Feeder Organizations – Charity Lawyer Blog

At Caritas Law Group, we talk to prospective nonprofit founders every day. They often ask about what activities qualify for tax exemption and what does not. Interesting discussions often arise when it comes to defining the term “charitable.” One common misconception is that someone can start an ordinary for-profit business, donate its profits to an exempt organization, and qualify for tax exemption itself. The idea is that because all of the profits are going to charity, the for-profit business can be construed as “charitable.” Unfortunately, this is not true. These types of businesses are called “feeder organizations” that do not qualify for tax exemption.

Internal Revenue Code Section 502

The federal tax code specifically refers to feeder organizations, stating “an organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt from taxation . . . on the ground that all of its profits are payable to one or more organizations exempt from taxation .  .  .”

The law promotes fair competition. Because feeder organizations compete with other for-profits, allowing feeder organizations to operate on a tax-free basis provides them with an unfair advantage. Not only that, Section 502 exists to prevent abuses where nonprofit organizations might attempt to circumvent tax obligations by conducting commercial activities through related entities.

Exceptions

In certain situations, a feeder organization may qualify for tax exemption. The exceptions to Section 502 are:

1. Where the organization derives rents that would be excluded from the definition of unrelated business income under I.R.C. § 512(b)(3).
2. Where the organization conducts any trade or business in which substantially all the work is carried on by volunteers.
3. Where the organization conducts any trade or business which is the selling of merchandise, substantially of which has been received as gifts or contributions.

Conclusion

 To qualify for tax exemption, the organization’s purpose and activities must be inherently charitable. Operating a for-profit business and tacking on a large charitable donation at the end of each year does not qualify as charitable. Moreover, such conduct is specifically stated to not qualify for tax exemption. If your nonprofit business plan consists of mostly business with charitable contributions on the side, you may need to consider alternative paths to making a difference.