Profitable Filmmaking for Nonprofits
An Introduction to the Laws
by Mary Ellen Tomazic
Can a nonprofit organization make a profit? And if so, what kind of trades or businesses can it operate at a profit and still keep its tax exempt status?
This question about companies exempt from taxation under I.R.S. §501(c) (3) came from a filmmaker whose father has a tax exempt ministry. The filmmaker wants to make a film related to the ministry and finance it by selling advertising on a YouTube channel which would show the movie and other videos related to it Since the documentary is about hte ministry, wou.d the YouTube channel advertising income come under the exemption of the nonprofit organization?Before analyzing the options the ministry has for financing its film, it is instructive to discuss the underpinnings and history of the §501(c) (3) tax exempt status for nonprofit organizations and how it has evolved over the last sixty years.
Nonprofit organizations have two concerns under the federal income tax law about running a business: 1) whether the activity adversely affects the organization’s tax exempt status; and 2) if not, will or should the net income of certain businesses run by nonprofits be taxed, and how far should this tax extend?
Tax Exemption
As a simple rule of thumb, to receive a federal income tax exemption , the profitable trade or business run by the nonprofit must be “related” to the purposes for which the nonprofit received its tax exempt status. Over the years, there was controversy over what “related” meant, and whether the trade or business was allowed to be carried on regularly or just for a brief time.[1]
Previous to the Revenue Act of 1950, the requirement was only that profits garnered by exempt organizations be used in
furtherance of the tax exempt purposes, without regard to the source of the profits. Nonprofits quickly took advantage of the old rules, carrying on full-fledged commercial enterprises in competition with corporations whose profits were fully taxable.
For example, in the case of C.F. Mueller Co. v. Commissioner,[2] Mueller, the largest manufacturer of noodles and macaroni in the U.S. qualified for tax exemption under §501(c)(3) because all its pasta profits were distributed to its sole shareholder, New York University, for the exclusive benefit of its law school. NYU also owned Howes Leather Company, American Limoges China and Ramsey Corporation, a manufacturer of piston rings.
The Macaroni Monopoly
As this case was working its way through the courts, the U.S. Congress was debating the first bill on the Unrelated Business Income Tax (UBIT.) In the hearings one representative warned of a “macaroni monopoly” by the university, where all the noodles in the country would be produced by corporations held or created by universities, depriving the Treasury of any tax revenue from an entire industry.[3]
The hearings eventually produced Internal Revenue Code § 502 and rules for the “Unrelated Business Income Tax”, providing that an income-producing activity (other than passive investment) that is regularly carried on and not “substantially related” to an organization’s exempt purposes, apart from the need for income to support its charitable or other exempt mission, will be taxed as a regular business.
Under § 502, an organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt from tax under § 501 on the ground that all of its profits are payable to one or more tax exempt organizations. Thus, § 502 denies exemption to so-called “feeder corporations” like the Mueller macaroni company, and other entities that operate a business as their sole activity and typically are obligated to pay over their profits to an affiliated §501(c) (3) organization.[4]
The Congress was concerned mainly with unfair competition with for-profit businesses which can use only their profits remaining after taxes, while the tax-free status of §501(c) (3) organizations allow them to use their profits tax-free to expand their operations. The House and Senate Reports both gave examples of these organizations actually using their tax exemptions to buy businesses, acquiring the business with little or no investment of their own part and paying for it in installments out of subsequent earnings, which could not be done if the business were taxable.[5]
Unfair Competition
Most of the changes in the tax law relating to nonprofit organizations after 1950 have been piecemeal, but the theme of preventing unfair competition between nonprofits and for profit companies continued. Nonprofits benefited from not only their federal tax exempt status, but also from state and local tax exemption, lower subsidized postal rates, antitrust exemptions, and the “aura” of a government imprimatur which helped as a marketing tool and a method of quality control and protection.[6]
The Congress was willing to allow otherwise qualified organizations to keep their exemption from taxation as long as the businesses they engaged in were “insubstantial” in relation to their charitable activities, even if they were unrelated to the organization’s exempt purposes.[7] This so-called “commerciality doctrine” was imputed by the courts and commentators into §501(c) (3). However, although the organization is allowed to retain its tax exempt status, such unrelated business activity is still taxable under the UBIT.
[1] See generally James L. Fishman and Stephen Schwarz, Nonprofit Organizations Cases and Materials 596-597 (3d Edition 2006).
[2] 190 F.2d 120 (3d Circuit 1951).
[3] Remarks of Rep. John Dingell, Hearings Before the House Comm. On Ways and Means, 81st Cong., 2d Sess. 579-580 (1950).
[4] Id. fn.1.
[5] H.R.Rep. No. 2319, 81st Cong., 2d Sess. 38 (1950); S.Rep. No. 2375, 81st Cong., 2d Sess. 28-29 (1950).
[6] From statement of Joseph O’Neil, Chairman, Business Coalition for Fair Competition, at Hearings Before the Subcommittee on Oversight, House Ways and Means Committee, 100th Congress, 1st Sess. 217-220 (Ser. 100-26, 1987).
[7] Treas. Reg. § 1.501 (c)(3)-1(b)(1)(iii).
Mary Ellen Tomazic is an attorney in Cleveland specializing in entertainment issues
such as copyright, trademarks, contracts and licenses for musical groups and filmmakers.
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