By Kimi Murakami

Recently, tax-exempt organizations have inquired whether it was legally permissible to establish a for-profit subsidiary to perform profitable work developed by the non-profit parent.

The answer is yes.

Like for-profit corporate entities, non-profit organizations are formed at the state level similar to forming for-profit corporate entities. To become tax exempt, once the corporate entity is recognized by the state, it must apply to the IRS to obtain tax-exempt status such as the commonly known charitable organization under Internal Revenue Code Section 501(c)(3). Organizations qualifying for tax-exempt status by the IRS do not pay corporate federal income tax on activities that are substantially related to the purpose for which the exempt organization was granted its exempt status.

If the exempt organization engages in business activities that are not related to its business purpose, the organization must pay taxes on the income generated. This is known as “unrelated business income” and will be taxed like income generated by a for-profit business.  If the unrelated business of the non-profit becomes too successful, however, it can jeopardize the tax-exempt status of the non-profit organization. There is no bright-line test for the amount of unrelated business income activity that an exempt organization may engage in. Generally, at least more than half of the activities of the non-profit organization must be in furtherance of the tax-exempt purposes.

To protect its exempt status, organizations can establish for-profit subsidiaries to help shield the tax exempt status at the parent level. The benefits of establishing a for-profit subsidiary include financial benefits to the parent for certain qualified tax deductible payments which are received on a tax-free basis, greater privacy in the information disclosed by the for-profit subsidiary, and greater flexibility in employee compensation.

There are a few best practices to keep in mind when tax-exempt organizations decide to set up a for-profit subsidiary. The subsidiary should be established with the idea of maintaining its separate corporate identity and existence. It is important to make sure that the commercial practices of the for-profit subsidiary do not bleed over to the non-profit parent thereby jeopardizing its exempt organization status.

The subsidiary, for example, should have an independent board of directors. Keeping in mind the different and distinct business purposes of each corporate entity, the boards of each will require different expertise. The individuals selected should be different and the boards should be fairly independent. In addition to board composition, the officers and employees of the subsidiary should be independent of the parent. Additionally, both companies should maintain separate books and records, and bank accounts to prevent commingling of funds. Other corporate formalities such as separate corporate meeting minutes and execution of documents should be maintained. Business transactions between the parent and subsidiary should be conducted as arms-length transactions, without either receiving special favors.

Control by the parent can still be maintained through ownership, for example, by having the non-profit parent own a majority of the voting shares of the for-profit subsidiary. The parent can also maintain a certain amount of control over the subsidiary by appointing the directors of the board or by establishing in the subsidiary’s bylaws requiring approval of the parent to amend the bylaws and formation documents of the subsidiary.

By implementing these best practices, it is possible for the non-profit to maintain its tax-exempt status in support of its continuing work for social causes while, at the same time, having the economic and other benefits of a for-profit subsidiary.

About the Author: Kimi Murakami is counsel with PilieroMazza in the Business and Corporate Law Group. She may be reached at [email protected].