Nonprofit entities often partner with
other organizations in joint ventures that meet their missions, but those
partnerships can create tax implications that a nonprofit should be wary of,
especially if that joint venture generates income or involves a for profit
organization. In this post I will describe the general tax issues surrounding
income created by a nonprofit as well as delve deeper into the property tax
issues nonprofits may face when including forprofits in their real estate
spaces.
As a tax-exempt organization, a nonprofit entity is generally not taxed on income it generates. The organization can operate a trade or business as a substantial part of its activities if the operation is in furtherance of the organization’s exempt purpose and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business.[1]
Tax-exempt organizations in Michigan are also exempted from property taxes. The General Property Tax Act of Michigan provides that “Real or personal property owned and occupied by a nonprofit charitable institution while occupied by that nonprofit charitable institution solely for the purposes for which that nonprofit charitable institution was incorporated is exempt from the collection of taxes under this act.” This means if a nonprofit owns real estate, occupies the space, and uses that space solely for its charitable purposes, the organization does not have to pay property taxes on the real estate. [2]
So, a charitable organization can generate income from activities, businesses, or trades that are substantially related to its charitable purpose as well as own and occupy property while being exempted from paying taxes on both the income and the property. But what about if a nonprofit entity wished to include a for profit entity in the space of its real estate? For example, what if a nonprofit wanted to rent out space in a building it owns to a for profit organization that would use the space to generate its own income? That’s where things get complicated.
- UBIT
According to the IRS, Rental income by itself should not
jeopardize your organization’s federal 501(c)(3) charity status. However, A
tax-exempt entity may be taxed on rental income as an unrelated business income
tax. The questions are whether the property is debt-financed or debt-free, if
the tenant's activities are related to the nonprofit’s purpose, and if the
nonprofit is providing services beyond the rental of the space. This website from Blue & Co gives a
breakdown differentiation of UBIT applications between debt-financed and
debt-free properties.
For both debt-financed and debt-free properties, If the activities of the for-profit business contribute substantially to the organization's purpose, the rental income will not be taxed. However, if the nonprofit landlord provides personal services beyond the rental of the space such as lending resources or staff, the rental may be considered an “active" investment and subject to the UBIT since the nonprofit would be providing substantial personal services for unrelated activities.
For debt-financed properties, UBIT applies to the rental income if the space is rented for continuous use as office space to an unrelated entity or if less than 85% of the space is used for exempt functions. For debt-free properties, passive investments like simply renting out the space for office use or retail space are tax-exempt.
However, just because a nonprofit organization can include for-profit organizations on its property without losing its federal tax-exempt status does not mean the organization is totally in the clear. The inclusion of for-profit businesses may still affect the business’s tax-exempt status in other areas. Organizations should be wary about losing their state property tax-exempt status as well.
- Property tax
Under Michigan law, property owned and
operated by a charitable organization and used exclusively for the
organization’s charitable purposes is exempt from taxation.[3]
According to a survey on property tax exemptions[4],
a nonprofit seeking a full real exemption must establish that it owns the real
estate, it is a charitable organization incorporated in Michigan, and the sole
reason for occupying the property is for the furtherance of its charitable
purpose(s).
So when it comes to a nonprofit leasing out its property, the statute only allows the full property tax exemption to stand if the space in the property is leased to another nonprofit charitable institution or trust.[5] This poses a problem to organizations who wish to include for-profit entities and keep their full property tax exemption. Nonprofit organizations that rent space in their real property to for profit entities in the state of Michigan do not qualify for a tax exemption on the full property.
A nonprofit organization can, however, claim a partial tax exemption for the space it owns that is not occupied by the for profit. This is illustrated in a few legal cases such McFarlan Home v. City of Flint where a nonprofit corporation whose property was principally used as a retirement home, was not entitled to a tax exemption for its entire property because part of it was used for the operation of a for profit historical house as a museum. The court decided the nonprofit was entitled to an exemption for the part of its property that was occupied solely for the purpose of elderly care.[6] So the nonprofit should balance the inclusion of a for profit entity with the loss of the property tax exemption for the space the for profit utilizes.
In conclusion, when
embarking on these ventures, nonprofits should consider the effect including
for-profit entities in its spaces would have on its tax-exempt statuses. The
organization should be mindful of considerations such as whether the for profit
fits into the mission or purpose of the nonprofit, whether the activities of
the for profit are substantially related to that mission or purpose, whether
the space to be occupied is owned outright by the nonprofit or financed by
debt, and if the organization is willing to forgo a tax exemption on the full
property.
By Tiara Bond
[1] (26 C.F.R. SS
1.501(c)(3) - 1(e)).
[2] MCL 211.7o(1)
[3] MI CONST Art. 9, § 4
Sec. 4.
[4] Elizabeth Siegal & Scott
Metcalf, Property Tax Exemptions: An Overview of State Constitutional and
Statutory Provisions (The Civic Federation, 2000).
[5] (MCL 211.7o(3))
[6] (McFarlan Home v. City
of Flint (1981) 307 N.W.2d 712, 105 Mich.App. 728.)