Generating income to a non-profit has never been easy. Non-profits are struggling more than ever to create income to support their efforts. Although many people believe that a non-profit structure increases and accelerates the availability of operational funds, in fact the opposite is true. Non-profits face ongoing struggles generating benefactors and grants that will fund charitable operations. Non-profits are increasingly looking to the for-profit sector, with hopes of generating funds to pursue worthwhile, charitable causes. In fact, we are seeing an increase in non-profit creation of a for-profit venture.
A for-profit undertaking by a non-profit entity is wrought with significant hurdles and potential pitfalls. If not handled correctly, the venture can create unintended consequences, ranging from unexpected taxes to complete loss of non-profit status. To avoid such problems, non-profit executives must know about the options, benefits, costs, and risks associated with this undertaking.
In the event that a non-profit is considering any type of venture, the non-profit should know and consider the following:
1. Options as a Program of the Non-Profit
Many non-profits seek to simply create a for-profit program within the existing structure of non-profit operations. Certainly, doing so lowers any startup costs of the new undertaking. Assuming the administrative systems already exist for the non-profit operation, such ease of expanding that administration for an additional program is very appealing.
What many non-profits fail to recognize is the IRS perspective on such undertakings. To the extent there is a for-profit component within a non-profit entity, the undertaking is subject to the unrelated business income tax (UBIT). The undertaking is treated as subject to income tax, similar to a C-corp tax rate. The IRS will still expect taxes to be paid, which must be appropriately calculated and submitted. For example, if a non-profit university opens a pizza parlor for its students, those pizza sales are subject to UBIT.
The risk associated with operating a for-profit venture as a program within the non-profit is significant. In the event that the IRS believes that the unrelated business income is “substantial”, and that the non-profit is involved in significant profit generating activity, the IRS has the right to revoke the non-profit status. There is no clear line delineating what constitutes conduct which would forfeit a non-profit status. Revocation is subject to the discretion of the IRS. As a rule of thumb, if the undertaking is going to be anything more than a minuscule side activity, such as a pizza parlor relative to an entire university, it should be avoided.
2. A Subsidiary C-Corp Arrangement
Non-profits are allowed to invest funds in a reasonable and prudent manner. Likewise, a non-profit can invest in ownership of a business as an investment of the non-profit, provided it is financially sound to do so. Taken to its extreme, a non-profit can be a 100% owner in a for-profit business, under the same guidelines. Provided the investment is objectively prudent, which would best be confirmed through the analysis of a third-party business appraiser, a non-profit is safe in forming and owning an interest in a subsidiary C-corp entity.
In doing so, the non-profit must have clarity in purpose and organization to preserve its non-profit status. There must be separation of the for-profit subsidiary C-corp. The non-profit would have to recognize that the separate, for-profit entity will incur the tax liability of a C-corp entity. There are also costs associated with establishing separate operations, along with the startup costs and fees.
Of critical importance is the need to treat the subsidiary as a separate entity. While there can be some overlap in board members, our general recommendation is that the majority of the non-profit board members and the majority of the subsidiary for-profit board members consist of separate individuals, without overlap. The board members of each entity will have a strict duty of loyalty to the entity they serve. It is extremely difficult to avoid a fiduciary conflict if a board member is serving in both capacities.
As a simple rule of thumb, the non-profit should treat the subsidiary for-profit as an investment, and the non-profit should not be managing ongoing affairs nor receiving any benefits for non-profit board members or staff. This separation is critically important, and legal counsel should be consulted regarding the structural arrangements. If the subsidiary is not treated as a separate entity, the non-profit can risk losing its non-profit status.
3. A Sister C-corp Arrangement
A non-profit can establish a sister C-corp, again provided that it is sound, appropriate, and within the fiduciary obligations of the non-profit board. The concept would entail a shareholder’s agreement among the for-profit owners (who are not the non-profit). The business would be separate from the non-profit and its board. The corporation may have a shareholders agreement which provides that some amount of profits of the c-corp would be subject to distribution to the non-profit. This could even be done by contractual agreement with the non-profit, in exchange for the initial funding for the establishment of the for-profit entity. Otherwise, the shareholders could change their minds, amend the shareholders agreement, and keep the profits for themselves.
A sister c-corp would again require startup costs, establishment of separate operations, and payment of taxes.
4. Creation of a Separate Non-Profit
A non-profit has the option of creating a separate non-profit, if there are efforts that are outside the scope of the founding non-profit. Such a separate non-profit would still have to meet the criteria for non-profit status. If the IRS concludes that the separate non-profit is a thinly veiled for-profit entity, the IRS will revoke their non-profit status.
5. Public Benefit Company
Some states have adopted statutes, or are in the process of adopting statutes, to create a public benefit company. This is also known as a b-corp. A public benefit company is created with a clear purpose, specifically identified, and directed toward a public need. A public benefit company has no tax advantages. However, such company structures are increasingly attractive to investors, who want to know their investment dollars are being spent for the public benefit. Additionally, the specific scope of a public benefit company is binding upon subsequent owners and management. There is also an appeal to employees who agree with the vision and purpose of the organization.
The legal structure is similar to a c-corp. However, there are additional reports required under some state statutes. The owners have a heightened duty to establish that they are continuing efforts directed toward the public need which they have identified, and that they are making progress in those efforts. Again, because each state is different in this regard, it is important that legal counsel be sought for specific requirements of a public benefit company.
For a non-profit to establish a public benefit company would lessen these advantages. Unless the non-profit seeks to sell the ownership interest, there is no need to attract investors through a public benefit company. Additionally, there is no need to undergo additional corporate structure to convey benefits to employees, as the efforts of the non-profit in forming the entity should convey the values, priorities and level of commitment to employees. Additionally, the public benefit company creates a heighted fiduciary duty among owners, including the non-profit, and could potentially require additional reporting requirements. Overall, a public benefit company is not recommended as a non-profit subsidiary, unless the non-profit has the intention to sell the entity in the future, and wishes to ensure that the entity will continue to remain committed to the goals for which the corporation was established.
Overall, there is a genuine need for non-profits to gain additional funding and consider for-profit undertakings. Such undertakings are precarious and can create significant consequences if not appropriately structured. It is strongly encouraged that any non-profit considering such an undertaking consult with legal counsel, an accountant, and a business advisor familiar with development of business plans and interrelationships among non-profit and for-profit entities.