Nonprofits are increasingly creating affiliate organizations for various reasons; to protect critical assets (like real estate) from risky activities, to avoid the tax implications of unrelated business activities, or to expand lobbying activities, among others.
But in some cases, nonprofits and their affiliates may unknowingly or unintentionally blur the lines between organizational activities, which can cause problems.
For example, the political activities of an affiliate may be attributed to an affiliate that is subject to restrictions on political activity or a parent nonprofit may lose the benefit of the liability shield that protects it from risky activities conducted by its affiliate entity.
Here you will read why nonprofits create affiliate organizations, the common issues, and the best practices.
Table of Contents
Reasons Nonprofits Create Affiliate Organizations
Asset Protection
First, the most common reason nonprofits form separate entities is to insulate their 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 the 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 its activities and consolidate certain back-office functions to gain economies of scale. This structure is common in the charter school and healthcare world.
Employment
Nonprofits and affiliated entities often prefer to have one organization serve as the employer and lease employees to the affiliates. In addition to consolidating human resources and costs into one entity, this structure creates greater scale and permits the network to attract the high-caliber talent it may not be able to attract on its own.
Common Issues and Best Practices in Nonprofit Affiliate Organizations
To reap the tax-advantaged and protective benefits of conducting business through multiple entities, organizations must take care to respect the formalities of the arrangement.
This includes remaining independent and dealing with each other at arm’s length, having separate board meetings, implementing conflict of interest policies, documenting transactions between the entities, and ensuring fair market value payment for any benefits received by affiliates.
Corporate Structure and Governance
To begin with, a nonprofit and its affiliate should take great care to ensure that the parent entity does not get so involved in the affiliate’s day to day activities that the relationship between them takes on the form of a principal-agent relationship or that the subsidiary/affiliate becomes merely an instrumentality of the parent.
For example, each entity should hold and separately document board meetings, maintain separate books, records, and bank accounts, and separately file annual reports and tax returns.
And, while the tax-exempt parent organization can (and should) maintain control of its subsidiaries through its power to appoint and remove the board of directors and approve amendments to the articles of incorporation and bylaws, it should not directly manage the affiliate’s daily affairs.
Can Directors Overlap?
So long as the parent nonprofit does not interfere in the day-to-day operations of the affiliate organization, the boards of the corporations may overlap, in whole or in part. It is, however, helpful to have some independent outside members on each board so that conflicts of interest can be managed according to state and federal law.
Can Officers Overlap?
Likewise, the affiliates may also share certain officers; however, it is advisable that individuals do not fill the same identical offices for both entities. Varying the roles of individuals serving both the nonprofit and its affiliate helps to provide some separation and protects against an impression that the parent is controlling the day-to-day activities of the subsidiary.
Documenting Relationships and Avoiding Improper Subsidies
A charitable nonprofit should carefully avoid providing subsidies to its non-charitable affiliate because the funds of the charitable nonprofit, which are often donated and deductible as charitable contributions, cannot be used to promote the non-charitable activities of the non-charitable affiliate.
If the IRS were to determine that a non-charitable affiliate received more than an incidental benefit from the charitable nonprofit, it could revoke the non-profit’s tax-exempt status.
Further, the non-charitable affiliate could become liable for significant penalties if any transaction is seen as providing an excessive financial benefit to the affiliate. If the affiliate and the nonprofit share certain resources“employees, office space, the services of vendors, etc.“the risk of inadvertent subsidies is ever-present.
A formal written resource-sharing agreement can help mitigate this risk. The arrangement should be in writing and the shared resources should be priced at fair market value to avoid a finding that the charitable nonprofit improperly subsidized the affiliate. Certain situations require additional attention in this respect:
Employees
Affiliated organizations can share employees, such as one staff that divides time between a nonprofit and its affiliate. This can be structured as a cost-sharing arrangement or each entity can establish a separate payroll. However it is structured, the charitable nonprofit must avoid providing any improper subsidy to non-charitable affiliates and the relationship must be disclosed on both organizations’ Form 990s.
Office Space
Frequently, only one of the affiliated organizations will be a party on a lease for the offices or other facilities occupied by both organizations. When negotiating such a lease, make sure that allowing the lessee’s affiliate to use the premises will not constitute a prohibited sublease or assignment of the primary lease.
And as is the case for employees and other resources, the charitable nonprofit should ensure it is receiving fair market value for the value of the office space provided to the affiliate.
Mailing Lists
Affiliated organizations should understand that lists of members, donors, clients, etc. must be treated as assets, and their ownership, license to use, and allocation of costs to maintain must be addressed to avoid any improper subsidy. A charitable affiliate must be sure to obtain fair market value in exchange for any contribution of lists to a non-charitable affiliate.
Intellectual Property
Intellectual property should be memorialized through license agreements and inter-company transfers should be documented through grant agreements, promissory notes, loan agreements, etc.
There are many reasons that nonprofits choose to work with affiliates. Proper management of affiliate relationships can ensure that the benefits of affiliates are realized without threatening the status of the parent organization.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. licensed to practice in Washington and Arizona. Ellis advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations nationwide. Ellis also advises donors with regard to major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.