Eager to find alternative sources of revenue, and to help their surrounding areas at the same time, scores of colleges and universities have created research facilities in which they seek to nurture small businesses. And a recent ruling by the Internal Revenue Service,  allowing one community college and its foundation to raise and invest "pre-seed" money in startup companies, may clear the way for even more such entities.
In a private letter ruling issued in January but released this month, the IRS considered the case of an unidentified community college in an "economically depressed" area with a high unemployment rate and an "economy dependent upon heavy industrial and manufacturing businesses which have been downsizing." The economic problems have made it difficult, the IRS noted, for the college’s graduates to find local jobs.
The college proposed one potential fix -- a “state-of-the-art technology innovation center and resource hub,” undertaken with the county government and local chamber of commerce, to help start and develop new businesses -- and sought assurance from the IRS in advance that steps the institution might take to help get the businesses off the ground would not jeopardize its nonprofit status. Colleges and other tax-exempt organizations must pay unrelated business income tax (or UBIT) on revenues from activities that are not "substantially related" to the underlying purpose for which they get the tax exemption – education, in the case of colleges.
The community college was particularly concerned about one component of the proposed business incubator program, in which its nonprofit foundation would create a separate fund in which it would raise money from donors and then distribute “pre-seed capital” to startups in the incubator for “early-stage product development, marketing and business planning efforts.”
The college would provide the funds to entrepreneurs “on a matching basis for a small equity interest in the venture,” the IRS letter said, with the hope that any revenues would result not in profit but “as a mechanism to self-perpetuate the fund.”
Bertrand M. Harding Jr., a Virginia lawyer who specializes in college and university tax issues, said that the college probably sought advance approval from the IRS because its plan involved “direct cash payments,” which, while technically no different from other services that a nonprofit entity might typically provide to startup companies, “sounds a little bit worse” from a commercialism standpoint.
In the ruling -- which like all such determinations by the IRS formally applies only to the entity in question, but are closely examined by others for a sense of the government’s view -- the revenue service cites a range of precedents to conclude that the community college and its foundation would be on solid ground in providing the seed money, because doing so would clearly “further [its] educational and charitable purposes.”
“The educational opportunities created directly through pre-seed capital businesses located at the research and business incubator and associated with your progress with contribute importantly” to the institution’s teaching and curriculum,” improving opportunities for students and faculty members alike. the IRS said. “You will invest your pre-seed capital funds primarily in companies and ideas that further the educational mission of exposing students and faculty to cutting-edge, innovative business endeavors.”
In addition, the agency said, “the pre-seed capital fund is expected to assist in the promotion of professional specialty occupations, including high-technology and new-economy careers” in the local region. “These careers will enhance the geographic area to attract new industry and provide useful products and services that support economic growth, new jobs, and expanding businesses” – thereby improving “the overall economic area and further social welfare purposes.”
Not only will the college not jeopardize its nonprofit status by raising the funds, the IRS ruled, but those who make donations to its startup fund can deduct the money as charitable contributions.