What begins as a revenue generating idea for a nonprofit can sometimes develop into a larger endeavor, possibly requiring consideration of a subsidiary to house the planned activities. Many times, these are activities that mix social and business purposes, and the programs or entities that operate them are often referred to as social enterprises. The definition of a “social enterprise” is a controversial subject to be discussed in a future post. Here, however, we will look generally at the issue of a social enterprise affiliated with an already existing nonprofit corporation, and specifically at whether these activities should be done within the existing nonprofit, moved into a subsidiary (nonprofit or traditional for-profit), or moved into a new form of hybrid entity.
Unlike for-profit corporations, tax-exempt nonprofit corporations are generally exempt from taxes on their income. As addressed in Part I, one caveat is that earned income must be from a related business activity to be nontaxable income; earned income from an unrelated business activity is subject to the unrelated business income tax (UBIT) at the corporate rate. In that sense, earned income from related activities gives the nonprofit entity the biggest slice of the pie available. Aside from maximizing nontaxable income, housing the activities within the existing nonprofit can offer other value as well which may still make it a preferable option even when dealing with unrelated business activity (so long as it is insubstantial). Reasons for keeping the activities within the existing nonprofit may include:
- It increases publicity and community relations for the nonprofit.
- It diversifies the nonprofit’s revenue stream.
- It leverages the nonprofit’s name and goodwill.
- It creates job opportunities.
- The majority of funding is likely to come from donors or grants.
- There is a strong connection between the activities and the nonprofit’s mission.
- The potential collaborators prefer, or are required, to work with exempt entities (e.g., USAID).
A nonprofit should also consider non-legal considerations, which can be just as important, if not more, depending on the circumstances. For example, in his article “Integrating Social Enterprise with Other Revenue Streams,” Tom Triplett highlights four examples of problems that can occur:
- Cultural dysfunction – The idea of earning income by selling goods and services is so at odds with a nonprofit “giving mentality” that the nonprofit is unable to embrace or maintain an entrepreneurial spirit critical to the activities’ success.
- Conflict with mission – The pursuit of earned income becomes viewed as competing with the nonprofit’s core mission, particularly if attention and resources are shifted to the new earned income activities.
- Concerned stakeholders – External stakeholders (rather than internal stakeholders such as staff) become troubled (and possibly turned off) because they view the nonprofit as operating like a “business.”
- Different service focus – Concern arises among various stakeholders due to the nonprofit’s shifted focus from the original constituents to new services, clients, or locations.
As Triplett suggests, there are avenues for working through these issues such as using a third party trainer or facilitator to help all board and staff understand how the earned income activities are consistent with the nonprofit’s mission. Thus, these types of issues do not necessarily mean the activities should not be conducted by the nonprofit, but the existing nonprofit has a responsibility to consider beforehand what types of obstacles are presented prior to taking on the activity and the effect they have on the health and effectiveness of the existing nonprofit.
A subsidiary, when formed correctly, is generally treated as a separate entity from the parent corporation for federal income tax purposes and liability purposes for claims arising out of the subsidiary’s activities; it can therefore provide much needed legal separation between the parent corporation and activities at issue.
As discussed in Part I of this post, the initial legal considerations for a nonprofit in conducting these activities include whether the income is categorized as related or unrelated, and if unrelated, whether the amount of activity jeopardizes the nonprofit’s tax-exempt status. If the activities are substantial in relation to the nonprofit’s overall activities and unrelated to its exempt purposes, a subsidiary or hybrid entity (discussed below) may be the only possibilities.
Additionally, depending on the type and nature of the activity, it can also raise any number of issues such as intellectual property or employment law matters. Sometimes this creates an exposure to liability that the existing nonprofit does not feel comfortable taking on.
Thus, reasons for electing to form a subsidiary may include:
- It provides more protection of the existing nonprofit's tax-exempt status from unrelated business activity issues.
- It protects the existing nonprofit from debts and claims involving the subsidiary and its activities.
- It provides a greater liability shield for the existing nonprofit from uninsurable risks arising out of the activities.
- It better preserves the existing nonprofit’s organizational culture by keeping the activities outside of the organization.
- It minimizes the association between the existing nonprofit’s reputation and goodwill and the reputation and goodwill of the activities.
- The existing nonprofit lacks the organizational capacity (e.g., time and resources) to manage and run the activities.
- The type of operation and workforce needed to conduct the activities, even if related or unrelated and insubstantial, are not complimentary or are disruptive to the existing nonprofit.
The activities can still be housed in a nonprofit through a nonprofit subsidiary for which the earnings are then contributed to the parent nonprofit corporation.
Reasons for choosing a nonprofit subsidiary may include:
- The subsidiary can still add a “halo effect” of being a nonprofit.
- The activities qualify for an exempt purpose (need not be the same exempt purpose as the existing nonprofit).
- The income is nontaxable to the subsidiary (if related).
- The funding will most likely come from donors or grants.
Alternatively, an existing nonprofit may instead determine the activities are better suited for a for-profit entity.
Reasons for dropping the activities into a for-profit subsidiary may include:
- The activities would not qualify under any exempt purpose.
- The subsidiary would not be subject to nonprofit or tax-exempt rules.
- The funding is from private investors.
- It still provides a nontaxable revenue source to the existing nonprofit through dividends (though taxable income to the for-profit subsidiary).
Robert A. Wexler of Adler & Colvin provides a helpful summary in his article, “Revenue Generating Activities,” on the challenges of using a for-profit subsidiary such as:
- The prudent investment standard for the charity’s investment in the entity.
- The costs incurred to form a new entity and increased challenges in maintaining both organizations.
- The requirement that the charity must receive fair market value for licensing, resource sharing/allocation, office rental, mailing list rental, and other agreements with the entity.
- The issue of a for-profit subsidiary being treated as a “controlled organization” (and therefore, amounts received by the nonprofit would be subject to UBIT under I.R.C. Section 512(b)(13)).
While a subsidiary can provide greater legal protection to the parent corporation, such protections are not afforded when the subsidiary is not actually operating as an independent entity. Whether forming a nonprofit or for-profit subsidiary, maintaining formal separation between the parent and subsidiary is critical so that the activities of the subsidiary are not attributed to the parent nonprofit corporation. Additionally, if there is an overlap between individuals involved, the existing nonprofit should take special care in helping individuals understand their respective roles and the value of appropriate procedures and policies for issues such as conflicts of interest. (More information on subsidiary-parent principles is available in the IRS Exempt Organizations CPE Text – For-Profit Subsidiaries of Tax-Exempt Organizations.).
New Hybrid Structures
In recent years, nonprofits have also been presented with the option of new legal structures that integrate social and financial returns within a single entity. There is much to say about hybrid structures, but for purposes of this post, we will only briefly highlight the two structures currently enacted into law in various states, the Low-Profit Limited Liability Company (L3C) and Benefit Corporation.
The L3C was first enacted by Vermont in April 2008 and is designed to attract private investments and philanthropic capital in ventures designed to provide a social benefit. Unlike a standard limited liability company, the L3C has an explicit primary charitable mission and only a secondary profit concern. But unlike a charity, the L3C is free to distribute the profits, after taxes, to owners or investors. (More on the L3C is available at the Americans for Community Development website and in our previous posts, “L3C - Low-profit Limited Liability Company," "L3C - Developments & Resources," "Private Letter Rulings and the L3C," and "L3C and Charitable Trust.").
The Benefit Corporation was first enacted by Maryland in April 2010 and is intended to create a triple bottom line of “people, planet, profits” by requiring, among other things, that the corporation create a material, positive impact on society and the environment (i.e., a “general public benefit”); consider the effects of any action or decision not to act on stockholders, employees, customers, the community, and the environment; and comply with public reporting requirements on the corporation’s pursuit of its general public benefit. (More on the Benefit Corporation is available at the B Corp Public Policy page on Benefit Corporation Legislation and in our previous posts, “Maryland’s Benefit Corporation” and "Corporate Flexibility Act of 2011.").
The challenges and strategies for forming and running hybrid entities are still developing as these are relatively new legal developments. Certainly though, using such structures will require consideration of how to communicate their value to investors over the traditional for-profit-nonprofit binary as well as how to successfully integrate what is sometimes viewed as an incompatible dichotomy of for-profit and nonprofit systems (e.g., organizational cultures, values, etc.) under one roof.
Regardless of the structure ultimately selected, Wexler provides a useful starting point checklist in considering different legal structures in his article, “Effective Social Enterprise – A Menu of Legal Structures”:
- Draft a business plan prior to looking at legal constructs (i.e., form must follow function).
- Identify your fundamental program, activity, good, or service.
- If not all activities would qualify for exempt status, determine whether they can be separated or are too closely linked.
- Identify sources of capital.
- Address what, if any, personal benefits founders want or need to derive from the activity.
- Address the level of importance of control to the founders, both short-term and long-term.
- Explore any perceived branding issues (e.g., Is the “halo effect” essential to the success of the activity?).
"The Profitable Side of Nonprofits - Part I: Earned Income" is available here.