The 85% Member Income Test: What 501(c)(12) Organizations Need to Know

Author: Mike Torgerson, Tax Partner

What should 501(c)(12) organizations know about the 85% Member Income Test and their tax filing requirements? 

Organizations exempt under Section 501(c)(12), including mutual ditch and irrigation companies and similar member-based organizations, are subject to tax rules that differ from those of many other nonprofits. 

One of the most important is the 85% Member Income Test. Understanding how the test works, and how grants and other sources of non-member income can affect it, can help organizations avoid unexpected filing and tax consequences. 

What Is the 85% Member Income Test? 

To qualify for tax-exempt status under Section 501(c)(12) for a given tax year, at least 85% of an organization’s gross income must consist of amounts collected from members for the purpose of meeting losses and expenses. 

For mutual ditch and irrigation companies, qualifying member income may include amounts members pay for services such as water. Interest income, gains from the sale of assets or securities, and certain other sources are not considered member income for purposes of the test. 

That distinction becomes particularly important when an organization begins receiving new or unusual sources of revenue. 

Why Grants and Other Revenue Require Attention 

A grant or other source of non-member income can change an organization’s overall income mix. Depending on the type and amount of revenue involved, that additional income may affect whether the organization continues to satisfy the 85% requirement. 

Organizations should consider the tax implications of significant new revenue sources before year-end rather than waiting until the tax return is prepared. 

Government grants also require careful analysis. The tax treatment and impact on the 85% calculation can vary depending on the organization and circumstances. 

What Happens if an Organization Falls Below 85%? 

Falling below the 85% threshold can have an immediate filing consequence. 

If a 501(c)(12) organization does not satisfy the Member Income Test for a tax year, it does not qualify for the Section 501(c)(12) exemption for that year and must file Form 1120, U.S. Corporation Income Tax Return, instead of Form 990 or Form 990-EZ. 

Importantly, failing the test for one year does not necessarily mean the organization permanently loses its 501(c)(12) status. If it satisfies the 85% requirement in a subsequent year, it may return to filing Form 990 or Form 990-EZ for that year. 

Planning Before Year-End Can Make a Difference 

Because the 85% test is applied annually, organizations should monitor their revenue mix throughout the year, particularly when they: 

• Receive significant grants or other non-member revenue 

• Generate investment or interest income 

• Sell assets 

• Experience changes in member assessments or operating revenue 

• Introduce new services or revenue streams 

Identifying these issues early gives management and its tax advisors more time to understand the potential impact, evaluate available deductions and depreciation, and plan appropriately before the end of the tax year.  For example, will accelerated depreciation options allow the organization to offset the taxable income resulting from grant income that is requiring the organization to file a Form 1120 (c corporation return)? 

Don’t Overlook Filing and Compliance Requirements 

The 85% rule is only one component of 501(c)(12) compliance. Organizations should also understand their annual filing obligations, maintain accurate documentation of member and non-member income, and periodically review whether their activities remain consistent with the requirements of their tax-exempt status. 

These considerations can be especially important when leadership or accounting staff changes. Processes that may have been familiar to a prior employee are not always documented or transferred to new personnel. 

How Can Squire Help? 

Want to learn more about the tax and accounting requirements for 501(c)(12) organizations? Join Squire Partners Mike Torgerson and Paul Winward on November 12, 2026 for our 501(c)(12) Tax & Accounting Essentials webinar, where they’ll discuss the 85% Member Income Test, filing requirements, and nonprofit accounting best practices. 

Register for the Webinar 

Have questions specific to your organization? Contact us at info@squire.com to connect with our team. 

About Squire 

Squire is an audit, tax, and business advisory firm with offices and teams across the Mountain West. With 50+ years of experience, we provide outsourced CFO and controller support, bookkeeping, payroll, sales tax, transaction support, ERP implementation and technology integration, helping businesses operate efficiently, stay compliant and achieve their financial goals. For more information, visit www.squire.com. 

The information contained in this article is provided for general informational purposes only and is not intended to constitute accounting, tax, legal, investment, or other professional advice. The information may not be applicable to your specific circumstances. You should consult with a qualified professional before taking any action or making any decision based on this information.