Just because you run a nonprofit doesn’t mean you can completely ignore taxes. You still have to file. In fact, if your nonprofit fails to file its required annual federal information return or notice for three consecutive years, its federal tax-exempt status will be revoked automatically. However, there are other areas in which a nonprofit may be subject to tax that are not as straightforward. A nonprofit organization may find that it is subject to tax in the following four circumstances.
Excise tax on executive compensation
Certain nonprofits are subject to a 21% excise tax on compensation exceeding $1 million paid to covered employees, as well as certain excess parachute payments. Beginning in 2026, the definition of covered employee generally expands beyond the five highest-compensated employees to include all current employees and certain former employees, subject to applicable exceptions. This tax is generally paid by the nonprofit, not the individual. Strategic compensation planning may help organizations understand and potentially mitigate the effects of this tax.
Local lobbying expenses
Certain Section 501(c)(4), 501(c)(5), and 501(c)(6) organizations are subject to special reporting requirements related to lobbying and political expenditures. These organizations generally must notify members of the portion of their dues attributable to lobbying and political activities that cannot be deducted as business expenses. Failure to provide the required notice may subject the organization to a proxy tax, although certain exceptions apply.
Unrelated Business Income Tax
The distinctions between tax-exempt revenue and unrelated business income tax (UBIT) are not always clear-cut. When nonprofits regularly earn income through business activities that are not substantially related to their exempt purposes, the income may be taxable. Examples include certain advertising revenue or commercial activities unrelated to the organization’s mission. Because it can sometimes be confusing to distinguish between related and unrelated business income, the IRS provides several exceptions and exclusions. Depending on the circumstances, the following activities or income may not be subject to UBIT:
- Activities performed substantially by volunteers
- Sales of merchandise that has been substantially donated, such as items sold at a nonprofit thrift store
- Activities carried out primarily for the convenience of members, students, patients, officers, or employees, such as a school cafeteria
- Certain qualifying bingo games
- Certain rental income, royalties, and investment income
Nonprofits with $1,000 or more in gross unrelated business income generally must file Form 990-T, even if no tax is ultimately owed. Organizations conducting multiple unrelated business activities generally must calculate taxable income separately for each activity.
Multi-entity planning
Nonprofits may be able to reduce certain risks to their tax-exempt status through multi-entity planning. A nonprofit organization can establish a separate taxable subsidiary through which it carries out unrelated business activities. This structure may help separate commercial operations from the organization’s tax-exempt activities while limiting certain risks and liabilities.
However, forming a separate entity does not automatically eliminate tax obligations or protect the nonprofit from all liabilities. The subsidiary may be subject to income taxes, and transactions between related entities may create additional tax and reporting requirements. Careful planning is important when considering this approach.
Final thoughts
This is just a summary of complex rules, and your organization may be subject to other tax obligations as well. Understanding these potential liabilities and strategically planning ahead can help protect your nonprofit’s financial health and tax-exempt status. If you have questions about your organization’s tax obligations, contact SEK’s Nonprofit team today.
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