"UBIT" off more than you can chew, the Social Venture Quandry

Ok, I admit, that's a horrible play on words above, but it's the reality of the situation. The Unrelated Business Income Tax (UBIT) stymies the entrepreneurial spirit of the nonprofit sector and is so entrenched, yet so misunderstood by even seasoned tax workers.

The landscape of nonprofits within the United States has transformed from religious base charities providing alms to the poor to sophisticated multi-million dollar organizations networked across the nation. No longer are these entities looking to hold golf outings and galas to raise their revenue, rather they are building and leasing structures for an NFL[1] team while churches “are opening restaurants, private gyms, and even [a] Starbucks coffee franchise.” [2]

The desire and necessity to diversify revenue streams in order to serve their mission has evolved nonprofit leaders into becoming social entrepreneurs.[3] The idealists of these innovative revenue generators view it as an organization embracing its mission; others see elements of both nonprofit and for-profit activities. Social entrepreneurship, defined as the “double bottome line,” requires nonprofits to financially sustain and have a greater impact on their mission by applying and operating with entrepreneurial strategies.[4]

These same social entrepreneurs are entering a field where they look upon the law as irrelevant to their endeavors, when they should be guiding their social enterprises according to the exisiting laws.[5] The controlling law, the Unrelated Business Income Tax (UBIT), taxes the income gained from activities unrelated to the mission of the exempt organization. Struggling nonprofits envision that turning to a social venture will be a quick fix, but often the entity needs to be structurally re-adjusted to conform to nonprofit standards, let alone for-profit elements.[6]

When the question of unfair competition is poised to the nonprofit sector as a roadblock to social ventures, their initial reaction is that small businesses and the government still have a perception that they either pay below market wages or volunteers do all of the work. According to Jed Emerson, Director of the Homeless Economic Development Fund, four main elements should be taken into account before accusations are established[7].

1. Non-profits pay market-based wages or above and therefore can not use “profits” to undercut the market,

2. Significantly increased training, supervision and other costs associated with the employment of individuals whom the mainstream labor markets will not employ[homeless, drug/mental/emotional problems, etc], leaves non-profit businesses at a competitive disadvantage,

3. Because of their community and public service missions, non-profits must consider more than just their own bottom line; they must keep a constant eye toward the broader social mission of the non-profit,

4. Non-profits are disadvantaged because their sources of funding are more limited than those available to for-profit businesses.[8]

The effect of globalization that has exploded within the last two decades has propelled the field of social entrepreneurship to the front of the pack, where “that magic moment when an idea, trend, or social behavior crosses a threshold, tips, and spreads like wildfire,” as the nonprofit sector works to incorporate for-profit business practices within their organizations.[9] Nonprofits survival in the 21st century depends not on charitable donations, but a necessity to evolve into a hybrid social venture, whereas they receive limited charitable tax benefits, enjoy the flexibility of operating like a business and continue to engage the general consumer as a customer first and a donor second.

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[1] “Baptist Hospital, Nashville’s largest nonprofit hospital, built a $15 million office and training complex to rent to the Tennessee Titans professional football team, partly for the revenue, but also for the marketing opportunities”

[2] John D. Colombo, Commercial Activity and Charitable Tax Exemptions, 44 Wm. & MARY L. REV. 487, 489 (2002).

[3] Gail A. Lasprogata, Marya N. Cotten, Contemplating “Enterprise”: The Business and Legal Challenges of Social Entrepreneurship, 41 Am. Bus. L.J. 67, 68 (Fall 2003).

[4] Id. at 68-69.

[5] Id. at 70.

[6] Id. at 69.

[7] Heather Gottry, Profit or Perish: Non-Profit Social Service Organizations & Social Entrepreneurship, 6 Geo. J. on Poverty L. & Pol'y 249, 258 (Summer 1999).

[8] Id. at 258-259.

[9] Janet E. Ker, Sustainability meets Profitability: The Convenient truth of how the business judgment rule protects a board’s decision to engage in social entrepreneurship, 29 Cardozo L. Rev. 623, 629-630 (November 2007).

Who is Governing the Nonprofit Sector?

Since the end of the last century the United States has experienced exponential growth and financial wealth within the nonprofit sector, thus leaving a disjointed development of regulation law directed towards nonprofit corporations. [1] There are approximately 1.4 million nonprofit organizations as defined by the Internal Revenue Service (IRS) pursuant to Section 501(c)(3)[2] of the Internal Revenue Code (IRC) within the United States. This sector of our economy “accounts for 5.2 percent of the gross domestic product and 8.3 percent of wages and salaries paid in the United States.”[3] It is estimated that only half of these registered charities filed an IRS Form 990, an annual requirement for those entities that recorded more than $25,000 in gross receipts.[4] The agencies that filed with the IRS reported approximately $1.4 trillion in gross revenue with nearly $3 trillion in assets in 2004.

These corporations that identify as nonprofit, as a majority, are not organizations that are well-defined, established or have strong internal governance policies. They are instead small with minimal to no organizational infrastructure and few business minded staff members, all key elements to enable these entities to function efficiently within a regulated sector.[5] This lack of coherent organization and growth within the nonprofit sector is nothing new, but has been a part of the development and proliferation of charities within this nation’s history. A majority of states early in our nation’s development actively encouraged individuals to incorporate private associations through their state legislatures to permit churches, schools and societies to be incorporated as charitable organizations.[6] This was seen as a way to reduce the state’s burden of providing similar services to those that required public benefits, which laid the framework of what was to become the public benefit corporation.

Public benefit corporations, the category most analogous to 501(c)(3) organizations, whereas their activities may be subject to various state and federal regulations, or lack thereof, has contributed to the sector's phenomenal growth during the past twenty years. When half of these organizations are not required to file a federal tax return, and the general public normally is not allowed standing, they enjoy benefits that any other corporation would not be extended or allowed to embrace. Subsequently with the recent scandals rocking not only the for-profit world, but the nonprofit as well, these exempt organizations may look to adopt some form of regulations, perhaps self-imposed, in a belief that it may eventually be required by different funders and their constituents.[7]

From the establishment and transformation of the nonprofit corporation, this note will evaluate how the regulation of this sector, specifically focusing on the “Public Interest” approach, supported and enhanced the welfare of the citizen and/or consumer.[8] Essentially, the basis behind this one of three perspectives of economic theory is how efficient the nonprofit market could become if there were regulations imposed upon it and at times may possess “higher moral objectives” in respect to those areas of our society that cannot have a monetary valued assigned. [9]

From this perspective it appears that nonprofit corporations do not need additional government regulation, but alternatively should seek to enjoin the sector to adopt enforced self regulation. This type of mandate is where nonprofits subject themselves to some system of order to include goals and adherence, thus attaining a more efficient sector, more so than having a more traditional regulation imposed.[10] The regulation of the charitable sector is necessary to some extent, even if the majority of the general population is not direct beneficiaries of their specific services, since their existence benefits the public as a whole, thus establishing the premise that this same public has a genuine interest to ensure an accountable charitable sector.[11]

The unique nature of the nonprofit sector requires enforced self regulation as a means to hold public benefit corporations accountable, since the current methods of regulations through the Revised Model Nonprofit Corporation Act are woefully inadequate and address concerns that are by and large not relevant to the sector. The current system of the IRS code provides a baseline for membership into the sector, and the attorney general ensures compliance, but that success will ultimately depend on the involvement of the sector’s members and their desire to ensure the public’s trust is retained.

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[1] James J. Fishman, The Development of Nonprofit Corporation Law and an Agenda for Reform, 34 Emory L. J. 617, 618 (1985).

[2] 26 U.S.C.A. § 501(c)(3) (2008)

[3] The Nonprofit Sector in Brief: Facts and Figures from the Nonprofit Almanac 2007, National Center for Charitable Statistics at the Urban Institute, pg. 1 (Urban Institute Press Forthcoming).

[4] Id at 2

[5] Julie Goldscheid, Transcript, Supporting Accountability: Assessing the Costs of Regulation, (Copy of transcript on file with the N. Y. C. L. Rev. Summer 321) (2006).

[6] Fishman, supra n. 1, at 631-32.

[7] Goldscheid, supra n. 5, at 321.

[8] Jeffery L. Harrison, Thomas D. Morgan & Paul R. Verkuil; Regulation and Deregulation, Case and Materials, 19 (2d ed. West 1997).

[9] Harrison, supra n. 8 at 32.

[10] Harrison, supra n. 8 at 494.

[11] Susan Gary, Regulating the Management of Charities: Trust Law, Corporate Law and Tax Law, 21 U. Haw. L. Rev. 593, 617 (1999).

Today's Down Economy- A Catalyst For Nonprofits to Change

No one enjoys being in a down economy. All three sectors of the economy (Government, Business & Nonprofits) are feeling the effects of today's recession and having to make difficult choices in reduction of services, staff and ability to carry out their missions as they have done in the past. Although Government will continue to exist and provide essential services and Businesses can redefine their market and become leaner, it sometimes seems more difficult for the nonprofit sector to adapt quickly incorporating a business mentality to insure long-term sustainable growth.

Instead of reducing services and looking at ways to hold another special event or launch another appeal, nonprofits should take this time to evaluate their position within the local community. Taking stock of their competition (yes, nonprofits "fight" over their constituents served), their donor base, organizations that may be able to offer additional resources or leverage for their mission. When resources are tight in business, they look for strategic partnerships to continue their operations and grow sales, which is what nonprofits should do.

There is a huge influx of smaller nonprofits, ones where their founders mean well, but nonetheless they seek out the same pool of donors, provide similar services and in the end duplicate, perhaps, what other more established organizations have continued doing. Although it appears that I place the onus on the smaller nonprofits, I charge the "named" nonprofits to become more adept at changing their operational structures to be inclusive and partnering with the smaller groups. Ideally, after strong partnerships have formed and the outcomes provide evidence of positive measurements, then perhaps fruitful conversations will take place on how this partnership can grow into a merger of some sort.

As the economy continues to move forward, away from a recession, nonprofits need to utilize this period to look at their mission and explore the unlimited possibilities of strategic partnerships with their smaller competitors (as well as their donor base). An organization that can respond to any situation, directly, competently and confidently will be able to whether this recession and ones in the future.

A New Era for the Nonprofit Sector

I am writing this as the bequest of my staff, interns and clients who for years have asked me when I will start blogging. Well, I am starting 2010 off with a Constare blog!

Before I start I should give a brief overview of the organization from it's humble beginning in a coffee shop. In late 2004, friends started having conversations about the need for a consulting firm that would assist nonprofits in the South Bend, Indiana region with their fundraising needs. We grew from conversations around coffee to launching a consulting firm that at first served grant-writing needs of organizations. During the next two years we worked out of our homes and met with clients at their locations (or even a coffee shop or two!).

In May 2007 we made the leap to a real office, with a coffee pot (we still visit coffee shops!). After setting up shop in downtown South Bend, we started launching into more complex issues with nonprofits, including board management, fund development studies and understanding the nuances of what makes nonprofits succeed. Also, i should note that in amongst these years I was working towards the completion of my Juris Doctorate (and drinking lots of coffee at night) and thus had the opportunity for some extensive research and writing on the law and how it relates to the nonprofit sector.

This brings us to the past year, where we have grown from a small firm, dedicated to our clients, embracing their passions as our own, to an organization that now works to develop sustainable income strategies for the nonprofit sector. My personal, professional and academic experiences with the nonprofit sector has led me to realize that the sector must adapt for-profit business practices, to an extent, to survive in this new century. No longer can organizations rely solely on the the dollar donation or dinner gala for their longevity. Today's nonprofit sector must be open to change, including developing strategies that will promote revenue models that embrace a sense of a for-profit organization.

Over the next few months I'll be sharing some thoughts on issues facing the sector, but more importantly exploring the avenues that support and maintain a sustainable income stream in these trying economic times. So grab a cup of coffee and I'll grab mine and we can start this journey together, standing together to strengthen our communities.