Fiscal Sponsorship: What You Should Know and Why You Should Know It

About the Authors:

Erin Bradrick is senior counsel at NEO Law Group in San Francisco, and a contributor to the Nonprofit Law Blog. Her practice is focused solely on providing corporate, charitable trust, governance, and tax counsel to nonprofits and exempt organizations of all types and sizes.

For lawyers who work with nonprofits and exempt organizations or individuals with philanthropic aspirations, “I want to start a nonprofit” may be the single phrase they hear most frequently. However, the most valuable advice an attorney can give to a client seeking counsel on starting a nonprofit might be to not do so. While forming a nonprofit corporation and applying for income tax exemption will be the right choice for some clients, there are often alternatives that may more efficiently and effectively allow a client to achieve his or her charitable goals. Fiscal sponsorship is one such alternative.

Fiscal sponsorship is a contractual relationship that allows a person or organization that is not tax-exempt to advance charitable or otherwise exempt activities with the benefit of the tax-exempt status of a sponsor organization that is exempt from federal income tax under Internal Revenue Code (IRC) Section 501(c)(3). When done correctly, fiscal sponsorship can be a great tool for fulfilling a client’s charitable goals without necessarily requiring the formation a new nonprofit entity, application for tax-exempt status, or compliance with ongoing filing and registration requirements. However, when fiscal sponsorship is done incorrectly, the Internal Revenue Service (IRS) can view it as a mere conduit relationship. This can lead to problems for both the sponsor organization and the sponsored project, as well as for donors. 

Because fiscal sponsorship does not refer to a relationship that is defined by the law, it may take many different forms. Understanding the most common forms of fiscal sponsorship and how they may be properly structured can enable an attorney to provide invaluable advice to clients seeking to start a charitable venture. This article provides an overview of several common forms of fiscal sponsorship and how they may be appropriately designed to benefit your clients.

Comprehensive Fiscal Sponsorship 

In what is probably the most common form of fiscal sponsorship, the sponsored project becomes an internal program of the fiscal sponsor. The pros and cons of this form of comprehensive fiscal sponsorship should be explained to and weighed by a client seeking to start a charitable venture. On the potential pros side, because the project becomes an internal program of the fiscal sponsor, it is not a separate legal entity and does not have its own initial or ongoing filing or registration requirements. Similarly, the sponsor will attend to many of the administrative requirements that would otherwise apply to the project if it were a separate entity. However, on the potential cons side, because the project is an internal program of the sponsor, the project’s founder will relinquish to the sponsor’s board of directors legal control over and ultimate oversight responsibility for the project. The funds raised in support of the project will also legally belong to the sponsor and the sponsor will have final discretion and control over the use of such funds. In addition, most fiscal sponsors will charge a percentage (often around 5–15 percent) of funds that are raised to support the project as an administrative sponsorship fee. Critics of fiscal sponsorship may scoff at the sponsorship fees that most sponsors charge. However, proper administration of a fiscal sponsorship relationship can be costly and the cost savings for sponsored project in the form of avoided administrative and startup fees can be significant. When viewed in this light, a reasonable sponsorship fee that serves to cover the sponsor’s expenses in a proper fiscal sponsorship relationship is often appropriate. 

For a project that is seeking comprehensive fiscal sponsorship, the importance of selecting the right fiscal sponsor – and not just the one with the lowest administrative fees – cannot be overemphasized. The sponsor’s board of directors will typically delegate day-to-day management of the project to a program director (often the project’s founder) or to a group of individuals (such as a program advisory committee). However, any individuals paid in connection with operating the project will be employees or independent contractors of the sponsor and any volunteers acting on behalf of the project will be doing so as agents of the sponsor. In light of the sponsor board’s ultimate oversight and control over the project, it is essential to seek and find the right fiscal sponsor for the particular project. The right fiscal sponsor likely has prior experience with successful fiscal sponsorship, is financially and organizationally healthy, has exempt purposes that are aligned with the purposes of the project, and provides a culture fit that will enable the project to be carried out according to your client’s intentions. 

Similarly, the fact that the project becomes an internal program of the sponsor in this form of fiscal sponsorship increases the importance of a written contract setting forth the terms of the relationship. Unfortunately, comprehensive fiscal sponsorship is sometimes entered into rather informally without the benefit of a written agreement. However, counsel to project leaders seeking fiscal sponsorship, or to organizations serving as fiscal sponsors, should insist on one. Because the law does not yet define fiscal sponsorship, the terms of the relationship, including the termination of the relationship, will be determined as set forth in a contract, if there is one. The contract should include language regarding (1) the activities of the project; (2) the creation of a restricted fund to house contributions received to benefit the project; (3) the sponsor’s retention of the ultimate right to determine the use of such funds (referred to as variance power); and (4) the sponsor’s sponsorship policies and fees, as well as any other terms relevant to the particular fiscal sponsorship relationship. 

From the perspective of the project’s leaders, it is also important that the contract contain a termination provision that permits the steering committee or other party to the contract to spin off the project to another Section 501(c)(3) exempt entity at a later time. Such a spinoff typically occurs either to another fiscal sponsor or to a new entity formed by the project’s leaders that has subsequently obtained tax-exempt status. The inclusion of an exit provision can make comprehensive fiscal sponsorship a particularly attractive option for a charitable startup that is risky or uncertain to succeed as it provides for an incubation period at an established sponsor, but with the right to transfer the project to a separate organization if it proves successful. 

Discussion of a written fiscal sponsorship contract, however, raises the question of who the appropriate party to the agreement is. The fiscally sponsored project will not be a separate legal entity once the fiscal sponsorship relationship is formed and, accordingly, should not be the party entering into the contract. Similarly, because some states may impose a minimum tax on corporations formed in the state, regardless of whether they have any income, it may not be advisable to form a separate corporation to enter into the fiscal sponsorship contract. Rather, in most instances, it will be preferable for the founders of the project to form a steering committee for the sole purpose of entering into and enforcing the fiscal sponsorship agreement. Because the individuals who form the steering committee are often the same individuals who the fiscal sponsor will designate as managers of the project, this can be a particularly tricky arrangement to explain to clients. However, this structure provides for a separate group of individuals (even if they are the same individuals involved with management of the fiscally sponsored project) with the legal right to enforce the fiscal sponsorship agreement if necessary. One additional point of caution is worth mentioning: the steering committee may constitute an unincorporated nonprofit association that may be subject to its own filing and registration requirements. The steering committee will also be subject to its own liabilities in connection with its actions. If the steering committee (as opposed to the fiscally sponsored project) is viewed as engaging in activities of its own beyond merely entering into and enforcing the contract, this risk may increase. 

Pre-approved Grant Relationship Fiscal Sponsorship

In another common form of fiscal sponsorship, the sponsor organization preapproves another individual or entity as a grantee, agrees to establish a restricted fund to receive contributions for the purpose of supporting the grantee’s charitable project, and makes grants to the grantee from the restricted fund. As with comprehensive fiscal sponsorship, the sponsor in a preapproved grant relationship fiscal sponsorship must ensure that the funds it receives in support of the project will be used in furtherance of its exempt purposes and in a manner consistent with the rules applicable to organizations exempt under IRC Section 501(c)(3). Accordingly, the sponsor should (1) conduct due diligence of the potential grantee in advance of entering into a fiscal sponsorship relationship, (2) have a written fiscal sponsorship agreement that sets forth the terms of the sponsorship and the purposes of the grants, and (3) require some reporting back regarding the appropriate use of the grant funds.

Preapproved grant relationship fiscal sponsorship may be particularly appropriate where a client desires legal control over the sponsored activities and ownership of the results of such activities. It may also be appropriate where a client requires sponsorship for only a short period of time, such as between when the client submits its federal exemption application and when it receives a favorable determination letter from the IRS. This form of fiscal sponsorship is relatively pervasive in the nonprofit sector and is especially common in the arts, where individual artists may often wish not to give up ownership of the intellectual property they create. However, it is often done incorrectly, particularly when structured without the advice of legal counsel. Sponsors also often step beyond the role of mere grantmaker to provide additional services to their grantees, making the relationship more complex. The risks of entering into an improper preapproved grant relationship fiscal sponsorship are high – the IRS may view the relationship as a conduit for making tax-deductible contributions to a nonexempt entity, collapse the transactions by disregarding the sponsor’s role, and deny donors deductions for such contributions. Obviously, this is likely to anger and alienate those donors, but it could also potentially lead to a lawsuit against the sponsor and a public relations fiasco.

When setting up this, or any other, form of fiscal sponsorship, a written agreement should be used and it should contain any provisions applicable to the particular relationship. Such provisions should include ones covering (1) the purposes for which the grant may be used and the limitations on such uses pursuant to the requirements under Section 501(c)(3); (2) the fact that the sponsored project remains a separate entity and the sponsor has no responsibility or liability for the programmatic work, fundraising, contracts, insurance, or other day-to-day activities of the sponsored project; (3) the sponsor’s ultimate control and discretion over the use of the funds deposited into the restricted fund and its variance power; (4) the sponsor’s sponsorship policies and fees; and (5) provisions for termination of the sponsorship relationship.

In order to ensure that the potential grantee will appropriately use the granted funds, the fiscal sponsor should conduct due diligence regarding the individual or organization in advance of entering into the fiscal sponsorship relationship. The scope of due diligence conducted may depend on many factors, such as whether the sponsor has had a previous relationship with the potential grantee, the nature of the potential grantee’s activities, the anticipated amounts to be granted, and the size of the potential grantee. However, at a minimum, it should likely include: receiving evidence that the entity was duly formed, is validly existing, and is in good standing; a review of the entity’s financial status; an assessment of the entity’s management to ensure its ability to successfully carry out the terms of the grant; and potentially a site visit, if appropriate. Once a fiscal sponsor has made grants pursuant to a preapproved grant relationship, it should also exercise oversight over the use of such funds to ensure proper and appropriate use by the grantee. This is often done by requiring the grantee to submit reports back to the sponsor regarding how the granted funds were used.

Preapproved grant relationship fiscal sponsorship often goes wrong when the fiscal sponsor agrees to provide additional services other than grantmaking to the sponsored grantee, such as administrative services, shared office space, or assistance with filings and registrations. Providing such services can turn the relationship into one that is more than a pure grantor-grantee relationship and can increase the risk of ascending liability from the sponsored project to the fiscal sponsor. In order to avoid this, a fiscal sponsor that wishes to provide services other than grantmaking to sponsored grantees should consider doing so only pursuant to a separate written agreement and possibly in exchange for fair market value for such services.

An advantage of preapproved grant relationship fiscal sponsorship is that it may be used to support certain activities carried out by individuals, foreign organizations, or even for-profit entities, so long as the grants are limited to use for charitable or otherwise exempt activities that are consistent with the exempt purposes of the sponsor organization. Although this model of fiscal sponsorship can serve as a great tool for advancing charitable goals, it often requires the assistance of knowledgeable legal counsel to get it right.

Recent Developments

It is worth mentioning a few recent developments that may have an increasingly significant impact on the field of fiscal sponsorship: the development of the single-member LLC form of fiscal sponsorship and the release of IRS Form 1023-EZ.

Single-Member LLC Fiscal Sponsorship

Because fiscal sponsorship is a contractual, rather than legally-prescribed relationship, it is possible for new models of fiscal sponsorship to be created and implemented, provided they comply with the provisions of the Internal Revenue Code and other federal and state laws applicable to organizations exempt under Section 501(c)(3). One such recently developed form of fiscal sponsorship involves the use of a single-member limited liability company (LLC). Extensive discussion of this model of fiscal sponsorship is beyond the scope of this article, but it is worth being aware of as an interesting emerging structure that may potentially be appropriate for some clients.

In a single-member LLC fiscal sponsorship relationship, an LLC is formed under state law with an existing Section 501(c)(3) exempt organization as its sole member and sponsor, thereby making the LLC wholly-owned by the sponsor organization, similar to a comprehensive fiscal sponsorship relationship. A single-member LLC that does not affirmatively elect to be treated as a corporation will be disregarded as a separate entity from its owner for federal income tax purposes. Accordingly, a single-member LLC with a Section 501(c)(3) exempt organization as its sole member will be treated as exempt itself and donors may deduct contributions made to the LLC directly or to the sponsor member according to the applicable rules.

Although the single-member LLC can be treated as part of the sponsor organization for federal income tax purposes, it remains a separate legal entity with its own liabilities which, assuming proper corporate formalities and separation principles are followed, should not ascend to the fiscal sponsor. This may make this model of fiscal sponsorship especially appropriate for activities with a higher risk profile than those of the sponsor or for activities that may not present a perfect cultural fit for the sponsor. However, it is important to note that the LLC will still be treated as an entity separate from its member for purposes of employment tax, certain excise taxes, and matters of state law.

Form 1023-EZ

In 2014, the IRS released the Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. The Form 1023-EZ is a three-page electronic application that some small organizations may use to apply for federal tax exemption in lieu of the longer standard Form 1023. The release of the Form 1023-EZ has reduced exemption application processing times significantly – some organizations that have applied for tax exemption using the Form 1023-EZ have reportedly received determination letters in a matter of weeks, as compared to the one year or longer that the IRS had previously told practitioners to expect to wait on applications made using the long Form 1023. Ultimately, the availability of the Form 1023-EZ and the ease with which a small organization may be able to obtain an exemption could decrease the demand for fiscal sponsorship, particularly comprehensive fiscal sponsorship.

Conclusion

Fiscal sponsorship in its many forms, a few of which are discussed in this article, can be a great tool for advancing the charitable intentions of your clients, particularly those for whom it may not be advisable to form a separate nonprofit. Attorneys can provide invaluable assistance to their clients by making them aware of the option of fiscal sponsorship, advising them as to the appropriate fiscal sponsorship structure to best achieve their goals, and helping to properly structure the chosen relationship pursuant to a written fiscal sponsorship agreement.

Additional Resources

People often refer to fiscal sponsorship as “fiscal agency” or to a fiscal sponsor as a “fiscal host” or “fiscal agent.” However, as the term “agent” is used in the legal context to refer to one who has been authorized to act on behalf of another, it does not appropriately describe a fiscal sponsorship relationship. In fiscal sponsorship, the fiscal sponsor is actually the entity with tax-exempt status and is exercising due diligence and oversight in determining whether to fiscally sponsor a project to engage in activities consistent with its own exempt purposes. Accordingly, “fiscal sponsorship” is a more appropriate description of the relationship.

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