Imagine this — and, unfortunately, it may be easy: Your largest private donor, a foundation, has whittled down its funding amounts to reach more organizations. And since the onset of the recession, individual donations to your nonprofit have dropped by 45%. Meanwhile, your not-for-profit’s expenses, and ambitions, continue to climb.
Don’t throw up your hands in despair yet. To be less dependent on others for your survival, you could consider forming your own for-profit subsidiary.
What should a nonprofit consider before taking on the cost and responsibility of establishing a for-profit company? You’ll need, of course, to weigh the pros and cons.
Avoiding unrelated business income (UBI) is the top reason why not-for-profits create a for-profit enterprise. A nonprofit can conduct a certain amount of revenue-producing activities unrelated to its mission, but it will pay tax on unrelated profits.
And if the IRS determines that the organization is pulling in too much gross revenue or net income, or the staff is spending too much time on UBI activities, it could revoke the nonprofit’s coveted tax-exempt status. To avoid such scenarios, the nonprofit can usually transfer its UBI activities to a for-profit subsidiary.
The subsidiary needs to be separate in structure and governance and must not be an agent or integral part of the parent nonprofit. The subsidiary can make payments to the nonprofit parent that generally aren’t considered UBI. As long as the two organizations maintain separate identities, these payments can fund activities that fulfill the nonprofit’s mission.
Let’s say the fictitious Food Cupboard of America (FCA) has a highly profitable commercial bakery and draws a significant portion of its revenue from the enterprise. FCA can create a for-profit subsidiary to handle its baking activities to avoid endangering its tax-exempt status.
Gain flexibility and lower risks
Other reasons exist for launching a for-profit. First, the new entity will likely have more latitude in determining compensation. A nonprofit is required to publicly disclose the compensation of key employees, but there’s no such requirement for a privately held for-profit entity. In addition, a subsidiary can attract and keep highly skilled employees in ways that are unavailable to tax-exempt entities, such as through profit-sharing and stock compensation.
For example, the FCA bakery might want to hire a well-known expert to formulate a special recipe for multigrain bread. If the FCA forms a bakery subsidiary, it might be easier to create a compensation package that will attract a top chef.
Access to financing is yet another plus. Banks are typically more apt to lend to a for-profit entity. And private investors can invest in such an entity — an option unavailable to nonprofits.
Finally, a separate entity can keep certain legal and uninsurable risks of the commercial activity away from the nonprofit.
Pinpoint the pitfalls
Despite the potential pluses, setting up a for-profit subsidiary comes with pitfalls. The not-for-profit needs to ensure that it has established and is maintaining a separate identity for the for-profit or it will endanger its tax-exempt status. Also, if the for-profit subsidiary is a corporation owned solely by the nonprofit, any profits paid as dividends to the parent will be limited to the amount left after paying tax at the normal corporate rates.
The nonprofit also must have a realistic idea of what taking on a for-profit endeavor will mean for the organization. Establishing a separate entity has its own costs and complexities, such as management, personnel, tax, audit and other requirements.
If your organization is considering a for-profit subsidiary, seek legal and tax advice at the onset. You’ll need to decide, for example, if the C corporation structure — the most popular structure for for-profit subsidiaries — is right for your goals. Forming a limited liability company is another option, although the tax consequences are quite different.
Additionally, your CPA can help you conduct a feasibility study. If your idea survives, he or she can assist you with your business plan and work out how to capitalize your endeavor.
Be aboveboard and business-like
Care must be taken to handle all business transactions properly. Neither the subsidiary nor the nonprofit should distribute to the nonprofit’s board members or key employees any amounts above fair compensation for the services or products received. That action could be considered an excess benefit transaction and is strictly prohibited. Any transactions between the parent and subsidiary, such as rental of shared space or sales of intellectual property, need to be at arm’s length and supported by independent valuations when significant.
Nonprofit executives who’ve successfully created for-profit subsidiaries report that hiring employees with relevant business experience is a key to success. Nonprofit employees — skilled and talented as they may be — often lack such experience and a profit-driven focus.
Creating a for-profit subsidiary can be a good way to help fulfill your not-for-profit’s funding needs. Just be realistic and make sure that your new funding source doesn’t jeopardize your organization’s tax-exempt status.