Avoiding IRS Scrutiny through Proper Fee-for-Service Accounting

If you’re like many not-for-profit organizations, you may offer your services for a fee. The fee-for-service income model has become increasingly popular among not-for-profits seeking more financial security since the 2008 recession. Faced with dwindling funding from federal, state, and local governments, as well as a reduced number of donations, not-for-profit organizations looked at other models to receive a steady flow of income. In the fee-for-service model, not-for-profit organizations receive compensation for offering a product or service to potential customers. The fee-for-service model can be a great way for not-for-profits to become more financially independent both because they’re more secure and because they can choose to do whatever they please with the money from sales. However, because nonprofits are not businesses, the fee-for-service model can also be a great way to receive scrutiny from the IRS. If your nonprofit operates in some part on a fee-for-service model, you should consider the following factors when facilitating and accounting for your operation.

not-for-profit organization accounting

Primary Purposes

If your organization accepts payment for services, you must consider whether the service for which you’re charging can pass the “exempt purpose test.” This effectively means that whatever service you’re charging for must clearly and directly support the reason(s) that your not-for-profit organization holds a tax-exempt 501©(3) status. Innately, both your organization and the IRS will exercise subjective judgment when considering the purpose of your organization, and whether charging for a service complies or disregards that purpose. However, if the process of selling your product or service is the primary function of your not-for-profit organization, and if the sale of your product or service does not necessarily further the purpose of your not-for-profit organization, it could imperil your organization’s 501©(3) status. If you are unsure of whether you are correctly accounting for your financial practices, or if you are unsure of whether by charging for services or goods your not-for-profit organization violates its 501(c)(3) status, please call a qualified accountant who has experience working with not-for-profit organizations in the Washington, DC area or wherever you live to ensure that you comply with federal tax codes.

Do You Know UBIT?

If the services that your organization charges for do legitimately further the purpose of your not-for-profit organization, they may nonetheless still be subject to taxation at standard corporate rates. In 1950 the Unrelated Business Income Tax (UBIT) was added to the 501©(3) section of the IRS tax code. The UBIT stipulates that your organization must pay income tax corporate income tax rates on the money earned from sales. However the UBIT contains three key stipulations which can determine whether your not-for-profit’s organization services qualify for taxation at corporate rates:

  1. Your product or service is a “trade or business” undertaken for the purpose of generating income
  2. Your product or service is a “regularly carried on” function of your organization
  3. Your product or business is “not substantially related” to furthering the exempt purpose of your organization

The “substantially” distinction in the UBIT guidelines is incredibly important. While your product or service must support the exempt purpose of your not-for-profit organization, it can do so without doing so “substantially.” In the event that your not-for-profit organization’s sales are not deemed tax exempt, you must pay your UBIT. If you do not believe that or are unsure of whether your not-for-profit organization has been complying with IRS standards, contact a qualified Certified Public Accountant to address your filing concerns. A knowledgeable accountant can help you determine whether you are at risk for losing your 501©(3) exemption, and whether you need to pay the UBIT. They can also provide you with crucial input on other nonprofit accounting questions you may have.