Throughout the country, there’s a misnomer that because nonprofit organizations are “tax-exempt,” they don’t have to think about taxes. However, the federal government and certain states do impose taxes on nonprofit organizations. State and local tax laws in particular are constantly evolving, which presents the risk of an unexpected tax bill. In addition, the tax-exempt status of nonprofits can be statutory, predicated on an application, or based on the purpose, volume, or frequency of activity. Changing types or amounts of activity can result in new or unexpected tax obligations, especially when operating across state lines. Therefore, it’s important for nonprofits to pay attention to three major categories of state and local tax risk: payroll, unrelated business income activities, and sales and use tax.
Payroll
Generally, nonprofit organizations aren’t exempt from federal or state payroll tax and the corresponding withholding requirements. As a result, payroll tax considerations are similar to commercial enterprises. The general rule is that employers must withhold payroll taxes in the jurisdiction in which their employees perform the work. An organization can also be responsible for withholding local payroll taxes in addition to those at the state level, depending on where employees reside and work. The rise of the remote workforce has required many organizations to reconsider their withholding requirements.
Specific registration and withholding requirements vary widely between taxing jurisdictions. Certain states have reciprocity agreements, where the employer is relieved of withholding income tax in certain circumstances.
Other payroll considerations include state requirements to pay unemployment insurance and workers’ compensation. Exemptions from unemployment and workers’ compensation requirements do vary, and some nonprofit organizations may be exempt from paying unemployment insurance and workers’ compensation based on the number of employees in a state.
Unrelated business income
The federal government imposes income tax on exempt organizations for income earned from activities that aren’t substantially related to the organization’s tax-exempt purpose called unrelated business income (UBI) activities. To further complicate matters, some states also impose their own UBI taxes. Depending on the type of organization reporting UBI, states like Michigan require UBI to be reported on the corporate income tax forms, while others such as California have their own dedicated UBI forms.
Typical examples of state UBI include income from alternative partnership investments or retail/merchandising sales that fall outside of the organizations exempt purpose. An analysis should be done to determine if your organization is subject to UBI in a given state and, if so, on which form you should report the income.
Sales and use tax
Sales tax is imposed at the state and/or local level on many types of transactions, and the seller is generally required to collect and remit to the state. In other situations, use tax may be levied on certain transactions where sales tax hasn’t been imposed, such as transporting inventory or materials into a state or purchasing taxable services or tangible personal property from an unregistered vendor. Sales and use tax exemptions can be statutory or application-based, which may require a special authorization from the state taxing authority.
An important concept that impacts a state’s ability to require an out-of-state organization to collect sales or seller’s use tax is nexus: the physical or economic presence necessary when operating or shipping products across states lines. Historically, states used physical presence to determine the requirement of nexus, but the 2018 U.S. Supreme Court case, Wayfair v. South Dakota, expanded the authority of states to create nexus based on economic presence that’s usually established by either gross receipts derived from a state, the number of in-state transactions, or both.
Nonprofits must also consider the types of services or tangible personal property they sell, as sales taxability can vary dramatically. Examples to watch for might include on-site food service, gift shops, fitness centers, healthcare services, and salons.
The practice of bundling services can further complicate matters. For example, an exempt residential care facility that provides on-site food service must separately consider the taxability of food served to residents, employees, and visitors, as well as whether sales to residents are separately charged or bundled as a part of the residency contract. Further, organizations that sell tangible personal property may be required to collect tax in other states, even if the sale is related to the organization’s exempt purpose.
Take stock of potential tax exposure
Nonprofit organizations must keep on top of potential state and local tax exposure for payroll, UBI, and sales and use tax. Depending on your activities, opportunities may be available to mitigate exposure for prior years. If your organization potentially falls within a state or local tax risk category, consult your tax advisor about your current activities and new activities undertaken each year.
