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.
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 licensed to practice in Washington and Arizona. Ellis advises tax-exempt clients on federal tax matters and fundraising regulation nationwide.