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. Is that earned income?
Depends on Opportunity to Profit
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. (From Charles King)
Depends On Deliverables
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. (From Tonia Papke)
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. (Warren Tranquada)
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 . . . (From Jerr Boschee)
From a Lawyer
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. (From Allen Bromberger)