(c)(3) public charity status. (IRS Internal Revenue Manual). Museums and zoos would easily qualify. They’re providing an educational, service to the public. This is allowed even though art galleries and circuses arguable provide a similar purpose on a for-profit basis.
On the other end of the spectrum, are entities that are too similar to their for-profit coutnerparts, and therefore do not qualify. For example, Congress decided in 1986 to deny exempt status to insurance companies that behaved similarly to for-profit companies and engaged in competition. (Hopkins, 114-15). Recently, there has been lobbying by the banking industry to disqualify credit unions from exempt status. (Time, 2013). Exemption for hospitals is an older, but still evolving questions. (Baker Tilly, 2016).
The doctrine allows the IRS or courts disqualify an entity from exemption when the entity is operated in a way similar to how a for-profit entity is operated. (Hopkins, 127). A leading case involved vegetarian restaurants and health food stores operated by the Seventh-Day Adventist Church. (Living Faith v. C.I.R., 950 F.2d 365, 7th Cir. 1991). In that case, the court looked at the following factors:
- Manner of operations. If the entity’s primary activities constitute a business, it weighs heavily against granting exemption. The court analyzed the entity’s balance sheets and looked at stipends paid to “volunteers”
- Competition with commercial firms,
- Prices set at market rate
- Advertising and use of commercial catch phrases to attract customers.
- Lack of plans to solicit donations from the public, no record of receiving donations.
- High gross profits,
- Hours of operation competitive with for-profit counterparts
In a later case, the court found major actors to be taken into account are:
- Competition with for-profit entities,
- Extent and degree of low-cost services provided,
- Pricing policies,
- Reasonableness of financial reserves. (factors quoted from Hopkins, 124).
Using Cooperatives Instead
The sound of tax-exempt is music to the ears of almost anyone. People attracted to a nonprofit model are also excited to meet needs in their community they see going unmet. Though not nearly as common in Kentucky as nonprofit organizations, cooperatives offer are tax exempt at the entity level for business done with members (all business in the case of an agricultural cooperative) and also historically stand for a commitment to improving the community.
Cooperatives are tax-exempt at the entity level. Various theories have been advanced to explain why the rule is different for cooperatives and corporations, but a personal favorite is that since cooperatives are formed by members to meet their needs any operating profit belongs to the members. The cooperative does not pay taxes on money distributed or promised to be distributed to members. Members are taxed when when the money is disbursed, but the entity itself is not.
For example, consider a group of design and marketing experts who want to provide services to nonprofit businesses. Chances are, the services are going to look and function a lot like their for-profit counterparts. The commerciality doctrine is going to create some level of uncertainty for the founders considering whether to be nonprofit, and they are going to have to consider how much to compromise their business ideas to increase their chances of qualifying for nonprofit status. Instead of trying to squeeze their business into a nonprofit mold, they should instead consider forming as a cooperative. Business with members would be the labor put into the cooperative. Wages, as with a nonprofit, would be taxed, but then profit distributed to members would only be taxed once, at the time the individual receives the money.
While the public cannot write off deductions to a cooperative on their taxes, cooperatives can still use crowd funding if they put in the work. Money from the cooperative, unlike in a nonprofit, can flow back to owners and investors. Most importantly though, a cooperative is expected to be operated for commercial purposes. Owners will know they are not violating federal tax law when they expand into new opportunities. For close cases, organizing as a cooperative will allow founders to build the business according to their goals and not accept limitations likely to conflict with their business plan.
To further illustrate, here is a list of organizations denied exempt status to organizations because of the commerciality doctrine that would work well as cooperative businesses:
- An entity that sales health insurance for insurance companies. As a cooperative, insurance companies would be the member/ owners.
- An entity that to provide rest and relaxation to caregivers of chronically and terminally ill individuals. Structured as a cooperative, member/ owners would be caregivers.
- An entity that facilitates home health services for a fee. Member/ owners would be users of health services.
- A paratransit or transit service provider to healthcare organizations to assist their elderly and disabled clients for a market rate fee. As a cooperative, the health care organizations, or the elderly and disabled people using the service, or both could serve be member/ owners.
- An internet service provider providing access through wireless internet (because it benefited for-profit companies that facilitate internet access by enhancing their ability to attract customers). The cooperative would be owned and managed by the for-profit internet access companies.
- Administrative service provider for nonprofit entities. The nonprofits would own the cooperative.
- An entity that provides travel services for synagogues nationwide. (entities denied exempt status from Hopkins, 125).