In order to qualify for tax-exempt status, charitable organizations must comply with very stringent rules related to the activities they are allowed to carry out. In general, these rules require that a charitable organization’s activities be directly related to the organization’s tax-exempt purpose. However, in most instances, a charitable organization is allowed to invest in or engage in a trade or business that is considered unrelated to the exempt purpose. So long as the charitable organization follows the rules, and pays the tax, they will continue to maintain their exempt status. This article addresses what activities are considered an unrelated trade or business under these rules, and how a charitable organization can comply with the reporting requirements related to these activities.

Definition of Unrelated Trade or Business

An unrelated trade or business is generally defined as an activity that is regularly carried on and unrelated to a charitable organization’s exempt purpose. This determination is made by looking at the actual activity – not what the organization does with the revenue generated from the activity. While this definition may seem straight forward, many activities would appear to be unrelated, but qualify for an exception. And many activities perhaps should be considered related, but are not.

For instance, some income from investment activities – interest, dividends, capital gains, and rental income – would appear to be unrelated to an organization’s exempt purpose, but these items of income are specifically excluded from the definition of an unrelated trade or business for most charitable organizations. In contrast, revenue generated from advertising in a newsletter that a charitable organization publishes in furtherance of their exempt purpose is generally considered unrelated to the organization’s exempt purpose because it is commercial in nature.

Determining whether an activity is an unrelated trade or business depends on the facts and circumstances of any given situation, and therefore the best guidance available comes from court cases, revenue rulings, and other guidance that the Internal Revenue Service provides. Here are some examples of activities that are unrelated and therefore subject to tax:

• The leasing activity of an exempt organization is considered an unrelated trade or business where the building that is being leased is subject to a mortgage, but only the rental income that relates to the mortgaged portion is subject to tax since it is financed by debt and not eligible for exclusion.
• The sale of scientific books and city souvenir items by an art museum is unrelated to the art museum’s exempt purpose because these items have no causal relationship to art or artistic endeavors.
• Income from pet boarding fees and grooming services for the general public that is received by an organization that advocates for the prevention of cruelty to animals is considered unrelated to the organization’s exempt purpose because the activities do not contribute to the purpose of preventing cruelty to animals.

On the other hand, these activities were found to be related to a charitable organization’s exempt purpose:

• A museum’s operation of eating facilities, which help attract visitors and allow them to spend more time viewing the museum’s exhibits, is related to the museum’s exempt purpose because it contributes to the museum’s accomplishment of its exempt purpose.
• A gift shop operated by an exempt hospital is substantially related to the hospital’s exempt purpose because it allows visitors to make purchases for patients and employees.
• The operation of a furniture shop by an exempt halfway house that provides full-time employment for the residents is related to the exempt purpose because it aids the residents in their transition from treatment to a normal and productive life.

Reporting Unrelated Trade or Business Income

Once a charitable organization determines that an activity is an unrelated trade or business, the organization must then account for the revenue and expenses related to that activity and then determine whether it is required to file Form 990-T to report the net income. A Form 990-T is required if gross income exceeds $1,000 during the tax year. If the organization is not required to file, it may still benefit from filing if there are losses that may carry forward to offset income in future years.

If an organization has more than one unrelated trade or business, these activities will generally need to be accounted for and reported separately, and tax must be calculated separately on each activity. This separate treatment is a relatively new reporting requirement, imposed by the Tax Cuts and Jobs Act (TCJA) of 2017. The Treasury Department recently issued regulations providing some relief to this requirement, and allowing organizations to aggregate some investment income received from partnerships and other entities that the organization may invest in.

Form 990-T is due on the 15th day of the fifth month after the end of the organization’s tax year. An organization that has a year-end of December 31st will therefore need to file Form 990-T by May 15th of the following year. The organization may also apply for a six-month extension to a filing by submitting a request on Form 8868 on or before the original due date. Note that this extension is separate from an extension to file the organization’s Form 990, 990-EZ, 990-N, or 990-PF. In addition, any taxes that may be owed must be paid by the original due date of the return. Payments are made electronically using the Electronic Federal Tax Payment System (EFTPS). Late payment and late filing penalties may apply if the organization misses these deadlines.

Conclusion

The rules governing unrelated trades and businesses that are carried out by charitable organizations are complicated. Having an experienced nonprofit specialist is critical to ensuring that an organization is in compliance with these rules and is not potentially subjecting the organization to unnecessary penalties. If you operate or are involved in the operation of, a charitable organization, we encourage you to reach out to the HBK Non-Profit Solutions Group to assist you in understanding and complying with the unrelated trade or business rules.

This week, October 19th through October 23rd, is the third annual International Charity Fraud Awareness Week (ICFAW). The ICFAW is led by an international coalition of over 40 charities, regulators, sector and professional representative bodies, and other interested stakeholders. The goal of this week is to raise awareness of, and to share good practices for, tackling fraud and cybercrime among non-profit organizations.

In support of this important initiative, the HBK Non-Profit Solutions group and HBK Risk Advisory Services is teaming up to provide the following information. We encourage everyone to learn more about ICFAW here: https://www.fraudadvisorypanel.org/charity-fraud/get-involved/

If you are a charitable donor:

• Make sure that a charitable organization is legitimate before donating.

Charitable scams are incredibly common, especially as we move into the holiday season. Before you decide to write a big check in support of a charity, make sure you check that the organization is legitimate on the IRS website (https://www.irs.gov/charities-non-profits/tax-exempt-organization-search). GuideStar (https://www.guidestar.org/) is also a great resource to research whether or not a charitable organization is worthy of your support. Often, its best to research the organization on both platforms to ensure information is accurate.

Other great resources to vet the organization include your state’s registry of non-profits and the Better Business Bureau.

1. 1. Watch for suspicious e-mails, text messages, and phone calls.
      

      Social engineering threats, such as phishing e-mails and fraudulent advertisements, continue to increase at alarming rates due in part to COVID-19. As a general best practice, avoid clicking links received via email and text. If you find a message or organization of particular interest, its often best to access their webpage via an internet search or typing their URL directly into the address bar of your browser—after ensuring they are legitimate, of course (Item #1). This extra step will reduce the risk of being misdirected to a fraudulent webpage. Remember, fraudsters often create exact replicas of common webpages making it difficult to spot the difference.

      To avoid falling for a fraudulent webpage, make sure you look at the domain name and web address populated in your browser. Does it match the intended organization? Are there any glaring errors or misspellings? Sometimes these may not be so apparent, so be careful. Simple tricks such as switching a lowercase “L” to a number “1” (l vs 1 –no, those are not the same character) may be the only difference between a legitimate page and a fraudulent one.

      If you are absolutely certain the email is trustworthy, take a second to hover over any URL’s contained in the body of the e-mail to ensure that it leads to a trusted website. Again, keeping an eye out for misspellings or swapped characters. However, avoiding the click will eliminate the need for vigilance at this stage.

      Lastly, we recommend similar actions for voice calls. Rather than disclosing your billing information and contributing money over the phone, advise the representative that you will donate via webpage or mail in check. Securely navigate to the trusted website via search engine or known URL.

1. Remain vigilant.
   

   Once you’ve made your contribution its important to remain vigilant. First, make sure you receive your donor acknowledgment letter in a timely manner. These should typically be received soon after your donation is processed and before the end of the year. Secondly, make sure your transaction is processed or check is cashed promptly. Slow processing could indicate your account information is being used for other things. Lastly, remember to review your account statements at least monthly. Daily monitoring of transactions is preferred where feasible.

If you are a charitable organization:

1. 1. Watch for suspicious e-mails, text messages, and phone calls
      

      Charities can be a treasure trove of donor information and financial records—information that is very attractive to fraudsters. As discussed above, avoid clicking links in emails and texts and be suspicious of unsolicited phone calls. If its too good to be true, it probably is. Always verify the source and do not be rushed into a decision.

1. 1. Stay educated.
      

      Maintaining an educated workforce is critical. Fraudsters are having an easier time given the recent pandemic as the workforce is largely working remotely. As such, cybersecurity awareness has never been more important. Consider undergoing awareness trainings to remain educated on the latest threats and how to avoid them.

1. Establish and maintain processes and internal controls.
   

   Established processes and sound internal controls have always been critical, but prior to COVID-19, few organizations faced the task of migrating these processes and controls to remote work environments. COVID-19 and a new environment is no excuse to stray from these fundamental concepts. In fact, it’s more important than ever to ensure your processes and controls migrate to, if not strengthen, this new environment.

   It should be noted that cybersecurity insurance coverage may be lost if these controls do not remain implemented, so make sure you understand the requirements of your insurance policy. The dispersed and remote work force is introducing greater risks, and we are seeing a rise in malicious attacks. Your employees are also out of their routines and may find new ways to accomplish old tasks that could put the organization at risk. This increased risk coupled with a potential loss of coverage can be disastrous.

If you would like to discuss ways in which you can protect yourself, your organization, and/or your employees from fraud and cybercrime, please reach out to your HBK advisor.

For more information about Charity Fraud Awareness Week, visit the Fraud Advisory Panel website.

For many small to medium-sized nonprofits registered in Pennsylvania, the requirement that a CPA provide assurance on their financial statements has been a substantial expense, money better used for their charitable missions. House Bill 1420 has amended the Solicitation of Funds for Charitable Purposes Act to increase the thresholds used to determine when, and to what extent, CPA assurance is required for the annual financial statements of charitable organizations registered with the State.

The Act continues the requirement for either internally-prepared, compiled, reviewed or audited financial statements. However the contribution ranges for which these various levels of assurance are necessary have been increased, as illustrated in the table below:

The definition of “gross annual contributions” remains unchanged as “total national contributions from all sources based on the organization’s immediate preceding fiscal year end.”

The new thresholds apply to all charitable registration renewals due February 15, 2018 or later (for March 31, 2017, fiscal year ends or later) and to all new charitable organization registrations filed on or after February 20, 2018. The Act should reduce compliance costs for smaller organizations and more closely aligns Pennsylvania’s requirements with those of the current Federal Uniform Guidance.

If you have questions or would like to discuss the impact of this change on your organization, contact Sean Kocan or your trusted HBK team member.