I am fortunate to represent a number of established and growing nonprofits, some of which are expanding into new geographic areas and new markets or scaling up their existing operations to meet demand. I am often asked to advise them on how best to structure their organizations to accommodate growth. Invariably, my answer is the classic lawyer answer – “it depends.”
I have also noticed a trend of sorts among lawyers and consultants who have decided on the ideal structure for X type of organization and seek to impose their vision on every client they meet. For example, a client recently brought me a proposal from a consultant whose entire career appears to be focused on asset protection planning. The consultant was selling, for a shocking sum, a rather commonplace “strategy” to reduce risk by creating multiple legal entities to isolate assets from risks. This isn’t a strategy its lawyering 101.
Creating Affiliated Networks of Entities
Most nonprofits understand that if a nonprofit corporation or limited liability company is properly managed and operated, it can provide a greater degree of personal liability protection to its directors and officers and insulate program risk from assets. This protection is known as the “corporate veil” and serves to isolate a corporation’s debts and liabilities within the corporation so long as directors and officers are respecting corporate formalities and fulfilling their fiduciary duties of good faith, due care, and loyalty.
The crux of the “strategy” is simply to create different entities to separate assets from potential liabilities and isolate the liabilities associated with each major program so that a catastrophic claim against one program does not threaten all of the programs. For example, a nonprofit purchasing a valuable piece of real estate might hold that asset in a separate corporation or LLC to protect its valuable real property assets from risks associated with its programs. Similarly, endowment assets are often held in separate nonprofit corporations.
Another example of entity planning includes nonprofits that are creating chapters in various regions or replicating their service delivery model. In such cases, putting each chapter or replicated program into a separate corporation or LLC will reduce the risk that a catastrophic loss experienced by one entity could impact the entire organization.
Many nonprofit and for-profit companies are structured in this manner and it can work well. In the nonprofit realm, subsidiaries can be created with varying degrees of autonomy from, or control by, the parent organization. However, if asset protection is of primary concern, we recommend striving for “maximum feasible separation.”
On the other hand, networks of affiliated companies aren’t for everyone. Decisions regarding corporate structure often come down to trade-offs between maximizing asset protection and maximizing efficiency. Affiliated companies can be burdensome to properly administer. Decision making is often less efficient in a network than in a consolidated entity as multiple organizations frequently have to approve key decisions.
To reap the protective benefits of conducting business through multiple entities, organizations must take care to respect the formalities of the arrangement. For example, where two entities share resources such as employees, office space, and equipment we recommend putting in place a written agreements to document the terms of the shared arrangements. Shared intellectual property should be memorialized through license agreements. Inter-company transfers should be documented through grant agreements, promissory notes, loan agreements, etc. Each entity must hold and separately document board meetings, file annual reports and tax returns, as well as other annual filings depending on the nature of its activities.
Consolidating Multiple Programs into One Entity
A consolidated entity is one that runs multiple chapters, multiple parishes, multiple schools, multiples hospitals, etc. out of one entity. This approach can work well for organizations that have a higher tolerance for risk and place a premium on efficiency. With enough insurance and a good risk management program, a board may be able to get comfortable with this structure. However, organizations that hold all of their assets and programs in one consolidated entity run a substantial risk that a devastating claim could bring down the entire entity and all of its programs.
Organizations working with children or other vulnerable populations should think carefully before adopting this structure due to the increased risk associated with their activities. The Catholic Church learned this the hard way when a number of Catholic Diocese, which consolidated parishes and churches into one entity, were forced into bankruptcy.
Consolidated companies also run regulatory risk. For example, if a nonprofit runs all of its programs out of one entity and that entity loses some sort of government approval (tax-exempt status, authority to operate a charter school, etc.) it can impact all of the organization’s programs instead of only the one that made a mistake.
In my experience, anytime a corporate structure created without extensive client input is introduced to actual clients with real wants, needs, cultures, management styles, etc. the proposed structure has to be modified and adjusted until it addresses their needs – often ending up looking very little like the initial proposal. Nonprofits should hold out for the structure that best meets their needs and not succumb to the lure of pre-packaged plans.