501(c)’s are organized and operated to serve charitable or other purposes, which allow them to be exempt from federal taxation. However, that tax exemption only applies to activities to further their exempt objectives. Income generated from activities outside a nonprofits’ exempt purpose is taxable as unrelated business income (“UBI”). Sometimes, nonprofits wish to conduct commercial activity outside of their exempt purpose, generally UBI. One option is to form a new company wholly owned by the nonprofit called a taxable subsidiary. Taxable subsidiaries are also known as “UBIT Blockers.” The IRS allows nonprofits to create taxable subsidiaries but warns that certain conduct may jeopardize the nonprofit’s exempt status.
Activities that Jeopardize Exempt Status
The IRS makes clear that the business activities of a subsidiary must be separate from those of its nonprofit parent. Under the law, the nonprofit and its subsidiary are taxed as separate entities, which allows a nonprofit to retain its tax-exempt status. In contrast, the subsidiary is taxed at standard corporate rates. Suppose the conduct of a subsidiary and its parent are too closely aligned. In that case, the IRS treats such activity as being conducted by the parent, thus rendering any proceeds from the subsidiary to its parent UBI.
A nonprofit is only permitted to generate a certain amount of UBI before its exempt status is questioned. To ensure that a nonprofit maintain its exempt status, its subsidiary must enjoy significant autonomy. The nonprofit parent should relinquish control of its subsidiary’s affairs so that there is no doubt the business conduct of the subsidiary is separate from that of the nonprofit.
Best Practices for Nonprofits Establishing Taxable Subsidiaries
These are some measures to help protect nonprofits from IRS scrutiny after forming a taxable subsidiary:
- A majority of the subsidiary’s Board should be members outside of and unrelated to the nonprofit. This separation signals to the IRS that the subsidiary is independent of its parent, and it also permits the two entities to manage conflicts of interest between them.
- The nonprofit should abstain from the day-to-day management of the subsidiary.
- The nonprofit and its subsidiary should be conducting transactions at arm’s length.
Forming a taxable subsidiary may be prudent for nonprofits that wish to conduct activities outside their exempt purpose. If successful, such entities can generate meaningful long-term income for a nonprofit. Note, however, that proceeds transferred from a subsidiary to its nonprofit parent may still incur taxes under certain circumstances. Therefore, it is best to consult with an attorney to evaluate the best course of action if your nonprofit considers forming a taxable subsidiary to conduct taxable activities.
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.