Do’s and Don’ts of Effective and Legal Use of For-Profits with Non-Profits

Increasingly, it has become common practice for churches and non-profits to combine their ministry with a related for-profit endeavor.  Whether it’s a coffee shop or a manufacturing enterprise, non-profits can often be seen involving themselves in successful and profitable businesses.  Because of the significant differences between for-profit and non-profit activities and structures, an unwary non-profit may inadvertently jeopardize its tax-exempt status.  In these situations, creating a wholly-owned, subsidiary, for-profit, entity is the most prudent decision – simultaneously separating liability and protecting the non-profit’s tax-exempt status.

Before creating a for-profit subsidiary, it is important that non-profits take into account a few considerations with the aid of knowledgeable legal counsel.

Do You Need a For-Profit Subsidiary?

Not every profitable (i.e. income-producing) activity requires a for-profit subsidiary.  The primary danger presented by for-profit activity is that it may defeat the tax-exemption of your entity.  The IRS generally allows a non-profit to carry out what they call an “unrelated trade or business” without jeopardizing tax-exemption, so long as the primary purpose of the tax-exempt entity remains to carry out its exempt functions.  The general rule of thumb is that as long as 51% of your activity remains charitable, your entity can remain tax-exempt.

However, even if you do not jeopardize your tax-exempt status, you may still have to pay tax on any income received from for-profit activities that are substantially unrelated to your non-profit’s exempt purposes.  This tax (the Unrelated Business Income Tax, or “UBIT”) applies to income derived from a regularly carried on trade or businesses that is unrelated to the performance of the organization’s tax-exempt (e.g., charitable) functions.

In addition, it is not always clear under federal tax law when an activity might be considered unrelated to the charity’s tax-exempt purpose. For instance, operating a training program or publishing books, while educational, may too closely resemble a for-profit business to qualify as an activity substantially related to a charitable purpose. An organization may focus on serving low-income or other underserved communities, or selling its product at a lower price only to other charities, in order to be comfortable that the activity is substantially related. However, a non-profit organization with a successful business model may not want to limit the scope of its activities in this way. Instead, it may wish to increase revenue by offering its product or service at fair market value to the broadest audience possible. A for-profit subsidiary maximizes flexibility to pursue a wide range of profit-making activities and to take advantage of future opportunities as they arise.

In PLR 200847018, the IRS considered an organization that claimed tax-exemption for the purpose of providing financing services to other tax-exempt organizations.  The entity in that case provided the services through its wholly-owned subsidiary LLC’s, which did not elect to be separate entities.  The IRS held that “providing financing services to tax-exempt organizations, in the manner described above, does not further a tax-exempt purpose . . . Rather, these activities further a non-exempt commercial purpose, obtaining advantageous financing for construction projects.”^[1]  The IRS relied on the following general rule:

Providing goods and services at cost and solely to tax-exempt organizations does not further a tax-exempt purpose.  See Rev. Rul. 72-369, supra.  Therefore, simply because you provide financing services to organizations that are tax-exempt under section 501(c)(3) does not mean you further a tax-exempt purpose within the meaning of section 501(c)(3) of the Code.  An organization that provides commercial services for free or at substantially below its cost to a charitable class is operated for a charitable purpose.  See Rev. Rul. 71-529, supra.  However, you are not providing your services to tax-exempt organizations for free and you have not demonstrated that you will be providing services at substantially below your cost.^[2]

If related for-profit activities simply provided at-cost services or products to non-profit organizations and were not an insubstantial part of the tax exempt activities through the disregarded status, then the non-profit’s tax-exemption would be endangered.  There are a few important considerations to take into account before a non-profit creates a related for-profit entity:

First, one must determine whether the business’ activities are unrelated to its tax-exempt purposes, thus potentially jeopardizing its tax-exempt status. In short, “are the business activities substantially related to our non-profit and tax exempt purposes that the IRS would consider it related income?” Unrelated business income tax, or “UBIT,” is a tax levied by the IRS in an attempt to prevent exempt organizations from gaining an unfair advantage when competing with for-profit enterprises.  Unrelated business income (UBI) is not in itself illegal; the IRS may simply tax the income that an exempt organization earns from activities unrelated to that organization’s exempt purpose.  The rationale is that an organization’s charitable purpose is what entitles the organization to its tax-exemption in the first place; any income-producing activities beyond that purpose tend to resemble commercial enterprises that compete directly or indirectly with for-profit businesses.

See Simms Showers Primer on Unrelated Business Income Tax memo.

UBIT is assessed only when the presumption of tax exemption for a 501(c)(3) organization is overcome.  This presumption is overcome when income is generated from an activity that meets three criteria: a) it is a trade or business, and b) it is regularly carried on, and c) it is not substantially related to the exempt purpose of the entity.^[3]

In general, if the non-profit is engaging in an activity with the primary purpose of making profit, that activity is likely subject to UBIT, especially if the activity is comparable to proceeding goods or services in a commercial business.  For example, an exempt organization, formed with the purpose to increase public awareness and understanding of environmental issues, may operate a bookstore. The store sells books that educate the reader about the environment, but it also sells gift cards, calendars, and other memorabilia bearing the name of the organization which are not about environmental issues in some direct way. Income derived from the sale of books should not be subject to UBIT because the books further the organization’s exempt purpose of public education and awareness.  But income from the gift cards, calendars, and other items may probably be taxable because the sale of these items does not primarily advance the organization’s exempt purpose. Suppose, however, that the organization designed the calendars and gift cards so that pictures of endangered animals were featured, along with an explanatory paragraph about the species’ disappearing natural habitat. Now, the sale of these items would probably escape UBIT because they have become primarily educational in nature instead of purely profit-making.

Second, if we cannot or do not want to make the regularly carried on business substantially related to the tax exempt purposes, is it substantial enough such that it would jeopardize our tax exempt status?  If the income from such regularly carried on business is over 50% then it would jeopardize the tax exempt status. While the IRS has never quantified this threshold, many commentators agree that when unrelated business income pushes above the 20% level, as compared to gifts, grants, and exempt function income, it is time for a legal evaluation. At that point, the exempt activity could be spun off into a controlled, for-profit subsidiary since it would begin to raise yellow and red flags with the IRS. At that point we must spin off the for-profit activity into another for-profit entity.

Third, managing unrelated business income associated with your Non-profit Organization has many options. It is not necessarily problematic for an exempt organization to generate unrelated business income (UBI).  In fact, unrelated business enterprises can be an appropriate way of making better use of an organization’s capital equipment and resources, while simultaneously providing an additional revenue source. A tax always indicates there is underlying income, and income and profits are generally good things.

For example, a non-profit youth camp using its facilities only one-third of the year might benefit more from its capital investment by offering its facilities for use as a business conference center during the off-season. A university that utilizes its own high-quality print shop at less than full capacity might wish to extend its services to the general public. Paying UBIT on the net income generated by these activities docs not jeopardize the organization’s tax­ exempt status so long as the activities are not a substantial part of the organization’s operations. The key is maintaining these activities at an insubstantial level.  However, local property taxes, state sales taxes, various state and federal wage-hour regulations, and other legal issues must be carefully evaluated with the help of legal counsel.

If unrelated business income becomes a substantial part of an exempt organization’s total activities, the organization has several options.  If the activity itself could qualify for tax-exemption, but is not covered under the organization’s current exempt purposes, the organization could attempt to redraft its basis for exemption.  More easily, a spin-off exempt organization could be formed or the expenses could out distance any profit so that UBIT would never be a problem. However, when the income-producing activity does not qualify for tax-exempt status, a for-profit subsidiary should be formed.  This should not jeopardize the current organization’s tax-exempt status. Remember, however, that such restructuring is only necessary if the income-producing activity nears the threshold of becoming a substantial part of the organization’s total activities.

Should the For-Profit Related Entity Be An LLC or Corporation?

First, the proper allocation of expenses in computing UBIT is a complicated subject beyond the scope of this memo, but certainly UBIT should not be avoided simply because there may be potential tax liability. However, this may be an important factor in creating a for-profit that effectively managing expenses with tax liability in mind,

Second, the best option may be to create a separate or controlled for-profit corporation that is related to the non-profit and funds the activities of the non-profit. Careful planning for the right organization under the right circumstances may result in UBI being the gap-filling revenue source that a charity needs to survive. Thus, spinning off the UBI into a controlled corporation appears the better option since any tax from the unrelated activity that cannot be offset with expenses will be paid and not jeopardize the tax exempt status of the non-profit.  Moreover, the profit that is paid to the controlled non-profit will not be computed as UBIT or further jeopardize its status, if managed correctly.

The general rule prohibits a 501(c)(3)  from operating a trade or business as a substantial part of its activities, unless it furthers the exempt purpose and the 501(c)(3)  is not formed primarily to carry on unrelated trade.  Consequently, it has been held that if a 501(c)(3)  owns some part interest (e.g. 50%) in an LLC that is treated as a partnership with another entity, then LLC’s activities are attributed to the 501(c)(3)  to decide if the 501(c)(3)  is operated exclusively for exempt purposes, as required under the rule above. As stated in an IRS Notice:

In Rev. Rul. 98-15, the IRS recognized that the activities of a limited liability company (LLC) “treated as a partnership for federal income tax purposes are considered to be the activities of a non-profit organization that is an owner of the LLC when evaluating whether the non-profit organization is operated exclusively for exempt purposes within the meaning of § 501(c)(3).”^[4]

For example, in Rev. Rul. 2004-51, the activities of an LLC treated as a partnership for tax purposes were attributed to an exempt university that owned 50% of the LLC, in order to determine whether the university operated “exclusively for educational purposes” as required under §501(c)(3).^[5]

Third, one could create an LLC that is partly owned by the non-profit. Under this analysis, a 501(c)(3)  won’t lose tax exempt status for the activities of an LLC is partly owns only if they are substantially related to the 501(c)(3) ’s exempt purposes.  This also applies for avoiding UBIT too.  As summarized in another PLR:

Rev. Rul. 2004-51, 2004-22 I.R.B. describes (1) whether an organization continues to qualify for exemption from federal income tax as an organization described in section 501(c)(3) of the Code when it contributes a portion of its assets to and conducts a portion of its activities through a limited liability company (LLC) formed with a for-profit corporation, and (2) whether the organization is subject to unrelated business income tax under section 511 on its distributive share of the LLC’s income.^[6]

Consequently, when the activities conducted through the LLC are substantially related to the exercise and performance of the exempt organization, the exempt organization will continue to qualify 501(c)(3), and will not be subject to unrelated business income tax under section 511 on its distributive share of the LLC’s income.^[7]

Fourth, one could create a wholly owned LLC but many things must be considered. The same rule above applies if a 501(c)(3)  wholly owns an LLC.  In that case, the default rule is that the LLC is disregarded for tax-exempt purposes and its activities are also treated as if they were the activities of the 501(c)(3) .  26 CFR 301.7701-2(a) provides that “if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.”  So while a wholly-owned subsidiary can help separate liabilities such as employment and certain excise taxes, the activities and income of the LLC nevertheless are still reportable to the 501(c)(3) :   A U.S. charity that wholly owns a disregarded entity must treat the operations and finances of the disregarded entity as its own for tax and information reporting purposes.  See Ann. 99-102, 1999-2 C.B. 545.  However, for employment and certain excise tax purposes, an entity that is disregarded as separate from its owner for any purpose under § 301.7701-2 is treated as an entity separate from its owner.  See § 301.7701-2(c)(2)(iv) and (v).^[8] In others words, the operations of a disregarded entity are treated as a “branch or division of the owner.”^[9]

Therefore, although a 501(c)(3)  doesn’t automatically lose tax-exempt status for having an interest in a for-profit wholly-owned subsidiary, the subsidiary still cannot confer private benefit on individuals or have a primary purpose contrary to its exempt purposes.  “The mere fact that an organization seeking exemption enters into a partnership agreement with private parties that receive returns on their capital investments does not establish that the organization has impermissibly conferred private benefit.”^[10]  The organization must still meet the requirement to avoid serving private interests through a substantially nonexempt purpose.^[11]

For example, in PLR 201322054, the IRs revoked the tax-exempt status of an organization that, on its form 990, showed that it received 99% of its revenue from the operation of wholly owned disregarded entities.^[12]

Therefore, if the subsidiary LLC elects to be treated as a corporation, or is a corporation, then the entity is NOT disregarded, and potentially avoids the “substantially related” test.  Under 26 CFR 301.7701-3(b)(1), an eligible entity (which includes most LLCs) with a single owner is disregarded unless it elects otherwise.^[13]  To elect to be treated separately, and to avoid the single owner from reporting the operations and finances of the for-profit on its annual return, the LLC must either file for separate entity treatment on a Form 8832, be its own for-profit corporation or file its own tax-exempt application using Form 1023.^[14] In short, it reverts to the best option of creating a solely owned for-profit corporation as discussed above.

Conclusion. When properly managed, UBI offers significant opportunities for creative and productive stewardship of under-utilized resources, staff, and services of exempt organizations.  Improperly handled, UBI presents substantial dangers. For churches and certain small organizations that do not currently file annual 990 reports, incurring UBIT will create a filing requirement for the first time that, for some organizations, is a strong deterrent. If the filing requirement is not a problem, often little or no UBIT liability is created because of the offsetting expenses. However, spinning off the UBI into a controlled corporation appears the best option although it could become a separate, but related, for-profit corporation or for-profit LLC where the sole member is the non-profit organization with the pitfalls and cautions discussed above. Because there are several key considerations to take into account before entering this kind of set-up, competent legal counsel who is familiar with these areas must be consulted at almost every turn.

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 Daniel Hebda at djh@simmsshowerslaw.com for legal advice that will meet your specific needs.

[1] 2008 PLR LEXIS 2383, 17-20, PLR 200847018 (I.R.S. 2008).

[2] 2008 PLR LEXIS 2383, 17-20, PLR 200847018 (I.R.S. 2008) (emphasis added).

[3] I.R.C. §§ 512, 513.

[4] 2011 IRB LEXIS 195, 12–13 (2011).  See also Rev. Rul. 2004-51, 2004-1 C.B. 974 (noting that the activities of an LLC treated as a partnership for tax purposes are attributed to a university that owns 50 percent of the LLC for purposes of determining whether the university “operates exclusively for educational purposes and therefore continues to qualify for exemption under § 501(c)(3)”).

[5] 2004-1 C.B. 974.

[6] 2005 PLR LEXIS 1575, 8, PLR 200610022 (I.R.S. 2005)

[7] 2005 PLR LEXIS 1575, 8, PLR 200610022 (I.R.S. 2005)

[8] 2012 IRB LEXIS 392.

[9] 2011 IRB LEXIS 388, 7-8, Notice 2011-52, 2011-2 C.B. 60, 2011-30 I.R.B. 60 (I.R.S. 2011).

[10] Redlands Surgical Servs. v. Commissioner, 113 T.C. 47, 74-75, 1999 U.S. Tax Ct. LEXIS 29, 58-59, 113 T.C. No. 3 (T.C. 1999).

[11] Id.  Compare Plumstead Theatre Socy., Inc. v. Commissioner, 675 F.2d 244 (9th Cir. 1982), affg. per curiam 74 T.C. 1324 (1980) (a nonprofit arts organization furthered its charitable purposes by participating as sole general partner in a partnership with private parties to produce a play), with Housing Pioneers, Inc. v. Commissioner, 49 F.3d 1395 (9th Cir. 1995), affg. T.C. Memo 1993-120 (a nonprofit corporation’s participation as co-general partner in low-income housing partnerships, structured to trade off its tax exemption to secure tax benefits for its for-profit partners, had a substantial nonexempt purpose and impermissibly served private interests).

[12] 2013 PLR LEXIS 211, 10, PLR 201322054 (I.R.S. 2013)

[13] 2013 PLR LEXIS 211, 69-70, PLR 201322054 (I.R.S. 2013).

[14] 2013 PLR LEXIS 211, 69-70, PLR 201322054 (I.R.S. 2013).