Tax in the Bluegrass
Taxes and doing business with nonprofits
February 12, 2020
By Mark A. Loyd, JD, CPA
Many for-profit businesses do business not only with other for-profit businesses and individuals but also with nonprofits. When a for-profit does business with a nonprofit, there are several things to keep in mind.
For-profit businesses compared to nonprofits
From a tax perspective, the primary difference between for-profit businesses and nonprofits is that the former pay taxes and the latter generally do not. To this point, for-profit businesses are subject to federal and state income tax on their taxable net income, i.e., gross income from whatever source derived less ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business under Sections 61 and 162 of the Internal Revenue Code of 1986, as amended (“Code”). In contrast, nonprofits are generally organizations, typically corporations, organized and operated exclusively for religious, charitable, scientific, literary or educational purposes or civic leagues or organizations not organized for profit but operated solely for the promotion of social welfare and the net earnings of which are devoted exclusively to charitable, educational or recreational purposes. However, other organizations may qualify under section 501 of the Code. Notably, when nonprofits operate like for-profits, they are subject to federal income tax on their unrelated business taxable income (often referred to as “UBTI”). Nonprofits must generally report and pay federal, state and local withholding and payroll taxes on their employees’ wages.
For income tax purposes, states generally provide nonprofits with the same treatment as for federal income tax, including subjecting UBTI to tax as Indiana does. However, some states, like Kentucky, exempt nonprofits from income tax but do not subject UBI to tax. Kentucky also exempts nonprofits from the limited liability entity tax (the “LLET”).
States also provide qualifying nonprofits with exemptions from sales and use tax on their purchases but not necessarily on sales that nonprofits make. States also exempt property owned by certain nonprofits from state and local ad valorem property tax.
Nonprofits are generally not subject to tax. However, they are not always tax-exempt (e.g., they fail to qualify as a tax-exempt nonprofit under the Code) or entirely tax-exempt (e.g., they are subject to income tax on UBI). So, a nonprofit organization may not be tax-exempt at all or in all respects.
Nonprofit owners of for-profit businesses
A nonprofit may own all or a portion of a for-profit business. IRS Publication 598 discusses the federal income tax consequences. If the business owned is a corporation, then the nonprofit would have dividend income, which is typically investment income and generally not UBTI. However, if the business owned is a partnership, whether the nonprofit’s partnership income is subject to tax depends on whether or not it is UBTI. An example in IRS Publication 598 provides an example that illustrates how this works, “An exempt educational organization is a partner in a partnership that operates a factory. The partnership also holds stock in a corporation. The exempt organization must include its share of the gross income from operating the factory in its UBTI but may exclude its share of any dividends the partnership received from the corporation.”
State income tax consequences of nonprofit ownership of a business generally follow the federal tax consequences, depending on the state’s adoption of the Code, but could also be materially affected by state allocation and apportionment provisions if the business operates in multiple states. Some states tax UBTI and some states do not, as noted above.
In certain instances, the ownership percentage of a business owned by a nonprofit is excluded or exempted from a state’s entity level tax. For example, there is an exclusion from the LLET tax base of a limited liability pass-through entity’s proportionate share of gross receipts or gross profits attributable to the ownership share of a nonprofit that is a qualified exempt organization.
For-Profit businesses selling to nonprofits
States impose sales and use tax on sales of non-exempt tangible personal property and taxable services. Most states, however, provide exemptions for sales to qualifying nonprofits. Importantly, nonprofits that do not qualify for sales tax exemptions are subject to tax. As such, it is vital for businesses making sales to nonprofits to ensure that they obtain and retain exemption certificates as evidence of exempt sales.
For example, in Kentucky, resident Section 501(c)(3) organizations are exempt from paying sales or use tax on their purchases under KRS 139.495, so long as the item purchased is used in an organization’s educational, charitable or religious function. Qualifying out-of-state tax-exempt nonprofit organizations are exempt under KRS 139.470(8). When a business makes sales to qualifying nonprofits, the seller should ensure that they receive a Purchase Exemption Certificate KDOR Form 51A126 from a qualifying Kentucky resident nonprofit or an Out-of-State Purchase Exemption Certificate KDOR Form 51A127 from a qualifying nonresident nonprofit.
Contractors constructing properties for nonprofits
Sales and use tax generally apply to sales of construction materials that will incorporate into real property, the sale of which is not subject to sales tax. Kentucky is a good example of that, and there is a regulation, 103 KAR 26:070, which addresses contractors.
Because nonprofits may make tax-exempt purchases, this can pose opportunities and risks, especially in states with statutory exemption language that does not explicitly deal with contractors. Again, Kentucky is a good example. To this point, a construction contractor must pay sales and use tax on materials purchased and used in fulfillment of a construction contract with a tax-exempt organization, according to Section 2 of 103 KAR 26:070. However, the Department advised that “If a nonprofit entity wishes to take advantage of its exempt status by making purchases directly, the Department of Revenue recommends that the exempt entity initially advertise separate competitive bids for materials and labor and any materials purchased by the exempt entity should be delivered to the exempt entity’s job site. In addition, the exempt entity must prepare and submit its own purchase order for materials and payment must be made directly by the exempt entity to the vendor.” Dep’t of Revenue, Kentucky Sales Tax Facts, Vol. 5, No. 1 (Dec. 1, 2003).
In states in which there is a statutory exemption, a contractor should obtain the appropriate state exemption certificate.
Nonprofit selling to for-profit businesses
When a nonprofit makes sales, that nonprofit seller must generally collect sales tax, which necessarily entails registering as a vendor, collecting sales tax, filing tax returns and remitting sales tax to the applicable state. When a nonprofit is a buyer, they are generally exempt from sales and use tax.
Nevertheless, states sometimes provide limited exemptions to nonprofits for sales tax. For example fundraising event sales are exempt, as provided for in KRS 139.495.
But, the point for for-profit business purchasers to keep in mind is that even though sales tax is not collected by the nonprofit, the for-profit business must pay tax on non-exempt purchases made from a nonprofit.
“What’s worth doing is worth doing for money.” – Gordon Gekko, Wall Street (1987)
For-profit businesses do business with nonprofits all the time and make money doing it. For tax purposes, the keys are to avoid the traps and to take advantage of the right tricks.
About the author: Mark A. Loyd, JD, CPA, is a partner of Bingham Greenebaum Doll in Louisville and chairs its Tax and Employee Benefits Department. He chairs the Society’s Editorial Board and Tax Committee. He can be reached at MLoyd@bgdlegal.com; 502.587.3552.
For more information regarding nonprofits be sure to attend the Nonprofit Conference on April 23 at the Gratzer Education Center in Louisville or via live broadcast.