npE FAQ: Defining Earned Income
Here are some of the many responses we received following Dustin Stiver's question about defining earned income.
SEA defines earned income as "payments received in direct exchange for a product, service or privilege." Suppose a nonprofit receives a $500,000 grant to provide consulting services to other organizations, and the grantee intends to leverage this opportunity to build a sustainable fee-for-service consulting social enterprise. Dusin asked: Is that earned income?
(1) From
Charles King <king@housingworks.org>
The fact that a foundation is the source of the funds does not define whether or
not the income is earned. The question is whether it is a grant or is money
being paid in a fee-for-service manner. If a foundation gives us a grant to
expand out catering operations, that is not earned income. If it hires us to
cater a function, that is. If the foundation hires one to provide consulting
services that are costed out just like any other consultant's retainer, that's
earned income. The real test, in my book, is whether or not the arrangement is
structured in such a way that efficient production allows for a profit to be
earned.
(2) From
Jim McClurg <jim@se-alliance.org>
It's important that semantics not confound the fundamental difference between
earned income and grants. Earned income consists of payments in exchange for the
delivery of a product, service or privilege (as in cause-related marketing).
Grants on the other hand usually come with programmatic, ethical and political
strings attached, but they are generally non-recoverable in the absence of
egregious disregard for the donor's intentions. If the $500k provided by the
foundation in the author's hypothetical situation were presented in the form of
a grant, then despite its use as seed funding for a sustainable consulting
practice, it would not technically be classified as "earned" any more than any
grant is earned in the process of complying with the terms of the award.
(3) From
Allen Bromberger <allen@perlmanandperlman.com>
The difference between grants and contracts is elusive. This is partly because
almost all grants are accompanied by grant agreements which are contracts -
pursuant to which the grantee promises to do certain things and abide by certain
restrictions in exchange for the grant. This issue often arises when
classifying payments as "gifts, grant or contributions" (essentially donated
income) as opposed to "gross revenues" (essentially earned income) on the Form
990. Although the IRS rules are a bit fuzzy, the essence of them is that gifts,
grant or contributions are gifts in the sense that donative intent is present.
Gross revenues, on the other hand, come from transactions where a quid pro quo
is intended by the parties. In my opinion, you have to look beyond the
form of the transaction to its substance in order to classify it properly. In
your example, for existence, I would call that a contract, and would treat the
revenue as earned income, although the IRS probably allows you to treat it as a
gift, grant or contribution if you want. The way I see it the foundation is
purchasing service from the grantee. The fact that the contracting party is a
foundation, or that the operative agreement is called a grant, or that the
organization plans to offer similar services to other parties are essentially
irrelevant. The intent of the parties is the key. In your example, the quid pro
quo arrangement is central to the bargain. In a proper grant - where a donor
provides funding for a specific activity, the restrictions and quid pro quo
aspects are really regulatory in nature; they are an essential part of the
agreement, but not central to the bargain. If you want to know more, the
instructions to Forms 990 and 1023 provide some guidance on this issue and
provide examples of how different kinds of income should be treated for tax
purposes.
(4) From
Tonia Papke <tonia@mdiconsult.com>
Are you paid based on deliverables? If you are paid per hour of consulting, I
would count this as earned income. I would credit the total amount of the
"grant/contract" to deferred revenue and debit either cash or receivable. As you
perform the services, you would debit the deferred revenue and credit earned
income. If it's a grant without regard to deliverables, I would treat it
as a restricted grant.
(5) From
Jerr Boschee <jerr@orbis.net>
The example you provide qualifies as earned income only if there is a head-count
relationship between the work performed and the money received. For example, if
the Foundation requires the nonprofit to provide any and every type of
consulting service required by the 50 daycare centers, regardless of how much
time it takes or how many centers are involved, then the $500,000 is not earned
income: it's a grant (in effect, a subsidy). However, if the Foundation
has agreed to pay the nonprofit "x" dollars for each unit of consulting service
provided, then those dollars are earned; under that scenario, the nonprofit
ceases providing services once the $500,000 limit has been reached (and also
does not receive the full $500,000 if it does not provide enough units of
service). The danger is in the details, obviously . . . this sounds as if
it would be a wonderful opportunity for the nonprofit, but it's more on the
order of what in the commercial sector would be a seed capital investment by
somebody purchasing part ownership in the company . . .
(6) From
Warren Tranquada <warren.tranquada@pepintranquada.com>
Earned income has three characteristics:
-
Customer Relationship (the payer expects to directly receive benefit)
-
Continuing Operations (the activity is expected to continue - it is a business)
-
Social Purpose Organization (the organization receiving the money is governed by a mission)
So I would argue that a foundation purchasing consulting is earned income. In my mind, it doesn't matter who the customer is - it just matters that they are a customer. A grant doesn't apply, because the foundation is not getting a product in return and is not the end beneficiary of the work, but if you are doing consulting, that is a different story. The foundation is buying services delivered to it for its own uses. Then again, does it really matter what the definition is and how closely it fits? If it feels like earned income, then that is good enough for me.
(7) From
Jeffrey Stern <jeffrey.m.stern@gmail.com>
I believe that the SEA definition still provides sufficient guidance in your
example. The question arises not in how the income is intended to be used, but
in the circumstances of how it is received. In the example you give, my question
would be whether the foundation "gives" the organization the money as a grant
(thus meaning it is not earned income), or whether the foundation contracts with
the organization to provide these consulting services (thus meaning that the
consulting activities are earned income). In either event, I don't think
that the definition really matters in practice. Whether you define the income as
"earned income" or not, the questions that attorneys, accountants and the IRS
will want answered are whether the income is related to the organization's
mission and whether it is substantial or not (see SEA's UBIT resources for more
on this). If you are simply trying to determine whether this transaction
qualifies the organization as being entrepreneurial, or a part of the field of
social enterprise, I tend to focus on the larger issues of innovation and impact
(see Greg Dees' article at
http://www.fuqua.duke.edu/centers/case/articles/1004/corner.htm for more on
this).