In order to effectively perform their duties, association CEOs must have a basic understanding of the federal tax laws as they apply to the tax-exempt status, income, meetings, educational programs, publications, lobbying, standard setting, certification, and other activities of their associations. Since the adoption of the federal income tax laws in 1913, an entire body of complex tax law unique to trade and professional associations has evolved. And if history is any guide, it will only continue to expand in complexity.
The following brief primer on association taxation is intended to provide association CEOs with a plain-language - and superficial - guide to the federal tax laws as they apply to particular organizational and operational characteristics of trade and professional associations. More than anything else, it is designed to alert the association CEO to potential tax problems. If you are so alerted, you should seek the advice of your association's tax adviser.
Nonprofit vs. Tax-Exempt Status
The terminology used to describe trade and professional associations often generates much confusion. Consequently, it is useful to clarify two key terms. Associations are generally organized and operated as both nonprofit andtax-exempt entities. Nonprofit status refers to incorporation status under state law; tax-exempt status refers to federal income tax exemption under the Internal Revenue Code (the "Code").
One who does not know otherwise might reasonably conclude that as nonprofit, tax-exempt entities, associations may not earn profits (realize more income than expenditures) and that they need not pay any taxes. Neither conclusion is correct.
Even though they are nonprofit organizations, associations are permitted to generate greater income than expenses and still retain their nonprofit status. As nonprofit organizations, what associations are barred from doing is distributing their net earnings to individuals who control the organizations (other than as compensation for services actually rendered at prevailing market rates). Similarly, they are barred from accumulating equity appreciation for a private person's benefit. Nonprofit organizations have chosen to undertake programs to benefit members and the public rather than private individuals. Their earnings, therefore, must, by law, be dedicated to furthering the purposes for which they were organized. Nonprofit organizations have no shareholders and pay no dividends - all earnings are "reinvested" in the organization in furtherance of its nonprofit purposes.
Most associations are also tax-exempt entities, but they need not be. Because the requirements for federal income tax exemption are more stringent than those for nonprofit corporation status, there are some associations that are nonprofit corporations but do not qualify for exemption from federal income tax. However, these organizations are few and far between. Most nonprofit organizations qualify for federal income tax exemption under one of 25 subsections of Section 501(c) of the Code. Most associations are tax-exempt under Sections 501(c)(6) or 501(c)(3), and a smaller number under Sections 501(c)(4) or (c)(5). Association political action committees are tax-exempt under Section 527. In addition, many 501(c)(6) associations form related educational or charitable foundations exempt under Section 501(c)(3).
But what does tax exemption mean? Does it mean that an organization is exempt from all taxes? No. Tax-exempt status means that an organization is exempt from paying corporate federal income tax on income generated from activities that are substantially related to the purposes for which the entity was organized (i.e., to the purposes for which the organization was granted tax-exempt status in the first place). Organizations that meet the requirements for federal tax exemption can generally rely on that status to exempt their income from state corporate income tax. Thus, for example, revenue derived from programs and activities such as educational conferences and seminars that contribute importantly to the furtherance of an organization's tax-exempt purposes (as defined in its governing documents and Internal Revenue Service ("IRS") filings) is exempt from federal (and likely state) income tax. The organization will, however, owe corporate federal income tax (at standard corporate rates) on income that isunrelated to its tax-exempt purposes, called unrelated business income ("UBI"). UBI is defined as income from regularly carried on business activities that are not substantially related to the organization's tax-exempt purposes (see further discussion below).
However, most associations that are tax-exempt do remain subject to a wide variety of other taxes, including federal payroll (Social Security, Medicare and unemployment) taxes, state and local unemployment taxes, real estate taxes, personal property taxes, sales and use taxes, franchise taxes, and taxes on lobbying activities, among others. Exemptions for certain state and local taxes are provided for charitable organizations (but generally not associations) in many jurisdictions.
Section 501(c)(6) Tax Exemption
Virtually two-thirds of all trade and professional associations are exempt from federal income tax under Section 501(c)(6) of the Code (a discussion of 501(c)(3) tax exemption is beyond the scope of this article). A 501(c)(6) organization is defined as an association of persons (including corporations) having a common business interest. Its purpose must be to promote the common business interest and not to engage in a regular business of a kind ordinarily carried on for profit. Its activities must be directed to the improvement of business conditions of one or more lines of business rather than the performance of particular services for individual persons or entities.
An organization must meet certain basic tests to qualify for exemption under Section 501(c)(6):
- It must be an association of persons having some common business interest, and its purpose must be to promote this common business interest (this should be reflected in the organization's governing documents)
- It must not be organized for profit (i.e., it should be incorporated as a nonprofit corporation, not as a stock corporation).
- It must be a membership organization and have a meaningful extent of membership support.
- No part of its net earnings may inure to the benefit of any private shareholder or individual (see discussion below in this Section).
- Its activities must be directed to the improvement of business conditions of one or more lines of business, as distinguished from the performance of particular services for individual persons or entities. ("Particular services" has been defined to include any "activity that serves as a convenience or economy to members in the operation of their business, rather than to promote or improve the industry represented by the association. The determination is a quantitative one - whether or not the particular service is only incidental or minor compared to the principal purpose or benefits of an activity. Denial or revocation of tax-exempt status will only occur if it is concluded that the primary purpose of the organization is the performance of particular services.)
- Its purpose must not be to engage in a regular business of a kind ordinarily carried on for profit, even if the business is operated on a cooperative basis or produces only sufficient income to be self-sustaining.
- It must be primarily engaged in activities or functions constituting the basis for its exemption.
Once an association's tax exemption has been recognized by the IRS, generally the three most significant ongoing threats to the tax-exempt status of a 501(c)(6) organization are:
- Too much unrelated business income (that amount that would cause the IRS or a court to conclude that the primary purpose of the organization was unrelated to its tax-exempt purposes).
- The provision of too many particular services for individuals (that amount that would allow the IRS or a court to infer that such services were the primary purpose of the organization).
- Inurement of benefit of net earnings of the organization to any "private shareholder or individual".
The term "private shareholder or individual" is defined as "persons having a personal or private interest in the activities of the organization." Inurement of benefit involves more than merely activities that are unrelated to the tax-exempt purposes of the organization, and more than the mere performance of particular services for individuals. Proscribed inurement of benefit has three elements:
- Distribution of the benefit of the earnings of the organization. The source of the funds is irrelevant; it is the use of the funds that matters.
- Such distribution of the benefit or earnings must be to a person having a personal and private interest in the activities of the organization.
- The inurement must be more than merely incidental to the tax-exempt purposes of the organization. As all legitimate activities of 501(c)(6) organizations provide some indirect benefit to their members, the IRS has recognized that benefit to individuals that is merely incidental to an activity that furthers the tax-exempt purposes of a 501(c)(6) organization will not result in proscribed inurement of benefit.
Unrelated Business Income Tax
Although associations are granted a general exemption from federal income tax by the Code - for income from activities that are substantially related to the purposes for which the association was granted tax-exempt status - they nevertheless are potentially taxable for income derived from unrelated business activities. The Code defines an unrelated trade or business as "any trade or business the conduct of which is not substantially related (aside from the need of such organization for income . . .) to the exercise or performance by such organization of its . . . purpose or function constituting the basis for its exemption . . ."
The tax on unrelated business income first appeared in the Code in 1950. Congress' principal purpose in enacting the unrelated business income tax ("UBIT") was to provide a level competitive playing field for tax-paying business - so that tax-exempt organizations could not use their privileged tax status to unfairly compete with tax-paying businesses in activities unrelated to their purposes. But instead of prohibiting tax-exempt organizations from engaging in any business activities at all (and denying or revoking tax exemption because of such activities), it chose to specifically permit a certain degree of business activity by tax-exempt organizations, but to tax it like any other for-profit business. Thus, such business activities are permissible, so long as the activities are not a "substantial part of its activities." The tax applies to virtually all tax-exempt organizations, including associations and their related foundations.
The imposition of the unrelated business income tax is generally at the federal corporate income tax rates. Deductions are permitted for expenses that are "directly connected" with the carrying on of the unrelated trade or business. If an organization regularly carries on two or more unrelated business activities, its unrelated business taxable income ("UBTI") is the total of gross income from all such activities less the total allowable deductions attributable to such activities.
Three-prong UBIT test. It is important to note that not all business income is subject to taxation or to limitations: only "unrelated business income" as defined in the Code. Unrelated business income will only exist if three conditions are satisfied; if any one of the three is not present, then income from the activity will not be taxable. The income must be:
(1) from a trade or business;
(2) that is regularly carried on; and
(3) that is not substantially related to the purposes for which the organization was granted tax exemption.
Exclusions. Even if all three conditions of the UBIT test are satisfied, there are numerous statutory exclusions (i) from the definition of an unrelated trade or business, and (ii) in the computation of UBTI, which can exempt otherwise taxable income from UBIT. Many such exclusions are potentially applicable to trade associations, while many are not. The most relevant exclusions include:
- Volunteer labor exception
- Qualified corporate sponsorship payments
- Qualified convention or trade show income
- Dividends, interest and annuities
- Royalties
- Rents from real property (non-debt-financed)
- Certain capital gains
Taxable subsidiaries. If the gross revenue, net income, and/or staff time devoted to unrelated business activities become "substantial" in relation to the tax-exempt functions of an association (thereby jeopardizing its tax-exempt status), the association can "spin off" one or more of the unrelated activities into a separate but affiliated entity, commonly referred to as a "taxable subsidiary." The stock of such a taxable subsidiary can be wholly owned by the association. Such a taxable subsidiary will owe corporate income tax on its net income, but can remit the after-tax profits to the parent association as tax-free dividends.
Filing and payment requirements. In computing UBTI, a specific deduction of $1,000 is permitted. If an association has gross UBTI of $1,000 or more during its fiscal year, it must file a completed IRS Form 990-T to report such income and pay any tax due. The Form 990-T is due at the same time as the Form 990, however, if an association expects its annual UBIT (after certain adjustments) to be $500 or more, then it must make estimated tax payments throughout the year. The Form 990-T is not subject to public disclosure like the Form 990.
Affiliated Entities
One of the most useful planning tools available to associations is the use of related entities to carry on activities. Whether it is to preserve tax exemption, generate revenue, limit legal liability, reduce unrelated business taxable income, engage in otherwise prohibited activities, or for other legal, financial, fund-raising, management, or political reasons, associations frequently establish taxable subsidiaries; related educational, research or charitable foundations; lobbying affiliates (created by 501(c)(3) associations); group insurance trusts; political action committees; regional, state and local chapters; coalitions; and other affiliated entities. Properly utilized, such affiliated entities can reap enormous benefits for the parent association. However, the legal terrain in which they operate is fraught with traps and pitfalls.
If an association is not prepared to do the detailed recordkeeping, cost allocation, and other administrative functions necessary to maintain separate governance structures and the requisite financial, management and operational separation, then it should not establish an affiliated entity. It is burdensome to hold separate board meetings, maintain separate financial records, time sheets, and bank accounts, allocate joint program expenses and overhead, observe strict financial separation, and utilize separate letterhead stationery, among other requirements. At the same time, however, there are significant benefits and opportunities to be derived from the creative use of affiliated entities.
Benefits of Related Foundations. Organizations exempt from federal income tax under Section 501(c)(3) are able to avail themselves of certain additional advantages available exclusively to 501(c)(3) organizations. For instance, only 501(c)(3) organizations are eligible to receive tax-deductible charitable contributions (501(c)(6) organizations can receive dues or other payments that will be deductible to the payor only if they serve a business purpose of the payor); eligible to receive many federal and state government grants; able to qualify for nonprofit postal permits (enabling utilization of significantly-reduced nonprofit postal rates); eligible for many state and local sales and use, real estate, and other tax exemptions (in many jurisdictions, only certain categories of 501(c)(3) organizations are eligible for certain state and local tax exemptions); eligible to issue tax-exempt bonds (providing for significantly lower financing costs); able to receive grants from private foundations without such foundations having to exercise "expenditure responsibility"; eligible to receive tax-deductible gifts of property; able to commence a deferred giving program through charitable remainder gift arrangements, charitable gift annuities, and pooled income funds; and able to maintain a charitable bequest program for federal gift and estate tax purposes (whereby individuals are encouraged and enabled to make some provision for support of the organization as part of their estate plan).
Consequently, certain trade and professional associations, where possible, seek federal tax exemption under Section 501(c)(3). Other associations, themselves tax-exempt under Section 501(c)(6), frequently establish related educational, research or charitable foundations under Section 501(c)(3) in order to take advantage of one or more of these benefits of 501(c)(3) tax exemption.
Conclusion
Associations are required to comply at all times with the strict guidelines for both tax exemption and nonprofit status - including those described above along with many, many others - in order to maintain their favored status under federal and state tax codes and state corporation laws.