Creating a For-Profit Subsidiary? Here’s What to Consider

Creating a for-profit subsidiary was once considered unusual and niche, but in the past few decades, it has become somewhat mainstream and even standard for tax-exempt organizations. This arrangement emerged as a solution to the various challenges tax-exempt organizations often face, including but not limited to:

• Managing an unrelated business activity.
• Separating activities that stray from the original purpose of the exempt parent.
• Protecting the organization’s assets from legal liability.

By far the most common reason nonprofits create a for-profit subsidiary is to separate an unrelated business activity from the parent organization. That protects it from violating the primary purpose test and, to a lesser extent, the commensurate test. The primary purpose test ensures that the nonprofit isn’t organized or operated for the primary purpose of carrying on an unrelated trade or business. In other words, it must be primarily focused on fulfilling its exempt mission.

What constitutes “primary” is determined by a few things, including the size and extent of the unrelated business activity. Ultimately, the resources devoted to an unrelated trade or business must be insubstantial — though “insubstantial” is not defined by any fixed percentage. This uncertainty may be the motivating factor that pushes some exempt organization managers and boards to gravitate towards the for-profit subsidiary solution.

Forming and operating a for-profit subsidiary requires careful planning and guidance from qualified legal and accounting professionals. Below are some of the most common issues to address during this process (depending on the underlying reason for creating the new entity, your considerations may vary).

Structure

Initially, the parent will need to decide how ownership of the new entity will be structured. The entity can be either wholly owned, majority owned, or minority owned. For simplicity’s sake, we will only consider wholly owned and majority-owned entities in this article, as most parent organizations seek to maintain control over their new subsidiaries.

There are three primary methods for establishing control of a newly formed corporation. The parent could control the subsidiary through board overlap or by stipulating in the governing documents that the parent has the authority to appoint the board. Second, the subsidiary could be a membership organization with the parent appointed as the sole member, granting it the ability to control the composition of the board at will. Finally, the subsidiary could issue stock, with the majority or all of it retained by the parent.

Capitalization and Transfers

Once the entity has been legally formed, the parent may consider infusing the new subsidiary with funds to pay vendors and staff, and to generally operate as a for-profit corporation. IRS rulings indicate that exempt parents may form, capitalize, and operate an affiliate corporation if it furthers the charitable mission.[1] There are a few ways the parent organization can accomplish this. The first is to loan the money to the subsidiary using terms that are at arm’s length (meaning terms that are generally offered to the public). This requires a written document that governs the loan, stipulating the interest rate charged and the repayment schedule. The interest paid by the subsidiary is deductible, but typically, interest, rent, royalty, annuity, and similar payments create taxable income to the parent when paid by its subsidiary.[2]

There are a few exceptions to this rule. One exception covers activities conducted by the subsidiary that are also conducted by the parent and are related to the parent’s mission. In that case, payments are excluded from taxation. The parent could also argue that the subsidiary is a “loss corporation,” provided it can demonstrate that the subsidiary consistently produces losses and therefore reaps no tax benefit from deducting interest payments.

The other option to capitalize a subsidiary is to make a contribution or grant to the organization. However, in most cases, the subsidiary will conduct unrelated business activities; therefore, such a grant by the parent would not be compatible with its exempt purpose. The most prudent capitalization may involve some combination of the two methods above.

Attribution

The subsidiary must establish itself as a separate legal and tax entity from the parent. This is because the IRS scrutinizes parent-subsidiary relationships that appear to lack bona fide intent to have real and substantial business functions.[3]

Consider this: In a 1986 ruling, the IRS examined a scientific research organization and its subsidiary. The subsidiary developed and manufactured products derived from technology generated by the parent’s research.[4] The activities of the subsidiary were ultimately attributed to the parent because the parent maintained a controlling interest in the subsidiary, there were overlapping employees between the two entities, and they shared facilities and equipment.

More recently, the IRS has shifted its approach, moving away from taking such aggressive stances. As long as no “clear and convincing” evidence shows the subsidiary is acting as an agent or integral part of the tax-exempt parent, the IRS has ruled that the subsidiary’s activities will not be attributed to the parent. However, in situations where the parent controls the affairs of the subsidiary so closely, like when the parent is directly involved in the day-to-day management of the subsidiary, the subsidiary may not be regarded as a separate entity and therefore would be disregarded for tax purposes.

There is no single factor that determines whether attribution should occur. Instead, the IRS weighs multiple factors in making this determination. These factors include:

• Do the officers, trustees, or employees of the tax-exempt parent constitute a majority of the for-profit subsidiary’s board of directors? This level of control demonstrates that the subsidiary is acting as an agent or an integral part of the parent.
• Are the boards between the two organizations identical?
• Are the activities between the parent and subsidiary conducted at arm’s length?
• Is the parent involved in the day-to-day management of the subsidiary?[5] The IRS examines the similarity of activities, location, and identity of the entities.

The use of for-profit subsidiaries by exempt organizations has become increasingly common, and attribution is typically reserved for cases of extreme abuse. However, tax-exempt parents should take care to factor the above considerations into the structure and operations of the subsidiary to minimize the potential for attribution in the future, when the IRS may have more incentive to examine the issue.

Exempt Status

Exempt organization parents have the burden of demonstrating that they plan to use the substantial assets of their subsidiaries to further their mission.[6] In some cases, this means making dividend payments to the parent; in other cases, the IRS has suggested that a subsidiary’s asset or stock be sold to generate proceeds to fund program activity at the parent. Ultimately, the parent should not use its exempt assets, which could have been sourced from charitable donations or membership dues, to expand the commercial business of the subsidiary.

Of greater concern to the IRS is the potential for founders to use closely held subsidiaries for their personal enrichment. Specifically in question are instances where nonprofit founders create a subsidiary and benefit unreasonably from its accumulated gains. This sort of abuse triggers intermediate sanctions under §4958 and can jeopardize the exemption of the nonprofit parent. Factors that indicate potential abuse include de minimis levels of exempt activities by the parent; loans by the subsidiary to closely held affiliates or disqualified persons (with or without formal repayment arrangements); and, in general, the lack of intent to use any of the earnings of the subsidiary for exempt purposes of the parent.

Compensation

A 501(c)(3) exempt parent should be aware that the structure of a tax-exempt parent and taxable subsidiary may create issues with regard to employee compensation. §501(c)(3) organizations are subject to limitations on how they can compensate their employees, an area that is governed by private inurement, private benefit, and/or excess benefit transaction doctrines.

In general, compensation must be reasonable and cannot exceed the fair value of the services rendered to the payor. Any compensation the subsidiary pays to officers, directors, trustees, or key employees of the parent should be reported on the annual information return of the parent. This is because wholly or majority-owned subsidiaries should be listed as a related entity. Although generally more scrutinized due to the potential for unreasonable levels of compensation, stock options to employees of the taxable subsidiary are a viable option, as is providing an employee stock ownership plan. Ownership of stock by anyone other than the exempt parent does increase risk in a several areas and should be analyzed carefully before offering these options.

Minority Ownership

If the subsidiary is formed as a stock-based corporation, it will have the opportunity to issue stock and ownership to third parties. This can help raise funds for the subsidiary or in attracting the skills and talent necessary to run the organization successfully. Generally, this sort of stock issuance is permissible and would not jeopardize the exempt status of the parent. That said, an exempt parent should be aware that the inherent risk associated with third-party stockholders is that the tax-exempt parent may unduly enrich private third parties by using charitable assets. This activity can jeopardize the exempt status of the parent and would be detrimental to the overall activities of the subsidiary.

Cost Sharing

Exempt parents will be able to share resources (via a cost-sharing or management services arrangement) with the taxable subsidiary without additional risk. This could include shared staff, offices, facilities, equipment, and more. Any §501(c)(3) parent must ensure that it is reimbursed for the full fair market value of any goods or services shared with the subsidiary. This must be done on an actual use basis rather than by allocation.[7] Any receivable from the subsidiary should be paid promptly, preferably with no amounts outstanding as of the end of the tax year.

Conclusion

The creation of a for-profit subsidiary is often recommended for nonprofits that have the potential to generate substantial unrelated business income. The corporate subsidiary can also provide a shield against liability for management and the exempt parent. But to minimize risk, nonprofits must keep the above considerations top of mind.  

If your organization is considering forming such an entity or has questions about an existing structure, please contact Aaron Fox at [email protected].

[1] Ltr. Ruls. 9316052 and 9240001
[2] §512(b)(13)
[3] Britt v. United States 431 F.2d 227 (5^th Cir. 1970)
[4] Priv. Ltr. Rul 8606056
[5] Gen. Couns. Mem 39598
[6] Tech. Adv. Mem 200437040
[7] E.G., Priv. Ltr. Rul. 9308047