Safeguarding Your Sanctuary – Asset Protection for Churches and Nonprofits
By H. Robert Showers, Esq.
Introduction
A church or nonprofit’s corporate structure is vital for both its long-term maintenance and day-to-day operations—but a single corporate structure no longer suffices to protect and provide all available advantages. The 21st century has seen an uptick in secular lawsuits that purposefully target churches and religious nonprofits. This, when combined with religious organizations branching out and receiving more government support, has led to an increasingly volatile legal landscape.
For this reason, churches and nonprofits must create and maintain properly structured subsidiaries to effectively separate their major assets from their greatest liabilities. Religious organizations must balance their desired amount of control against the threat of liability, contemplating this central question with a qualified attorney when creating and sustaining a subsidiary.
I. Examples of Potential Subsidiary Liability
Take as an example a church-run K–12 school. Although the school is well-staffed and takes all practical safety precautions, injury or abuse could occur at any moment. The resulting liability could threaten the church’s assets and even its very existence.
Many churches also face increasing conflict with the LGBTQ movement. This conflict could expose churches and nonprofits to civil rights liability if they do not include sufficient legal protections in their governing documents, employment agreements, and facilities use agreements.
II. Legal Advantages of Subsidiaries
The “liability shield” is undoubtedly the greatest benefit arising from a properly formed subsidiary. When a religious parent organization creates a suitable subsidiary, the liabilities of the subsidiary usually do not flow to the parent—or vice versa. A proper organizational scheme can protect the assets held in one organization from lawsuits against the other.
Subsidiaries also can relieve a parent church/nonprofit’s tax liability for business activities that otherwise would jeopardize the parent’s tax-exempt status. A subsidiary can take on the bulk of non-exempt activity, including any that would result in unrelated business income tax (UBIT).
III. Administrative and Practical Considerations for Subsidiaries
Churches and nonprofits must consider the additional administrative requirements of creating subsidiary organizations. Corporate lawyers often say that creating an organization is like birthing a baby—the incorporation is just the beginning. After the religious organization incorporates, it must file IRS forms1 to remain in good standing. Depending on its structure, the organization also may need to hold separate board meetings, keep its own minutes, and pay various administrative fees separately from the parent organization.
IV. Types of Church Subsidiaries and Affiliates
The subsidiary and affiliate options for churches are expansive and diverse, including: (1) Integrated auxiliaries; (2) statutory property holding companies; (3) single-member nonprofit LLCs; (4) separate 501(c)(3) nonprofit corporations; and (5) affiliated for-profit corporations.
1. Integrated Auxiliaries
Integrated auxiliaries are the subsidiary structures that best protect religious freedom and allow the most control for the parent church.2 Integrated auxiliaries benefit from their “derivative” tax-exempt status, which frees them from filing for tax exemption or annual tax returns3 (although they still are subject to IRS civil tax inquiries).4
The IRS requires an integrated auxiliary to meet the following test: (1) The subsidiary must be described in the language of Section 501(c)(3); (2) the subsidiary must be “affiliated with a church or a convention or association of churches”; and (3) the subsidiary must be “internally supported.”5
Integrated auxiliaries—as the name suggests—are nearly united with the parent church; thus, the church benefits from its substantial control over the subsidiary’s operations. However, this extensive church control comes with an inherent downside: Because integrated auxiliaries are so intricately linked to their churches, they pose a much higher threat of liability to churches’ assets.
2. Statutory Property Holding Companies
A statutory property holding company (PHC) is a unique option for churches and nonprofits that wish to secure their tangible assets away from the grasp of claimants and creditors. By creating a 501(c)(2) holding company, a church or nonprofit can separate real property and investments from risky activities—with a high degree of confidence in the strength of the corporate shield.
PHCs must exist for the exclusive purpose of acquiring, holding, and collecting income from property.6 They must also remit their income to their parent organizations (with certain exceptions).7 8 After a religious organization has transferred its assets to a PHC, the organization must maintain control over the PHC’s activities in order to keep the subsidiary’s tax exemptions.9
PHCs do have drawbacks: They must file certain forms10 with the IRS, and the parent must maintain strict control over the PHC’s activities to prevent loss of tax-exempt status. Religious organizations may have better options in some scenarios, in light of the high cost of maintenance for a property holding company.
3. Single-Member Nonprofit LLCs
Many jurisdictions (including Virginia,11 D.C.,12 and Maryland13) have passed laws allowing organizations to create nonprofit single-member limited liability companies (LLCs). In this subsidiary structure, a church or nonprofit can be the LLC’s sole member. Like integrated auxiliaries, a single-member nonprofit LLC can achieve derivative tax exemption by being an IRS “disregarded entity,” but without the limitations of integrated auxiliaries.14 The LLC need not file the usual IRS forms, because the parent’s income includes the LLC’s income—the two organizations are treated as one only for tax purposes (unless the LLC files for its own 501(c)(3) status).15
One drawback to using an LLC is the lack of legal precedents regarding their use. Churches and nonprofits considering an LLC should first consult a qualified attorney to interpret the relevant law in their jurisdiction—they may discover that a creditor can “stand in the shoes” of the parent against whom the creditor has a judgment, allowing the creditor to take over the LLC and its assets.
4. Separate 501(c)(3) Nonprofit Corporations
Churches and nonprofits that bear severe liability risks or are especially risk-averse may wish to create separate 501(c)(3) nonprofit corporations to completely isolate liability. The “parent” and subsidiary corporation are linked in name only and are legally separate, which usually prevents liability from transmitting between church and subsidiary.16 This separate corporation would need to meet the usual Section 501(c)(3) test and comply with IRS filing requirements.
Separate 501(c)(3) nonprofit corporations have their own drawbacks, including high costs and administrative burden. Churches also have little real control over subsidiaries structured in this way, because the two organizations are legally separate. Thus, although a church may find that its liability decreases when creating a separate nonprofit, the church will also discover that its influence has fallen and its costs have multiplied. Any attempt at more control over the separate 501(c)(3) corporation will probably increase the parent church’s liability.
5. For-Profit Subsidiaries
A nonprofit, tax-exempt organization that expands into a substantial for-profit enterprise will lose its tax exemption unless it organizes a subsidiary.17 Creating a for-profit subsidiary allows a nonprofit organization to engage indirectly in activities that otherwise would have been unavailable to a tax-exempt organization. Any type of for-profit corporate structure (corporation, LLC, etc.) can appropriately isolate a nonprofit’s liabilities and assets.
If properly organized and maintained, a for-profit, non-exempt subsidiary can allow a church or nonprofit to pursue revenue-generating activities unrelated to its tax-exempt purpose. For-profits can generate monies for the parent, do business in religion-restricted countries, and enter joint ventures with nonprofits.18 Again, knowledgeable legal counsel is essential to determining what subsidiary best serves the needs of an organization, and what consequences necessarily follow from that choice.
V. Additional Risks: Veil-Piercing and Bankruptcy Consolidation
For any choice of subsidiary, a church must properly maintain the subsidiary as a separate legal entity throughout its existence. Otherwise, a court may hold that the church is liable for the torts/debts of its subsidiary (or vice-versa). This type of finding is known as “piercing the corporate veil” (or “PCV”). Courts employ this legal device when an organization’s policies and activities clearly indicate that the corporate form is merely a cover—a legal fiction.19 Churches must take care not to commingle funds with their subsidiaries,20 they must observe any formalities associated with business structures involved,21 and they must be properly financed.
Strategies that prevent veil-piercing can also decrease the risk of harmful bankruptcy consolidation. Courts essentially consider whether a subsidiary is an “alter ego” of its parent—if so, a court will consolidate the two organizations’ assets in bankruptcy.22 A church that creates “shell” corporations to escape deserved liability will not find sympathy in court.
Finally, churches and nonprofits should manage their advertising and public relations in a manner that accurately represents their true relationship with subsidiaries (e.g., as a “family of ministries” or a “close partnership for common purposes”).23
Summary
The ideal subsidiary structure depends on a church or nonprofit’s purpose, priorities, potential liabilities, and volume of assets. Before even considering subsidiaries, a church or nonprofit must properly incorporate—then, it should assess its need for subsidiaries. The church or nonprofit should balance its significant assets against its potential liabilities before deciding whether to create a separate but related entity.
Remember: More parent control over the subsidiary generally means less liability protection for both—this is the crucial balancing test. A knowledgeable church and nonprofit attorney can help a religious organization choose the ideal subsidiary structure for legal compliance and limitation of liability.
This short article has introduced the basic asset protection concepts and structures. Our firm has also produced a 17-page version of this article, which includes a more in-depth explanation, legal citations, and sample diagrams of church/nonprofit organizational structures. That full version is available for $25 when you contact our firm at MJSchachtner@simmsshowerslaw.com or www.simmsshowerslaw.com.
Disclaimer: This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers LLP expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum. Please contact Robert Showers or Justin Coleman at jrc@simmsshowerslaw.com for specific legal advice on this issue for your needs. We thank our law clerk Micah Schachtner for his valuable contributions.
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1 Forms 990, 990-EZ and 990-N – 509(a)(3) Supporting Organizations, Internal Revenue Service, https://www.irs.gov/charities-non-profits/charitable-organizations/forms-990-990-ez-and-990-n-509a3-supporting-organizations (last visited June 6, 2023).
2 Treas. Reg. § 1.6033-2(h)(1) (as amended in 2020) (LEXIS).
3 Id. § 1.6033-2(g)(i) (as amended in 2020) (LEXIS).
4 Restrictions on Church Inquiries and Examinations, Internal Revenue Service, https://www.irs.gov/charities-non-profits/churches-religious-organizations/restrictions-on-church-inquiries-and-examinations (last visited June 6, 2023).
5 Treas. Reg. § 1.6033-2(h)(1).
6 I.R.C. § 501(c)(2) (LEXIS through 2023 Pub. Law 118-3).
7 Tax-Exempt Status for Your Organization, Internal Revenue Service, 48, https://www.irs.gov/pub/irs-pdf/p557.pdf (last updated Jan. 2023).
8 I.R.C. § 501(c)(25)(G)(i–ii).
9 See id.
10 Organizations Not Required to File Form 1023, Internal Revenue Service, https://www.irs.gov/charities-non-profits/charitable-organizations/organizations-not-required-to-file-form-1023 (last visited June 6, 2023); Forms 990, 990-EZ and 990-N – 509(a)(3) Supporting Organizations, supra note 3.
11 Va. Code Ann. § 13.1-1008 (LEXIS through 2023 Sess.).
12 D.C. Code § 29-801.04(b) (LEXIS through March 2023).
13 Md. Code Ann., Corps. and Ass’ns § 4A-201 (LEXIS through Chapter 34 of 2023 Reg. Sess.).
14 Taxation of Limited Liability Companies, Internal Revenue Service, 2, https://www.irs.gov/pub/irs-pdf/p3402.pdf (last updated March 2020).
15 See id.
16 Note: An exception to the general rule is “piercing the corporate veil” (“PCV”), which appears later in this article. If the separate 501(c)(3) corporation is a mere formality, PCV may nullify the liability shield.
17 Life Cycle of a Public Charity – Jeopardizing Exemption, Internal Revenue Service, https://www.irs.gov/charities-non-profits/charitable-organizations/life-cycle-of-a-public-charity-jeopardizing-exemption (last visited June 7, 2023).
18 Rev. Rul. 98-15, 1998-1 C.B. 718, at *23 (LEXIS 1998).
19 “‘Piercing the Corporate Veil’ of Nonprofits,” Insights, Wagenmaker & Oberly, https://www.wagenmakerlaw.com/blog/piercing-the-corporate-veil-of-nonprofits.
20 See Sea-Land Services, Inc. v. Pepper Source, 941 F.2d 519, 521–22 (7th Cir. 1991) (holding that the defendant improperly used for personal banking the bank accounts of his various “corporations”—he did not even have a personal bank account).
21 See Kinney Shoe Corp. v. Polan, 939 F.2d 209, 212 (4th Cir. 1991).
22 See Clark’s Crystal Springs Ranch, LLC v. Gugino, 548 B.R. 246, 251–55 (B.A.P. 9th Cir.).
23 See Evans v. Multicon Constr. Corp., 574 N.E.2d 395, 400 (Mass. App. Ct. 1991) (holding that a corporation may not abuse the corporate form to confuse third parties regarding the corporate identity with which they are dealing).
