Earlier this year, we presented at Henry and Horne’s annual conference for nonprofits on the topic of nonprofit affiliates. Increasingly, nonprofits are creating affiliate organizations such as entities to hold real property, taxable subsidiaries that run unrelated businesses, lobbying organizations, foundations, chapters, and even management organizations. There are myriad reasons to create affiliates but there are a number of common scenarios that we will touch in this post.
Asset Protection. First, the most common reason nonprofits form separate entities is to insulate its critical assets from risky activities. High-risk activities, such as developing real estate and working with vulnerable populations, can threaten the nonprofit’s assets. Common threats include personal injury claims, employment related claims, claims for breach of contract, and where real property is concerned, environmental claims. Conducting high-risk activities through a separate entity helps protect the parent company from the risks associated with the subsidiary’s activities.
For example, it is common to hold real property in a separate entity. Similarly, nonprofits often move endowments to separate foundations once the endowed funds grow to a significant amount. Nonprofits forming geographically dispersed chapters often organize the chapters as separate corporations or limited liability companies to protect the parent from the liabilities of its chapters.
Unrelated Business Activity. Many nonprofits are looking for ways to diversify their income through social enterprise. The idea is that the nonprofit can run a business that will help to support the nonprofit. The social enterprise may or may not directly contribute to the organization’s mission. If the social enterprise activity does not contribute significantly to the mission other than by generating funds, then it may be an unrelated business activity.
If the gross revenue, net income, or staff time dedicated to an unrelated business becomes “substantial” as compared to the tax-exempt activities, the organization will be at risk of losing its tax-exempt status. To protect its tax-exempt status, the organization can consider “spinning off” the unrelated business activity into a taxable subsidiary.To ensure the unrelated business activity is not attributed to the tax-exempt owner, the subsidiary must be structured as a “C” corporation that pays tax at the corporate level. The subsidiary would distribute profits to the tax-exempt owner through dividends that are exempt from unrelated business income tax. If properly structured, this arrangement permits the nonprofit to benefit, on a tax-free basis, from the income generated by the social enterprise without risking its tax-exempt status.
Expanded Lobbying Opportunities .Section 501(c)(3) organizations can engage in lobbying within limits. There are two options for measuring lobbying activity. 501(c)(3) organizations can either adhere to the “no substantial part test” or they can make an election to have their lobbying expenditures measured according to specific dollar limits that are calculated as a percentage of their total exempt-function expenditures. This election is known as the “501(h) election.” Tax-exempt organizations that exceed these limits are at risk of losing their tax-exempt status.
To avoid this risk, many 501(c)(3) organizations create affiliated entities such as 501(c)(4) or (6) organizations. Section 501(c)(4) and (6) entities are allowed to engage in unlimited lobbying so long as it is related to their tax-exempt purpose. The funds of a 501(c)(3) generally cannot flow to this separate entity, but the organizations can share common goals, share certain resources, have overlapping boards and generally operate as affiliates. The 501(c)(4) or (6) can then solicit its own funds to engage in lobbying activity to a greater extent than the 501(c)(3).
Federal Grants. A provision in the Lobbying Disclosure Act of 1995 known as the Simpson Amendment prevents section 501(c)(4) organizations lobbying the U.S. Congress from receiving federal grants. However, the Conference Report, which accompanied the law states that 501(c)(4) organizations may form affiliated Forming an affiliate permits one entity to receive federal grants while the related entity performs lobbying activities with non-federal funds.
Non-legal Reasons. Organizations often decide to spin off significant programs for reasons that have nothing to do with legal considerations or taxes. The decision to form an affiliate may be driven by funder preferences, by political considerations, or by the need for a program to build a separate identity. For example, once an organization has several large and discrete programs that are organized into separate entities, it may want to form a central parent organization to coordinate their activities and consolidate certain back-office functions to gain economies of scale. This structure is common in the charter school and healthcare world.
Conclusion. Whether the decision to form an affiliate is motivated by asset protection concerns, tax concerns, he desire to lobby more freely, or some other reason, it is imperative that the relationship between the affiliated entities be carefully thought out. We have seen too many affiliated nonprofits that did not fulfill their intended purpose due to poor planning on the font end.
Ellis Carter is a nonprofit lawyer licensed to practice in Washington and Arizona. Ellis advises tax-exempt clients on federal tax matters nationwide. If you are seeking legal advice, contact firstname.lastname@example.org or 602-456-0071 for information about our services.