Nonprofits are tax-exempt organizations, which is why many business owners are interested in starting or adding a nonprofit arm to their for-profit operations. However, the IRS has rules to prevent this very loophole. A for-profit cannot own a nonprofit, but there are ways to structure your organization to make it possible to affiliate your corporation with a nonprofit. Here's how this could work.
Background: nonprofit vs. for-profit
First, it's essential to understand how these two business entities work. A nonprofit is organized to further a social cause or support a shared mission. These companies are tax-exempt by the IRS since they exist to benefit the public. They're required to keep financial information public to ensure donations are only for the nonprofit's further advancement.
"Nonprofits are designed to serve the public, and as such, don't have actual owners. This includes nonprofit corporations, which must meet certain criteria to remain exempt from taxes," wrote UpCounsel.
Conversely, a for-profit operates intending to make money. They sell a product or service to customers, earn an income from the profit, and may also pay shareholders and investors from the profits. These entities are subject to specific IRS tax rules depending on income, location, and business structure.
[Read more: Nonprofit vs. Not-for-Profit vs. For-Profit: What's the Difference?]
Can a for-profit own a nonprofit?
Because the nonprofit doesn't have owners, a for-profit cannot "own" a nonprofit. However, a corporation can align itself with a nonprofit without ownership. Adding a nonprofit or charitable arm to your for-profit company is possible as long as you are careful to follow IRS rules and restrictions.
"Legal conflicts of interest may arise if a 501(c)(3) tax exempt charity is associated with a for-profit parent because the charity must exist to benefit the greater public good, must be headed by an independent board of directors, and generally draw the bulk of their support from public source," wrote Candid Learning, an education resource for nonprofits.
For-profit business owners seeking to start a nonprofit should be careful to create subsidiaries that are not related in any respect to their for-profit business. For instance, a nonprofit formed by a law firm could sponsor a local animal shelter but should avoid providing legal services in any way. Likewise, the nonprofit should not entirely rely on the services or products of a for-profit company to achieve its core mission.
If the nonprofit engages in activities that are not substantially related to its exempt purpose, it may generate unrelated business income (UBI) that is taxable.
What are the legal and tax implications of adding a nonprofit arm?
Adding a nonprofit arm to a for-profit organization can quickly complicate your taxes and compliance. If the nonprofit engages in activities that are not substantially related to its exempt purpose, it may generate unrelated business income (UBI) that is taxable. Likewise, the IRS scrutinizes transactions between for-profit and nonprofit entities to ensure that goods, services, and other resources are transferred at fair market value. This is to prevent the for-profit from improperly benefiting from the nonprofit's tax-exempt status.
Running dual entities requires separate governance, accounting, and compliance efforts. The IRS is strict in enforcing 501(c)(3) compliance. As a result, if you do not properly delineate the assets and operations of your two entities, the nonprofit could be exposed to a lawsuit or loss of tax-free status.
Can a nonprofit form a for-profit arm?
Far more common is a structure in which a nonprofit forms a for-profit subsidiary. A nonprofit can add a for-profit entity regardless of whether or not it is a corporation or limited liability company.
A nonprofit may choose to establish a for-profit subsidiary for a few reasons. Primarily, the leaders in the nonprofit may decide they wish to engage in business activities that don't pertain to the mission of the nonprofit. Setting up a separate for-profit helps the leaders avoid paying Unrelated Business Income Tax Income (UBIT). And a for-profit structure can also protect the nonprofit from the liability of carrying out certain business activities under tax-exempt status.
Ultimately, forming a for-profit subsidiary of a nonprofit helps a business owner clearly delineate which activities are carried out on behalf of which organization, clarifying for the IRS that the rules and regulations for each entity have been satisfied.
Hybrid nonprofit for-profit entities
Recent years have seen the rise of so-called hybrid organizations, such as benefit corporations or low-profit limited liability companies.
"The low-profit LLC, or L3C as it is known, is structured like an LLC but must have a nonprofit purpose, although it may also generate income," wrote LegalZoom. "Additionally, an L3C which qualifies as a program-related investment may also be useful in attracting investments from private foundations."
There are two main types of hybrid entities:
- Parent subsidiaries operate with the nonprofit as the parent organization and the for-profit as a subsidiary owned by the nonprofit.
- Brother-sister hybrids operate the nonprofit and for-profit completely separately.
These structures tend to be complicated and have specific rules. For instance, under either format, money can go from the for-profit to the nonprofit, but not from the nonprofit to the for-profit.
"The for-profit entity can donate money to the nonprofit (and lower its tax liability by up to 10% of its net income). However, because all assets of a nonprofit must be permanently dedicated to charitable causes, a nonprofit could not give away its funds to the for-profit," wrote SPZ Legal.
[Read more: Choosing the Right Nonprofit Type: Which Is Right For Your Business?]
Examples of successful for-profit/nonprofit collaborations
Hybrid entities are more common than you may think, usually structured in the parent-subsidiary format.
"For decades, nonprofits such as the National Geographic Society have created for-profit subsidiaries and entered into strategic relationships with for-profit companies to exploit their assets in the marketplace," wrote Allen R. Bromberger in the Stanford Social Innovation Review. "Catholic Charities USA, the American Health Assistance Foundation, the National Center on Family Homelessness, Community Teamwork, the DC Central Kitchen, and the United Spinal Association are all examples of charities that over the past 10 years have created LLCs to carry out profit-making activity."
Hospitals, universities, and museums are other organizations that combine nonprofit and for-profit entities. If you're interested in a hybrid organization, consult a legal expert who can help you structure this entity in a way that is compliant with IRS regulations.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
CO—is committed to helping you start, run and grow your small business. Learn more about the benefits of small business membership in the U.S. Chamber of Commerce, here.
