Finding the most effective and least expensive solutions to key social problems is one of the most important tasks facing social planners. Should government entities have responsibility for seeking solutions to juvenile delinquency, drug and alcohol abuse, mental illness, illiteracy, poverty and the plight of the aged, or should we look to the nonprofit sector? Nonprofit organizations (NPOs) serving as grass roots mediating structures can be more effective than government bureaucracies because they are able to bring together a wide array of both public and private resources, launch initiatives without myriads of bureaucracy, take risks, adjust to social changes and involve the citizenry in meaningful ways in seeking solutions to complex social problems. The "non-establishment" character of NPOs makes them often more flexible and less complex, less intrusive and more trusted than government counterparts. The President seemed to recognize this in 1982, when he stated that "volunteerism is an essential part of our plan to give government back to the people." He then announced the start of a national drive to enlist private sector resources to help solve the country's economic and social problems. Traditionally, the nonprofit sector has served an important mediating role between the "haves" and the "have nots" and between the public and private sectors in our country. Based on these foregoing strong arguments, the need for an active and effective nonprofit sector is of critical importance to the survival of the country.
The central question is and always has been, how should the nonprofit sector be financed? This article suggests a new approach to this old dilemma.
THE PROFIT VERSUS NONPROFIT DICHOTOMY
Cultural Determinants Against Profit
Traditionally, nonprofit "charitable organizations" operated with the perceived mandate of performing "charitable services" as supported by "charitable contributions" from individuals, business and industry, and foundations. This "tin-cup" mentality mitigated any thought of operating as a business, generating a positive cash flow, seeking long-term investments, charging fees for services, seeking government grants, or becoming involved in social action and exercising power. These business concepts were foreign and, for the most part, unacceptable to trustees and management of yesterday's charities. To pay competitive salaries, have adequate facilities, market services, compete for service contracts, etc., were viewed as inconsistent with the altruistic/humanitarian charitable cause of the NPO. This era of the "tin-cup charity," with its culturally assumed prohibition against profits and its relaxed and informal structure, faded considerably when the federal government launched its massive initiatives to meet the social problems of the early 1960s.
Federal Grants- "No Profit" Provision
Responding to civil unrest, poverty, discrimination, social injustice and other problems were the targets of Great Society efforts of the 1960s. The general thrust of this era was to meet human needs through massive infusions of public funds in ways that least expanded the federal bureaucracy. Thus, the process known as "federal grants" or "grants in aid" to non-government service providers was instituted. Nonprofit organizations were viewed as primary vehicles for translating much of the federal funding into services to people. These massive infusions of public dollars initiated what could be referred to as "the 10-year NPO renaissance." The game of grantsmanship was on. Those who played it well were amply rewarded. This increase in funding also precipitated a renaissance of thought about the role and function of NPOs in American society. The first demand was that the NPO sector increase its professionalism and change its self-concept. Next, the government grants monitor demanded accountability for dollars spent and services provided. Excess revenues over expenses (profits) were usually not allowed to accrue from one year to the next. Though most NPOs resented the federal intrusion, the typical response was to "play the game" by demonstrating greater accountability and improved business operations. Improvements in accounting and auditing practices, contracts for services, personnel classification systems, policies and procedures manuals, lines of accountability and organization structures contributed significantly to moving NPOs from their traditional nonbusinesslike laissez-faire modes of operation. Unfortunately, growing dependence on federal funding and federal prohibition against accumulating an operating contingency fund (profit) caused many NPO trustees and managers to neglect other possible sources of revenue and survival strategies, thus rendering them totally incapable of accommodating the massive federal reductions of the 1980s. The short-sighted policy of the federal funders to not allow NPOs to generate a "profit" was the single most crippling practice imposed upon NPOs of the 1970s. They were totally unprepared to accommodate the sudden cessation of federal support in the 1980s.
A New Look at Profit
As the 1970s drew to a close, the nonprofit sector's "golden era" of federal support soon became recognized as the years of "the federal entrapment." Short-sighted and federally dependent NPOs panicked. The federal government's funding alternative, the block grant mechanism of channeling replacement federal dollars to states, was no match for the former federal "come on," especially in light of spiraling inflation and the problematic recession. These events extracted a heavy toll on those nonprofit organizations that had fallen into the federal trap that prohibited the accumulation of an operating reserve ("profit"). Thus, without operating reserves and entrepreneurial expertise many NPOs were incapable of dealing with the resulting cash flow problems. This experience has caused NPOs to re-examine their attitude toward the importance of "profit" in their mode of operations.
IRS on NPO "Profits"
The question about whether a nonprofit organization can legitimately generate a "profit" is answered in part by examining the IRS provisions on the subject. Galloway, in The Unrelated Business Income Tax clearly points out that NPOs can generate "related" and/or "unrelated" business income.1 If the income is the result of activities that are substantially related to the organization's charitable purpose as defined by the IRS, no tax is required. If the income results from unrelated activities, it is subject to taxation. In reference to Section 513 of the Internal Revenue Code, Galloway clarifies:
The term "unrelated trade or business" means . . . any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501 .. .
Understanding the purpose of the unrelated business income tax is key to the question of whether or not it is fair for nonprofit organizations to engage in competition with taxable enterprises. Indeed, governance boards, some funding sources and occasionally the general public will take a dim view of the nonprofit organization that engages in business ventures. The notion is that such activity is unfair because the NPO does not pay taxes. Galloway dispels this notion completely in describing the purpose of the unrelated business income tax (UBIT): "... the purpose of the unrelated business income tax is to prevent the exempt organization from having an unfair edge when competing with taxable enterprises."1 The Figure can be used to make a rough determination as to whether or not a given type of income is taxable (unrelated) or non-taxable (related).
Unrelated business income constitutes an important portion of the revenue base for the NPO with which the author is employed. Income from the NPO's interest in a Wendy's Restaurant, rental income from leasing a portion of its 36,000 square foot shopping mall, and other real estate ventures are examples of "unrelated business income."
The Internal Revenue Service provides the 990, 990T and Other forms for the NPO to use in reporting its income and computing its tax liability. In an environment where NPOs are becoming aggressively involved in income-producing activities, some of which are unrelated, it is of critical importance that the organization understand the tax code and engage in proper tax planning or face unexpected assessments and possible loss of exempt status from an IRS audit. Unrelated business income tax may apply to all types of nonprofit organizations, from churches to colleges to social clubs. In a similar vein, the unrelated debt finance tax can also unexpectedly strike almost any organization, including pension trusts, if the organization is not knowledgeable. The amount of unrelated business income that an NPO may generate is difficult to define and should be monitored very closely by the organization's accounting firm. According to some authorities, the amount of unrelated business income an organization can generate is approximately 15% of its gross annual revenues, beyond which the likelihood of losing the tax-exempt status increases rapidly.
ENTERPRISE IN THE NONPROFIT SECTOR
Enterprise in the nonprofit sector has been defined as "those income-producing activities that are beyond the normal mission of an institution . . . [including] 'profits' generated via ingenuity, much of it consistent with and parallel to the institution's purpose, as well as cost savings accrued through enterprise."2 The first step to take in considering enterprise management strategies is to become familiar with business world strategies such as diversification of revenue sources, expansion of markets, mergers and acquisitions, divesture of non-producing/nonprofitable operations, streamlining modes of operations, fostering government relations, creative tax avoidance, and high yield investments.
The second step is to understand the magnitude of "built-in" enterprise opportunities in the nonprofit sector. This requires that we understand how the sector fits into the rest of the American economy. Such an understanding is essential in opening up new possibilities for not only the survival, but also the prosperity of the NPO.
Reliance on the nonprofit sector rather than the government is a part of the American tradition. As such, many provisions have been written into the tax code to enhance the viability and functional capacity of the nonprofit organization. Several outstanding references on the subject are available.24
Unfortunately, there are those who use the law for their own personal or devious gain. For example, some questionable activities have been organized as "religious" in nature and purpose and have thus qualified for tax-exempt status. On the surface they may meet all of the provisions and requirements but the underlying motive is tax avoidance or cover for highly suspect or questionable activities. In an effort to protect the legitimate nonprofit organization, new rules and regulations are being written and in a sense have served to penalize both legitimate and illegitimate NPOs. Unfortunately, this trend will probably continue until adequate safeguards to protect the public and the legitimate NPO are established.
If understood and applied wisely, the tax laws regarding the nonprofit organization can open new doors for organizing, structuring, managing and maintaining charitable activities. Some of these provisions are described below.
IRS Options (NPO Prerogatives)
Key to any enterprise or profit-minded activity in the nonprofit sector is an understanding of the basic ground rules. A starting point in understanding the operating parameters (constraints and opportunities) of the NPO is to review tax code provisions regarding the nonprofit organization. The following represents a summary of the main forms and procedures.
Figura. The unrelated business income tax. Adapted from Galloway JM: The Unrelated Business Income Tax. New York. John Wiley & Sons. 1982. p 6.
1. Application for Recognition of Exemption. When applying for tax exempt status as a charitable organization (ie, hospital, private college, human service organization, etc.) IRS Form 1023 "Application for Recognition of Exemption" is used. This form is used for the traditional 501(c)(3) nonprofit organization and can be obtained from the IRS. When the instructions are closely followed and all applicable schedules completed, the IRS will make its determination. Basically, the major requirements for designation as a 501(c)(3) organization are summarized as follows: a) an altruistic purpose per IRS definition; b) a non-paid governing body (board of directors/ trustees); c) provision for little or no lobbying; d) provision for revenues in excess of expenses to inure to furthering the aims of the organization.
2. Application for Special Category Exemption. The IRS has made provision for various special organizations and activities whose purposes are "nonprofit" in nature but are not specifically defined under Section 501(c)(3). Application for exemption for these entities is made by completing IRS Form 1024. This form is used for those organizations described in Sections 501(c)(2), (4), (5). (6), (7), (8), (9), (10), (12), (13), (15), (17). (19) and (20) of the Internal Revenue Code. These additional nonprofit corporate options were established to give greater opportunity for the nonprofit approach to succeed in place of the government. A good understanding of these options can provide greater opportunities for NPO operational diversification and flexibility. IRS reporting forms 990, 990T, 5500 and 5500(c) are used for recording and reporting to IRS the organization's activities. From these forms, basic determination can be made as to whether or not the NPO has incurred any tax liability and whether or not it is in compliance with the code.
APPLICATION OF IRS OPTIONS
Armed with the basic tools (knowledge of IRS options and provisions, a few good references, an NPO attorney and accountant), the NPO manager can survey his organization to see what challenges can be met via corporate structuring or, "Corporate Configuring." Some of the basic concepts of corporate configuring have been borrowed from the business world. It is a well-known practice that business entities frequently establish a variety of corporate structures to provide flexibility, protection, tax advantages and other enhancements to achieve economic gain. Similarities between what can happen in the nonprofit sector and the private sector are striking (but then, this should not come as a surprise since those who established the provisions for the nonprofit sector were in many instances those who were well-versed and knowledgeable about business world transactions).
Five is Better Than One?
The author's NPO system consists of five separate corporate entities, each with a definite purpose. The structure has a separate but interlocking governance and directorate system to give unified and coordinated direction. This multiple corporate matrix has proven to be a powerful management tool in helping position the organization for creative and entrepreneurial activities that take it beyond mere survival. The organization chose this strategy to gain needed flexibility to structure services to more efficiently meet community needs and avoid the excessive bureaucratic control and expense that often accompany government funding. It is well-known that although the government funder may provide only a portion of the total funding for an organization the expectation is that the entire organization comply with the rules and regulations accompanying the funding.
Surprisingly, the author's organization discovered that many of the answers it sought were to be found in the provisions of IRS law, rules and regulations regarding NPOs. Trie following paragraphs contain some of these important decisions.
1. Establish a lateral corporation. An NPO stymied by excessive government bureaucracy and reporting requirements could consider establishment of a separate corporate entity to house those services not directly paid for by a government entity. This separate organization, with its own articles of incorporation and bylaws, could operate in a somewhat parallel capacity to the base organization. Contracts for service could be established between both organizations to either purchase or sell services the other does not provide, eg, management and administrative support services. Also, program services could be handled in a similar manner. The lateral corporation could provide services to area citizens who do not require government subsidy. It could also provide services beyond the scope of those of the base corporation. For example, if the base NPO were a mental health center, the lateral corporation could provide conferences and workshops for the public, employee assistance programs for business and industry, parenting seminars, etc., in which the center would not open clinical charts for review by government monitoring entities. In addition to providing increased flexibility for operations, the separate corporation could also provide extra work opportunities for the staff of the base corporation which in turn might be useful in discouraging them from seeking employment elsewhere or entering private practice.
Additional lateral 501(c)(3) corporations could be established, each to meet specific defined needs that cannot be achieved by the base organization or another lateral corporation. Thus, greater relevancy to community needs, protection of the basic corporation, additional opportunities for staff involvement, increased opportunities for citizen participation in the governance structures, are some of the advantages occurring from establishing a lateral corporation.
2. Establish a non-private foundation. It might be advantageous to establish a separate corporation known as a non-private foundation for the base NPO. IRS Form 1023 is used to set up this special foundation, also categorized as a 501(c)(3) corporation. By establishing a non-private foundation, the organization's function as a "cooperating charity" can be effectively expressed without creating undue complications for the base NPO. The foundation could carry out resource development activities such as charitable remainder unitrusts and annuity trusts, gifted annuities, charitable lead trusts, pooled income funds, and creative use of life insurance. Functioning as a "cooperating charity," the foundation would involve realtors, insurance agents, estate planners, accountants and attorneys, many of whom recognize the value of working with an NPO that has some degree of sophistication in pursuing these planned giving strategies. As a separate corporate entity, the trust arrangements and accounting systems, are separate from the base NPO. Not only does this new corporate entity provide increased partnershipping opportunities with the business community, but it also provides opportunity for service for many area citizens to be involved in a worthy cause.
3. The 501(c)(2) holding company. Section 501(c)(2) of the IRS code provides for "corporations organized for the exclusive purpose of holding title to property, collecting income therefrom, and turning over the entire amount, less expenses, to an organization which is itself exempt." An existing 501(c)(3) corporation may set up a separate 501(c)(2) title-holding company to hold title to and manage real estate for the base NPO. Real estate rental to the public is usually allowable as well as to the base corporation or other exempt corporations. To help ensure IRS acceptance of a tide-holding corporation, the articles and bylaws of that corporation should be worked very strictly with regard to its limited purposes and activities. They should state clearly and unmistakably that it is controlled completely by the parent organization, that it cannot engage in any leasing solely of personal property, that it cannot receive charitable contributions, that all net income is to be turned over annually to the parent organization.
If established properly and approved by the IRS, the parent corporation can transfer title to real estate (usually via quit claim deed) to the 501(c)(2) title-holding corporation. With this arrangement the parent corporation leases back the facilities and pays a predetermined fair lease price to the (c)(2). The (c)(2) in turn is responsible for mortgage payments and any other encumbrances on the property. This process enables the base NPO to render an accounting to its funding sources that revenues received from government sources are used for the purpose of making lease payments rather than mortgage payments. Government hinders are thus disengaged from "acquiring" property through their grants to the base corporation.
4. Employee benefit corporations. The IRS code provides several options for housing employee benefits in a subsidiary corporation known as a 501(c)(9). This corporation can be established "to provide for the payment of life, sick, accident or other benefits to the members of such association or their dependents or designated beneficiaries." For such an organization to be exempt, the regulations require that there be no private inurement (ie, no self dealing, no unreasonable compensation, no disproportionate benefit payments, etc.), and that the organization be an association to provide benefits to employees.
A 501(c)(9) offers several potential values to 501(c)(3) corporations. First of all, several small agencies, some with small staffs, could jointly sponsor a 501(c)(9) to achieve a larger employee base, thus making the larger group more attractive to prospective insurance companies and also to secure more competitive bids on benefit plans. Secondly, since 1969 when the restrictions on investment income and the accumulation of reserves were lifted from the 501(c)(9) regulations, employee benefit associations have become excellent vehicles for self insurance plans because of reduced costs and more flexibility in plan design. In a self insurance trust a certain amount is paid into the trust regularly and claims are paid from that trust. In addition, a fee is paid for claims processing and as a premium for "stop loss" insurance which guarantees that when claims for a specified period exceed a specified amount, the stop loss carrier assumes responsibility for additional claims. This arrangement allows the participating employer and employees to contribute to their own reserve fund instead of a reserve for an insurance company and that reserve can in later years be used partly to modulate increases in benefit costs and/or to improve plan benefits.
5. Creative venturing. Once the nonprofit organization has an "enterprise mindset," ie, engaging in "income-producing activities that are beyond the normal mission of an institution" a variety of new and exciting revenue generating possibilities will become possible.2 For example, the acquisition and leveraging of properties can begin to occur. An NPO can enter into partnership arrangements with a private investor to acquire real estate. As a general partner, the NPO can designate the extent of risk for the limited partner(s) to enable them to obtain tax shelter credits under the Accelerated Cost Recovery System. This is another example of how the private and nonprofit sectors can team for each other's benefit. Additional opportunities for co-venturing between NPOs and private investors are possible since many would be investors searching for tax shelter opportunities such as those the NPO can provide. Leveraging properties to acquire additional holdings is also an effective method of acquiring additional real estate holdings.
6. Establish a for-profit subsidiary. There are several misconceptions about whether or not an NPO may or may not make a profit or may or may not directly own a for-profit subsidiary. A nonprofit organization may legally conduct for-profit business activities within the parameters of IRS provisions and may also directly own for-profit subsidiaries.
Many nonprofit organizations have either formed or acquired subsidiary for-profit corporations to engage in profit-making business activities. Thus, it may be in the best interest of the NPO to establish a for-profit entity rather than run the risk of losing its tax exempt status by surpassing the allowable income level from an unrelated activity. Those who have developed for-profit subsidiaries arrange the accounting records as any other for-profit business and use depreciation schedules and other business related expenses, including charitable donations to the base NPO, in calculating the amount of taxable income. These for-profit entities are usually "wholly owned" by the base NPO.
ENTERPRISE STRATEGIES VERSUS CUTBACK STRATEGIES
In answering the question of whether not-forprofits should go into business, Skloot maintains that with the right product and managerial talent, an NPO 's business venture can be a commercial success.5 There are a number of risks involved but occasionally the "economic climate" virtually "demands the pursuit of earned income." Skloot outlines five basic principles which he considers essential in starting or expanding such a venture. These five principles are summed up as follows: "Suppose the not-for-profit organization meets all five criteria - something to sell, management talent, trustee support, entrepreneurial attitude, and the money, or the ability to get it. What then? The key factor in the success of the venture is treatment of it as a business, not a service: they should use earned income to support program activities, not use the latter to enhance the former."5
As we view the plight of today's NPO, we see a variety of contrasts. First, for the NPO that does not adapt to an enterprise management reality, a bleak future of continuing years of cutback management is forecasted. Dr. Leland Kaiser of the University of Colorado warns about becoming entrapped in the cutback management syndrome. He points out that a 10% per year cutback strategy would leave an organization with absolutely nothing in 10 years. He advocates an alternative approach - that of cutting back 15%, where perhaps 10% might have been adequate. The organization should use the extra 5% cut to re-design, re-tool and restructure itself on a path toward self-sufficiency. For the organization that can recognize the importance of developing enterprise management strategies, its future will hold new opportunities for business ventures, partnershipping with both the public and private sectors and developing new revenue sources to pursue its altruistic aims. The American way of "doing it" without government involvement is a challenge but one which can usher in new dimensions of NPO opportunity. In this way, we can make the "new federalism" become our opportunity for growth and expansion rather than allow it to be a form of "new fatalism."
Nonprofit organization managers and trustees must be oriented toward creating a revenue base that will yield both financial stability and financial capacity. This requires creative and thoughtful decisions about how the organization perceives itself and moves toward creating its own future. The following steps seem critical: First, organizational self-analysis. Does the organization fulfill an essential and critical role in its community? Does its mission justify the effort to survive? Will its constituency fight for its survival? Second, could the organization be merged with another similar type organization to effect certain economies of scale or could it become a part of a larger consortium? Third, what is the extent of need and how large should the operation be in order to meet that need? Fourth, given that there is ample justification for the organization, is the organization willing and capable of adapting a businesslike approach to organizing itself and conducting business? Fifth, what are the legal parameters within which the organization must operate? This step requires a review of the articles of incorporation and the bylaws to determine what type of activities in which the organization may engage to generate "related" or "unrelated" business income. Managers and trustees should constantly keep in mind the question, "What is our business?" This question should help guide the thinking on both sides of the related and unrelated fence.
The critical challenge for NPOs in the mid and late 1980s is to develop strategies for growth and prosperity in light of a cutback and cost containment national policy. Shrinking public support, combined with the increasing demand for human services resulting from economic and fiscal change, gives rise to unique opportunities for creative and effective management strategies to meet the increasing "high touch" needs of an evolving "high tech" society. The impact of reduced federal funding on many NPOs across the country suggests that those organizations surviving and prospering are those that have abandoned the traditional charity model (tin cup) and have adapted techniques of the modern business enterprise. It is that challenge of developing strategies for growth and prosperity in a cutback era that remains our challenge - profitminded management in the nonprofit sector is a step in the right direction.
1. Galloway I: lite Unrelated Business Income Tax. New York, lohn Wiley & Sons. 1982.
2. Crimmins JC. Keil M: Enterprise in the Nonprofit Sector. Washington, DC, Partners for Livable Places end the Rockefeller Brothers Fund. 1983.
3. Treuieh PE. Sugerman NA: Tax Exempt Charitable Organizations, ed 2. Philadelphia, PA, American Law Institute, American Bar Association Committee on Continuing Professional Education, 1983.
4. Connors TD: Nonproß Organization Handbook. New York. McGraw-Hill. 1980.
5. Skloot E: Should not-for-profits go into business? Harvard Business Rei'iew 1 983, January-February.