Revenue generation continues to draw significant attention in the nonprofit sector. Rather than rely exclusively on donations, many nonprofits seek to become self-sustaining through earned income. While in some cases revenue may be generated by activities that clearly further the nonprofit’s mission, other activities may be desirable primarily for the revenue they produce or involve other aspects that do not fit neatly within a nonprofit (or tax-exempt) framework. In these situations, legal and business factors may favor the creation of a for-profit entity to carry on the activity.
While any nonprofit organization might consider launching a subsidiary, this article focuses on public charities that are tax-exempt under Internal Revenue Code Section 501(c)(3). Private foundations and nonprofit organizations that fall under other categories of tax exemption, like trade associations or social welfare organizations, will encounter compliance requirements specific to their tax-exempt status.
Why Would a Charity Want to Create a For-Profit Subsidiary?
Expanding Activities Beyond Those That Are Clearly Charitable
Although charities and other nonprofit organizations generally are exempt from income tax, they can incur tax on their unrelated business income. The unrelated business income tax, or “UBIT,” applies to income derived from a regularly carried on trade or businesses that is unrelated to the performance of the organization’s tax-exempt (e.g., charitable) functions. This tax was introduced in 1950 as a means to prevent tax-exempt organizations from having an unfair advantage by virtue of their tax-exempt status over for-profit, taxable competitors when they engaged in commercial business activities.
An organization potentially can derive significant income from unrelated business activity and pay any UBIT incurred. At some point, however, the activity may become so substantial that it could threaten the tax-exempt status of the organization. In that case, the entity may be well-advised to move the activity into a separate legal entity, such as a subsidiary corporation. There is no bright-line for how much unrelated business activity is too much for a nonprofit to conduct; housing the activity in a corporate subsidiary can avoid concern about when this line has been crossed.
In addition, it is not always clear under federal tax law when an activity might be considered unrelated to the charity’s tax-exempt purpose. For instance, operating a training program or publishing books, while educational, may too closely resemble a for-profit business to qualify as substantially related to a charitable purpose. An organization may focus on serving low-income or other underserved communities, or selling its product at a lower price only to other charities, in order to be comfortable that the activity is substantially related. However, a nonprofit organization with a successful business model may not want to limit the scope of its activities in this way. Instead, it may wish to increase revenue by offering its product or service at fair market value to the broadest audience possible. A for-profit subsidiary maximizes flexibility to pursue a wide range of profit-making activities and to take advantage of future opportunities as they arise.
Shielding the Parent from Liability
A nonprofit organization, especially one with a large endowment or other significant assets, may not want to risk those assets by operating a business with potential liabilities. In these circumstances, it may be prudent for the nonprofit parent to protect its other assets and activities by isolating the business in a limited-liability subsidiary. No social service organization, for instance, would want to see its programs for at-risk youth jeopardized if the day-care center that it also owns is sued.
Attracting Outside Investors
A for-profit entity can raise money for its business by offering equity to outside investors. The nonprofit organization is limited to relying primarily on contributions, loans, investment income, or earned revenue to finance its activities, but it cannot offer ownership interests in itself. When contributions and other sources of revenue are insufficient to sustain or grow an activity, additional capital may be necessary. The for-profit vehicle expands access to capital by attracting investors who are motivated by receiving a return, in addition to funders who are willing to donate to the nonprofit parent.
Attracting and Compensating Employees
A for-profit entity can offer equity compensation to employees and other profit-sharing opportunities that a nonprofit organization cannot. This flexibility may be important for attracting talent, especially when competing with for-profit employers. A for-profit subsidiary also may be able to compensate individuals without concern about providing excess compensation under state and federal laws that govern the nonprofit parent.
Spinning Off the Business
If the nonprofit organization ultimately may sell the business, it may be easier to segregate the activity in a subsidiary, where the business can be valued separate from the parent organization. The parent’s equity interest in the subsidiary also could be transferred, avoiding a potentially complicated process of identifying and assigning individual assets and liabilities from the nonprofit in order to transfer the business activity.
Public Disclosure and Perception
While the existence of a controlled subsidiary and certain transactions with that subsidiary will be disclosed on the nonprofit organization’s publicly available annual Form 990, the subsidiary’s activities will not be subject to the same level of disclosure as it would if the activity was conducted directly by the nonprofit organization (for instance, with respect to the subsidiary’s income and expenditures and possibly the compensation it pays individuals, depending on what other roles the recipients have with respect to the nonprofit organization.) The nonprofit also may prefer a clear separation between its charitable activities and any for-profit endeavors, to avoid mission drift or a perception that its charitable work has been tainted or overshadowed by profit-making objectives.
Other reasons also may exist for forming a separate legal entity (e.g., administrative convenience, availability of certain government funding, or requirements for operating in a foreign country).
What Are Some Disadvantages to Establishing a For-Profit Subsidiary?
Administrative Cost and Complexity
Two entities in general are more complicated to operate than one. The costs to form a subsidiary and maintain two separate entities therefore will be higher.
Corporate formalities must be observed to protect the separation of the entities. Each organization must have a separate governing body and should conduct separate board and committee meetings, with separate minutes taken. The entities also should avoid commingling assets by using separate bank accounts and should maintain an arm’s length relationship. If the subsidiary and the parent will share any resources such as office space or employees, or if one entity is going to provide goods or services to the other, or a license of any intellectual property, the entities should enter into a written resource-sharing, services, or licensing arrangement. A charity must receive at least fair market value for whatever it provides to the for-profit entity.
While the nonprofit parent will be the only (or at least the controlling) equity holder of the for-profit subsidiary and therefore will control the for-profit’s governing body, there are reasons to avoid complete overlap in the directors and officers of the two entities. Having some different directors and officers helps clarify when individuals are acting on behalf of the for-profit subsidiary versus the nonprofit parent; these lines can get blurred more easily if the directors and officers of both are identical. In addition, for transactions between the two entities, it may be desirable, or even required, for the nonprofit to have some board members who are not affiliated with the for-profit entity to approve the transaction.
A failure to segregate the subsidiary’s operations from the parent can result in the subsidiary's separate status being disregarded by a regulator or a court and the activities being attributed to the parent for tax, liability, or other purposes. The time and expense involved in properly maintaining two separate entities therefore should be considered.
Prudent Investment Considerations
If the subsidiary’s activities are not related to the parent’s charitable purposes, investment in the new entity should be a reasonable use of the organization’s resources and may need to satisfy a “prudent investment” standard. (See “Capitalizing the New Entity” below.)
Compliance with Securities Laws
Depending on the number, residence, and sophistication of any other investors involved other than the nonprofit organization, securities laws may apply; this can involve compliance costs and delays. However, if participation is limited to the nonprofit, or to a small number of outside investors in addition to the nonprofit, securities-law compliance costs may not be significant.
Winding Down the New Entity
In order to wind-down a subsidiary, a dissolution process may be required. In addition, when a for-profit corporate subsidiary is dissolved, the subsidiary’s assets are deemed to be sold, potentially resulting in adverse tax consequences. This may make it difficult to liquidate an existing corporation. The nonprofit parent should consider its exit strategy before establishing a new entity.