It is fairly common for a parent corporation to set up a subsidiary in part because it intends to enter into some business transactions with that subsidiary. For example, a 501(c)(3) nonprofit (referred to generally as a nonprofit in the rest of this post) and for-profit in a parent-subsidiary structure may enter into arrangements such as a transfer of programs, license to use intellectual property, split of royalties, or payment of dividends. Transactions between nonprofits and for-profits will generally trigger more scrutiny in a parent-subsidiary context because of concerns related to control and separateness (as discussed in Part I) and especially when benefits are conferred by the nonprofit to the for-profit. Below are some key considerations for a nonprofit when entering into business relationships within a parent-subsidiary context.
Nonprofits are not prohibited from transferring assets or providing goods or services to a for-profit parent or subsidiary (see, e.g., PLR 201125043); however, such transactions generally result in heightened attention on the nonprofit entity in particular because nonprofits cannot be organized to benefit private interests and are subject to strict laws that require them to be organized exclusively and operated primarily for exempt purposes. For-profits, on the other hand, have much more latitude in entering into business arrangements that may benefit private interests.
Nonprofits should not enter into this territory lightly as the IRS may deny or revoke tax-exempt status when impermissible benefits are conferred to a for-profit. The IRS has flagged issues, for example, when a nonprofit operated to provide a market for a for-profit business controlled by some of the nonprofit’s officers (see Church by Mail, Inc. v. Commissioner, 765 F.2d 1387 (9th Cir. 1985)); a nonprofit operated to increase income of a for-profit business owned by the nonprofit’s founder (see International Postgraduate Med. Found. V. Commissioner, 56 T.C.M. (CCH) 1140 (1989)); a nonprofit’s exclusive association with a for-profit business owned by the nonprofit's founders created substantial benefits for the for-profit (see KJ’s Fund Raisers, Inc. v. Commissioner, 63 T.C.M. (CCH) 669 (1997)); and a for-profit subsidiary carried on activities very similar to its nonprofit parent without any meaningful separation (see PLR 201044016).
Importantly, a nonprofit cannot assume a given transaction is in its best interest simply because the other party to the transaction is its parent or subsidiary. Common due diligence questions to ask before entering into a business transaction with any party, related or not, include:
- Is the transaction in furtherance of the nonprofit’s exempt purposes?
- Are the terms and conditions of the transaction fair and reasonable as to the nonprofit?
- Is the for-profit paying at least fair market value in exchange for the goods or services received from the nonprofit?
- Is the transaction being negotiated at arm’s length?
- Is entering into the transaction in the best interests of the nonprofit?
- Is there a conflict of interest, and if so, do we have a sound conflict of interest policy in place and are we enforcing it?
Additionally, when the parties have an ongoing relationship such as a parent-subsidiary relationship, it would be prudent to ask big picture questions that can help to expose red flags such as:
- Do the activities of the nonprofit steer customers to the for-profit?
- Does the for-profit benefit substantially from the nonprofit’s operations?
- Do any directors, officers, or employees of the nonprofit benefit financially from the for-profit’s operations (e.g., as shareholders or through other ownership interests)?
- Do the nonprofit and for-profit carry on similar activities and serve similar groups?
- Are the benefits conferred by the nonprofit to the for-profit or private persons, if any, incidental to the exempt purposes of the nonprofit?
Another important consideration for a nonprofit parent specifically is whether it will be taxed on the income received from a for-profit subsidiary. When a nonprofit sets up a for-profit subsidiary for the purposes of generating income, the for-profit subsidiary will distribute income to the nonprofit parent that is generally considered unrelated business income to the nonprofit. The general rule for nonprofits is that certain passive income such as rent, interest, dividends, and royalties are not subject to the unrelated business income tax (UBIT) under Internal Revenue Code section 512(b). Some of these exclusions may not apply however if the passive income comes from an entity controlled by the nonprofit. Therefore, at least two important inquires for a nonprofit parent will be (i) whether it meets the IRS’s definition of “control” which means owning “at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation” (IRC Section 368(c)); and if so, (ii) whether the income received has been properly classified by the nonprofit (e.g., dividends from a controlled entity continue to be excluded from UBIT under IRC section 512(b) while interest received will not be excluded from UBIT).
Accordingly, nonprofits that are involved in a parent-subsidiary structure with a for-profit must remember that the structure comes with both benefits and risks. The nonprofit and for-profit entities to a current or planned parent-subsidiary structure can help to maximize benefits and minimize risks by diligently exploring issues such as those that commonly occur with control, separateness, and business relationships.
"Part I: Control and Separateness" and is available here.