When creating a for-profit subsidiary, it’s important to remember why the arrangements have become standard for tax-exempt organizations. Most commonly, nonprofit entities create a for-profit subsidiary to separate unrelated business activity from the parent organization, protecting it from violating the primary purpose test, which ensures that the nonprofit isn’t organized or operated for the primary purpose of carrying on an unrelated trade or business. Therefore, the nonprofit itself must remain focused on fulfilling its exempt mission.
But before forming and operating a for-profit subsidiary, remember that it requires significant planning and proper guidance from the appropriate legal and accounting professionals. Depending on the underlying reason for creating the new entity, several common issues could arise and need addressing throughout the process, including:
The structure of the new entity:
At the outset of creating a for-profit subsidiary, the parent organization will need to decide how ownership of the new entity will be structured. There are three primary methods for establishing control of a newly formed corporation. The new entity will either be wholly owned, majority-owned, or minority-owned. Keeping in mind that most parent organizations will want to maintain control over the new subsidiary, most choose to be wholly owned or majority-owned entities. Under these options, the parent organization could control the for-profit subsidiary by maintaining board overlap or stipulating that the parent organization can appoint the board in the governing documents. Additionally, the subsidiary could be a membership organization with the parent organization established as the sole member, granting it the ability to control the overall composition of the board. The subsidiary could also issue stock, with the parent organization retaining the majority of it. The preferred entity type is a C corporation, allowing the for-profit entity to pay the profit tax. If an S corporation or partnership entity type is selected, this generates pass-through income on a Schedule K-1, resulting in an additional tax filing requirement for the tax-exempt entity (Form 990-T).
Capitalization of the new entity:
Once the new entity is formed, the parent organization may consider allocating the subsidiary with necessary funds to pay the operating expenses associated with the operation of a for-profit corporation, including vendors and staff. They may loan the money to the subsidiary using terms generally offered to the public. This agreement should be documented in writing. Another option would be to make a contribution or grant to the newly formed subsidiary. However, most often, the subsidiary will be conducting unrelated business activities, making such a grant by the parent organization incompatible with its exempt purpose.
Attribution and Cost-Sharing:
While the use of for-profit subsidiaries by exempt organizations has become commonplace, tax-exempt parent organizations should take precautions to ensure that the subsidiary establishes itself as a separate legal and tax, and separate operating entity from the parent organization. Exempt parent organizations can share resources with the taxable subsidiary through a cost-sharing arrangement, including shared staff, offices, facilities, and equipment. This can be done without additional risk so long as the parent organization ensures reimbursement for the full fair market value on any goods or services shared with the subsidiary. The IRS may scrutinize parent-subsidiary relationships that appear to lack a legitimate intent to have substantial business functions. It’s important to remember that as long as there is no “clear and convincing” evidence showing that the subsidiary is acting as an agent of the tax-exempt parent, the subsidiary’s activities will not be attributed to the parent. However, in situations where the parent organization controls the affairs of the subsidiary closely, including when the parent organization is directly involved in the day-to-day management of the subsidiary, the subsidiary may not be regarded as a separate entity, and could jeopardize its tax standing.
Exempt parent organizations have the burden of demonstrating their intent to use the substantial assets of their subsidiaries to further their mission. This often means making dividend payments to the parent organization, or stock being sold to generate proceeds to fund program activity at the parent organization. It’s crucial that the parent organization not use its exempt assets to expand the commercial business of the subsidiary. The IRS particularly pays close attention to nonprofit founders who create subsidiaries and benefit unreasonably from their accumulated gains. Signs of potential abuse include de minimis levels of exempt activities by the parent organization and the lack of intent to use any of the earnings of the subsidiary for exempt purposes of the parent organization—all of which can jeopardize the exemption of the nonprofit parent organization.
501(c)(3) exempt parent organizations should be aware that the structure of a tax-exempt parent and taxable subsidiary may create issues regarding employee compensation, as these organizations are subject to limitations on how they can compensate their employees. Compensation must be considered reasonable and cannot exceed the fair value of the services rendered to the payor. Any payment the subsidiary makes to officers, directors, trustees, or key employees of the parent organization must be reported on the annual information return of the parent organization, as wholly or majority-owned subsidiaries should be listed as related entities. If the subsidiary is formed as a stock-based corporation, there is the opportunity to issue stock and ownership to third parties. While this sort of stock issuance is permissible and would not jeopardize the exempt status of the parent organization, there is an inherent risk involved. The best practice is for a sub-committee of the board (i.e., executive committee or compensation committee) to conduct market research and studies to determine “reasonable compensation” for management and highly compensated individuals. This sub-committee then presents the results and recommendations to the entire board for approval.
The creation of a for-profit subsidiary is a common occurrence for many nonprofits. While doing so, it’s vital to protect the parent organization from any appearance of impropriety. If you have questions about organizing your for-profit subsidiary, contact your CRI advisor. We’re prepared with the answers you’ll need to minimize risk and undo liability to the exempt parent organization and its assets.
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