Losses by Charities Create Conundrums
By: Arthur Drache

Most people who give some thought to the rules relating to charities carrying on businesses think that the primary purpose of these rules was to limit the ability of tax-exempt organizations to compete in the market place with taxable entities.

But they are wrong.

When the rules limiting business activities to those which are "related" were developed in the 1974-75 period, competition was not a significant issue for policy makers because there was so little. The key policy problem was to try to discourage activities which could produce losses for a charity.losses which might be extremely difficult to make up and losses which would ultimately have a negative effect on the ability of a charity to fund its core charitable activities.

Of course, losses can occur from other activities, primarily those related to fundraising. We have all heard of "galas" where the organizers did not recoup their costs, much less raise funds.

Earlier this year The Royal Columbia Hospital of British Columbia sustained a $3 million loss on a house lottery. The reason was essentially that after a four year hiatus, they re-entered the lottery market which was saturated.

It was the letter to donors which the Foundation issued which we found interesting, not because there was anything wrong but because it emphasizes how the loss would be dealt with.[1]

"RCHF will access unrestricted funding to meet the loss. Unrestricted funding takes the form of revenues such as parking, television rentals, marketplace and undesignated investments. While we continue to meet our funding commitments to the hospital as planned, we will also be committed to rebuilding our reserves over the next few years. All donor money will be used as directed by our supporters and channelled to meet the needs of RCH."

The Foundation obviously has capital to help absorb the loss but reading between the lines, funds donated which are not specifically earmarked will go to re-building reserves.a pretty hard sell to pitch to donors.

Consider this hypothetical which is based on a facts situation we faced a few years ago.

The charity ran a home for abused women out of rental premises. As with most such operations, almost every cent went to operations and there was no capital on hand.  Out of the clear blue sky, an individual approached them and offered $500,000 to allow them to buy a house.[2] They accepted the money, bought the house mortgage free and started operating from the new premises.

Two years later they were horrified to find that their donor had been involved in a major financial fraud. Some of the victims approached the charity and asked that the donation be returned. A legal opinion told them that there was no legal obligation to do so. But the directors felt that there was perhaps a moral obligation and started to look at options.

An informal opinion from the CRA elicited the opinion that the regulator would not oppose a repayment even though the money would be paid to a non-qualified donee,.[3] the trustee in bankruptcy of the donor.

But that didn't solve the problem. Where would be money come from?

The only options seemed to be to (a) sell the house at a loss and scale down operations or (b) get a mortgage. A bank was willing to give a mortgage on very fair terms.

But the board was split on the moral issue. One group felt that given the opinion that there was no legal obligation to return the gift they should retain it and continue to operate. The second group felt that it was "tainted money" and should be returned, not matter what the consequences.

The decision was made based on the concerns of the executive director who also was in charge of fundraising. How, she asked, can we go to our usual supporters and ask for money which they know will be going to repay a debt which we had no legal obligation to incur.and if the money is used for this purpose, how will we maintain our day to day operations?

By a close vote, the Board decided not to return the donation and the charity has operated well and efficiently for several years since.

Now this scenario was not based on a business or fundraising situation where the board should consider risks before taking the initial step. But the ex post facto issues are similar, namely the need for calling upon future donors and donations to fund past errors.

We can't think of a single organization which would turn down a windfall gift unless questions about its provenance were staring them in the face. But when boards are faced with making decision of major fundraising events or new business enterprises (even if they are "related") the possibility of losses should be high on the agenda. If after discussions, the decision to go ahead is made, so be it.though good practice would require that there be at least a not in the minutes that the downside of the enterprise was given full consideration.

Losses and charities don't mix well together (which explains some parts of the legislative restrictions) so prudence suggests that when there is risk to a particular course of action, some thought is given to how the charity will cope if the worst case scenario develops.