Why would a nonprofit want to form a for-profit subsidiary? When a nonprofit conducts business activities unrelated to its nonprofit purpose, these revenues are generally taxable at corporate rates as unrelated business taxable income (UBTI). Any amount of UBTI revenue that exceeds $1,000 requires reporting to the IRS via Form 990-T. Estimated taxes may also be required if an organization anticipates tax obligations of $500 or more.
In addition to the tax consequences of UBTI, a nonprofit can risk losing its tax-exempt status if it engages extensively in an income-generating business activity that is unrelated to its nonprofit purpose. A common solution to this risk is for a nonprofit to form a subsidiary to carry out its unrelated income-generating activities. This serves the dual purpose of protecting a nonprofit’s tax-exempt classification and lowering its tax liabilities.
What activities can trigger UBTI obligations?
Any revenue-producing activity that is unrelated to a nonprofit’s primary purpose can be considered UBTI by the IRS. The IRS says UBTI can flow from activities where the following conditions are present:
- Trade or business-related activities: This includes any activity conducted with the intent to produce income from “selling goods or performing services.”
- Regularly conducted: I.e. conducted frequently and continuously. Ad hoc activities of limited duration are excluded as UBTI.
- Not substantially related: This is a very fact-specific inquiry. The IRS says that business activity is not substantially related if it “doesn’t contribute importantly to accomplishing” the nonprofit’s purpose. They also give the following guidance:
Selling products: Selling products that result from performing exempt functions is OK if it is sold mostly in the state where the nonprofit conducts its activities. The IRS gives one example–revenues that accrue to a nonprofit that rehabilitates handicapped persons by these persons making items that are incidentally sold to the public would not be considered UBTI.
Dual-use of facilities: Assets or facilities that are used for BOTH commercial and nonprofit activities do not exempt the commercial activities from being considered UBTI.
The IRS provides specific examples of what it considers UBTI activities, along with a list of exceptions and exemptions here.
When should your nonprofit consider forming a subsidiary?
The IRS says that any income from a trade or business regularly carried on that is more than insubstantial can threaten the organization’s tax-exempt status. What does the IRS consider substantial?
While the agency does not specifically define what it considers substantial, court case guidance indicates that receipts of 5% or less are probably safe but 20% or more is too much. If your nonprofit’s UBTI receipts regularly exceed more than 5% of gross income, it’s probably time to start thinking about forming a subsidiary.
Forming and operating a for-profit subsidiary
A taxable subsidiary is essentially a separate for-profit entity that the charity owns and controls. As the owner, the tax-exempt parent is entitled to distributions from the for-profit subsidiary, which is taxed as exempt passive income.
However, if the subsidiary is not properly structured, the distributions of business income to the tax-exempt parent will retain their character as unrelated business income. To avoid this consequence, the tax-exempt parent should take specific steps to separate the activities of the nonprofit entity from its subsidiary. These include:
- Setting up the subsidiary with a bona fide purpose of its own. The subsidiary must have a business purpose or activity that shows it is not merely a sham or instrumentality of the parent.
- Maintaining separate books and records, bank accounts, meetings and minutes, stationery, and tax returns, and signing documents in their own corporate name.
- Maintaining control of subsidiaries through the power to appoint and remove the board of directors and the power to approve any amendments to the Articles of Incorporation and Bylaws.
- Not directly managing the subsidiary’s daily affairs.
- Avoiding too much overlap between the board of directors of the tax-exempt parent and the subsidiary. Some directors can overlap but it is recommended that the subsidiary board include outside directors.
- Documenting transactions between the tax-exempt parent and the subsidiary (for services, rental of space and equipment, loans, etc.) in writing and with approval by both boards of directors.
- Also, note that new IRS rules under the Tax Cuts and Jobs Act clarify that an exempt organization with more than one unrelated business or trade must compute UBTI separately for each business.
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.