By: Thomas (“Graves”) Upchurch

In the nonprofit world, organizations are constantly looking for opportunities to increase their impact on society. That requires reach, capacity, and of course, money. While nonprofits can go through the traditional donor and foundation route, a number are seeking to make their own money to fund their causes/initiatives in the form of a for-profit arm. However, nonprofits, specifically tax exempt 501(c)(3) organizations, have to be wary about maintaining their tax-exempt status. Section 501(c)(3) of the Internal Revenue Code (IRC) provides that a tax-exempt organization can affiliate with a for-profit entity in an effort to increase funding and resources, while retaining its tax-exempt status. The Internal Revenue Service (IRS) has recognized several ways of accomplishing this type of affiliation including a parent-subsidiary relationship, a general partnership, a joint venture in the form of an LLC, and an ancillary venture. For this post, I will be focusing on the ins-and-outs of the parent-subsidiary structure.

 

The parent-subsidiary relationship (a nonprofit parent and a wholly owned for-profit subsidiary) can be primarily structured in three ways: the for-profit subsidiary may be C corporation, an S corporation, or a single-member limited liability company (LLC).[1] Each comes with its own advantages and disadvantages.

 

Option 1: C Corporation

 

A C Corporation is a corporation, regardless of jurisdiction, that is taxed under subchapter C of the IRC. This is typically the default manner in which corporations are taxed. Here, “wholly owned” means owning a 50% or more controlling interest of stock in the subsidiary. Like a normal shareholder in a  corporation, the C Corporation subsidiary offers the parent limited liability protection. In terms of taxation, the C Corporation subsidiary will be subject to double taxation, meaning income will be taxed twice, once to the corporation, and again when any dividends are paid to shareholders. However,  any income the exempt parent receives from the subsidiary in the form of a dividend, and gain or loss from the sale of the stock, would be excluded from the parent’s unrelated business taxable income (UBIT).[2] Unrelated business taxable income means the “gross income derived by any organization from any unrelated trade or business regularly carried on by it, less the deductions allowed…”[3] In the context of nonprofit organizations, UBIT must be paid if an exempt entity participates in business activity that doesn’t relate to the nonprofit’s specific exempt purpose. It is designed to close the loophole that would allow exempt organizations to avoid tax liability on activities that would otherwise be paid by a nonexempt organization. Income in the form of rent, interest, annuities or royalties from the controlled subsidiary to the parent will be considered unrelated business income.[4] In addition to simply paying the tax on unrelated business income, excessive unrelated business income can jeopardize the parent’s exempt status. Fortunately, because dividend income is not subject to UBIT, the simple ownership of stock in the C corporation subsidiary is highly unlikely to affect the parent’s exempt status.

 

Although receiving dividend income from a wholly owned C corporation will not have an effect on the parent’s tax exemption, there are a few transactions that will be subject to UBIT. These include any payment from the controlled subsidiary to the parent consisting of interest, rent, annuity or royalty.[5] The rationale here is that the tax-exempt entity should not be able to avoid taxation on unrelated business simply by transferring it to the controlled corporation. The C corporation subsidiary structure can be a beneficial structure for an exempt nonprofit parent, but leadership should be careful about transferring assets, as well as activities that may subject the parent to taxation.

 

Option 2: S Corporation

 

An S corporation is a corporation that has elected to be taxed under subchapter S of the IRC and must meet certain requirements laid out by the IRS.[6] Different from a C corporation, the S corporation subsidiary and the exempt parent will be treated as one entity for tax purposes, and all income, deductions, etc., will flow to the exempt parent.[7] Unfortunately, unlike a C corporation, the net income derived by the subsidiary will be subject to UBIT, hindering the exempt organization’s ability to avoid taxation while maintaining a for-profit subsidiary. On the other hand, the S corporation structure can be beneficial if the activities conducted through the subsidiary would otherwise the parent’s overall exempt status at risk. This is due to the fact the underlying assets or activities of the S corporation will not be attributed to the parent, in turn not affecting the parent’s exempt status. Finally, the S Corporation offers limited liability protection for the parent entity.

 

Option 3: LLC

 

For tax purposes, the single member LLC differs from the previous two options. While the C Corporation and S Corporation subsidiaries are treated as separate entities, the LLC subsidiary’s parent will be treated as owning the LLC’s assets and conducting its activities directly. The IRS classifies this type of subsidiary as a disregarded entity. As a disregarded entity, the subsidiary’s income flows straight to the parent entity. Under the Internal Revenue Code, any income from a disregarded subsidiary in the form of rent, interest, annuities, and royalties will not be subject to UBIT as they would in the case of the C or S Corporation. Consequently, the parent exempt organization should report all of the LLC’s activities on its own information filed with the IRS. The major disadvantage of this set up is the risk of jeopardizing the parent organization’s exempt status. Unlike the S corporation where the activities will not be attributed to the parent, if the LLC’s conduct does not further the exempt purpose of the parent nonprofit, its tax-exempt status could be stripped.

The single member LLC does offer several key benefits. First, the like the C Corporation and S Corporation, the LLC subsidiary offers significant liability protection for the parent.[8] A single-member LLC can engage in activities that carry more risk than the nonprofit parent is willing to take on. For example, a nonprofit entity can use the LLC to handle real property donations where the nonprofit, for various reasons, would like to exclude itself from the chain of title to avoid future liability.[9] Second, as previously stated, the exempt organization can directly control the LLC’s activities as the sole member, making sure those activities further the exempt parent’s stated purpose. Third, in terms of taxation, the single-member LLC will benefit from pass-through taxation. Meaning the parent and the subsidiary will be taxed once for all income, gain, losses, deductions, etc. Finally, under Notice 2012-52, the IRS recognized that donations to an LLC, wholly owned by a 501(c)(3) organization, can be claimed as a charitable deduction.

 

Conclusion

 

The C corporation, S corporation, and single-member LLC are all potential options for a tax exempt parent wishing to create a for profit subsidiary. Each carries with it unique tax concerns that can affect the exempt parent through UBIT, or even jeopardize its exempt status. The exempt organization’s board should take the time to evaluate what types of activities the organization will engage in, the appropriate tax structure, and how much control over the subsidiary the parent organization would like before making a decision on which wholly-owned subsidiary is the right choice.

[1] Michael Sanders, Joint Ventures Involving Tax-Exempt Organizations, 498.

[2] Id. at 499.

[3] I.R.C. § 512(a)(1).

[4] I.R.C. § 513(b)(13).

[5] Michael Sanders, Joint Ventures Involving Tax-Exempt Organizations, 499.

[6] I.R.C. § 1361

[7] Michael Sanders, Joint Ventures Involving Tax-Exempt Organizations, 500.

[8] Michael Sanders, Joint Ventures Involving Tax-Exempt Organizations, 501.

[9] Spencer G. Nauman, Does Your Nonprofit Need an LLC Subsidiary, Nauman Smith, https://www.nssh.com/2017/10/nonprofit-need-llc-subsidiary/.

In the nonprofit world, organizations are constantly looking for opportunities to increase their impact on society. That requires reach, capacity, and of course, money. While nonprofits can go through the traditional donor and foundation route, a number are seeking to make their own money to fund their causes/initiatives in the form of a for-profit arm. However, nonprofits, specifically tax exempt 501(c)(3) organizations, have to be wary about maintaining their tax-exempt status. Section 501(c)(3) of the Internal Revenue Code (IRC) provides that a tax-exempt organization can affiliate with a for-profit entity in an effort to increase funding and resources, while retaining its tax-exempt status. The Internal Revenue Service (IRS) has recognized several ways of accomplishing this type of affiliation including a parent-subsidiary relationship, a general partnership, a joint venture in the form of an LLC, and an ancillary venture. For this post, I will be focusing on the ins-and-outs of the parent-subsidiary structure.

 

The parent-subsidiary relationship (a nonprofit parent and a wholly owned for-profit subsidiary) can be primarily structured in three ways: the for-profit subsidiary may be C corporation, an S corporation, or a single-member limited liability company (LLC).[1] Each comes with its own advantages and disadvantages.

 

Option 1: C Corporation

 

A C Corporation is a corporation, regardless of jurisdiction, that is taxed under subchapter C of the IRC. This is typically the default manner in which corporations are taxed. Here, “wholly owned” means owning a 50% or more controlling interest of stock in the subsidiary. Like a normal shareholder in a  corporation, the C Corporation subsidiary offers the parent limited liability protection. In terms of taxation, the C Corporation subsidiary will be subject to double taxation, meaning income will be taxed twice, once to the corporation, and again when any dividends are paid to shareholders. However,  any income the exempt parent receives from the subsidiary in the form of a dividend, and gain or loss from the sale of the stock, would be excluded from the parent’s unrelated business taxable income (UBIT).[2] Unrelated business taxable income means the “gross income derived by any organization from any unrelated trade or business regularly carried on by it, less the deductions allowed…”[3] In the context of nonprofit organizations, UBIT must be paid if an exempt entity participates in business activity that doesn’t relate to the nonprofit’s specific exempt purpose. It is designed to close the loophole that would allow exempt organizations to avoid tax liability on activities that would otherwise be paid by a nonexempt organization. Income in the form of rent, interest, annuities or royalties from the controlled subsidiary to the parent will be considered unrelated business income.[4] In addition to simply paying the tax on unrelated business income, excessive unrelated business income can jeopardize the parent’s exempt status. Fortunately, because dividend income is not subject to UBIT, the simple ownership of stock in the C corporation subsidiary is highly unlikely to affect the parent’s exempt status.

 

Although receiving dividend income from a wholly owned C corporation will not have an effect on the parent’s tax exemption, there are a few transactions that will be subject to UBIT. These include any payment from the controlled subsidiary to the parent consisting of interest, rent, annuity or royalty.[5] The rationale here is that the tax-exempt entity should not be able to avoid taxation on unrelated business simply by transferring it to the controlled corporation. The C corporation subsidiary structure can be a beneficial structure for an exempt nonprofit parent, but leadership should be careful about transferring assets, as well as activities that may subject the parent to taxation.

 

Option 2: S Corporation

 

An S corporation is a corporation that has elected to be taxed under subchapter S of the IRC and must meet certain requirements laid out by the IRS.[6] Different from a C corporation, the S corporation subsidiary and the exempt parent will be treated as one entity for tax purposes, and all income, deductions, etc., will flow to the exempt parent.[7] Unfortunately, unlike a C corporation, the net income derived by the subsidiary will be subject to UBIT, hindering the exempt organization’s ability to avoid taxation while maintaining a for-profit subsidiary. On the other hand, the S corporation structure can be beneficial if the activities conducted through the subsidiary would otherwise the parent’s overall exempt status at risk. This is due to the fact the underlying assets or activities of the S corporation will not be attributed to the parent, in turn not affecting the parent’s exempt status. Finally, the S Corporation offers limited liability protection for the parent entity.

 

Option 3: LLC

 

For tax purposes, the single member LLC differs from the previous two options. While the C Corporation and S Corporation subsidiaries are treated as separate entities, the LLC subsidiary’s parent will be treated as owning the LLC’s assets and conducting its activities directly. The IRS classifies this type of subsidiary as a disregarded entity. As a disregarded entity, the subsidiary’s income flows straight to the parent entity. Under the Internal Revenue Code, any income from a disregarded subsidiary in the form of rent, interest, annuities, and royalties will not be subject to UBIT as they would in the case of the C or S Corporation. Consequently, the parent exempt organization should report all of the LLC’s activities on its own information filed with the IRS. The major disadvantage of this set up is the risk of jeopardizing the parent organization’s exempt status. Unlike the S corporation where the activities will not be attributed to the parent, if the LLC’s conduct does not further the exempt purpose of the parent nonprofit, its tax-exempt status could be stripped.

The single member LLC does offer several key benefits. First, the like the C Corporation and S Corporation, the LLC subsidiary offers significant liability protection for the parent.[8] A single-member LLC can engage in activities that carry more risk than the nonprofit parent is willing to take on. For example, a nonprofit entity can use the LLC to handle real property donations where the nonprofit, for various reasons, would like to exclude itself from the chain of title to avoid future liability.[9] Second, as previously stated, the exempt organization can directly control the LLC’s activities as the sole member, making sure those activities further the exempt parent’s stated purpose. Third, in terms of taxation, the single-member LLC will benefit from pass-through taxation. Meaning the parent and the subsidiary will be taxed once for all income, gain, losses, deductions, etc. Finally, under Notice 2012-52, the IRS recognized that donations to an LLC, wholly owned by a 501(c)(3) organization, can be claimed as a charitable deduction.

 

Conclusion

 

The C corporation, S corporation, and single-member LLC are all potential options for a tax exempt parent wishing to create a for profit subsidiary. Each carries with it unique tax concerns that can affect the exempt parent through UBIT, or even jeopardize its exempt status. The exempt organization’s board should take the time to evaluate what types of activities the organization will engage in, the appropriate tax structure, and how much control over the subsidiary the parent organization would like before making a decision on which wholly-owned subsidiary is the right choice.

[1] Michael Sanders, Joint Ventures Involving Tax-Exempt Organizations, 498.

[2] Id. at 499.

[3] I.R.C. § 512(a)(1).

[4] I.R.C. § 513(b)(13).

[5] Michael Sanders, Joint Ventures Involving Tax-Exempt Organizations, 499.

[6] I.R.C. § 1361

[7] Michael Sanders, Joint Ventures Involving Tax-Exempt Organizations, 500.

[8] Michael Sanders, Joint Ventures Involving Tax-Exempt Organizations, 501.

[9] Spencer G. Nauman, Does Your Nonprofit Need an LLC Subsidiary, Nauman Smith, https://www.nssh.com/2017/10/nonprofit-need-llc-subsidiary/.