The lure of the for-profit subsidiary

For-profit subsidiaries of nonprofit organizations are strikingly diverse. Consider these real-life examples: In one part of the country, a nonprofit health maintenance organization (HMO) creates a for-profit subsidiary to offer health insurance unavailable through HMOs.

Elsewhere, a university business school starts a venture capital company to fund worthy startups and give students a first-hand look at what makes businesses tick. And, an investors association acquires a software developer to broaden its product line and add investor clubs and individual investors to its target market.

Sound interesting? In the wake of a severe recession — with a drop in public grants and private donations — for-profit endeavors can have a magnetic appeal as nonprofit survivors look for new sources of revenue.

What’s the draw?

What factors should a nonprofit consider before taking on the significant cost and responsibility of operating a for-profit company? You’ll need, of course, to weigh the pros and cons of this strategic move.

Unrelated business income (UBI) is the top reason why nonprofits decide to create a for-profit enterprise. As a nonprofit, an organization can conduct a certain amount of revenue-producing activities unrelated to its mission, but it will pay tax on UBI profits. And if the IRS determines that your organization is pulling in too much gross revenue or net income, it could lose its coveted tax-exempt status. The same risk exists if the IRS decides that your staff is spending too much time on UBI activities.

To avoid such scenarios, the nonprofit can usually transfer its UBI activities to a for-profit subsidiary and conduct activities under that umbrella. The organization can generate after-tax surpluses through the subsidiary and, after paying tax in the subsidiary, use the profits (in the form of stock dividends) to fund activities that fulfill the nonprofit’s mission.

Care must be taken to keep the nonprofit and the for-profit separate. For instance, neither the subsidiary nor the nonprofit should distribute the proceeds to the nonprofit’s board members or key employees. That action could be considered private inurement and is strictly prohibited for nonprofits.

Some see creating a for-profit subsidiary as a way to, in effect, pay for the next phase of a not-for-profit’s growth. For example, the fictitious American Society for the Prevention of Cruelty to Ferrets (ASPCF) has a profitable publishing arm in the nontraditional-pets field, and draws over 15% of its revenue from the publishing operation. The nonprofit should create a for-profit subsidiary to handle its publishing activities — or it might risk endangering its tax-exempt status if publishing profits continue to grow.

Are there other incentives?

Additional reasons why a nonprofit might want to launch a for-profit subsidiary involve internal flexibility and reduced risk in some areas.

More leeway in setting compensation. Let’s say that the ASPCF wants to hire a nationally respected animal nutritionist to create a line of nontraditional pet food. With a subsidiary, one is able to attract and keep highly skilled employees in ways that are unavailable to tax-free entities — for example, through stock compensation and profit-sharing.

Better outlet for research. If the nonprofit conducts research, it would automatically have a commercial outlet for marketing its discoveries. Taking the ASPCF example further, if the organization developed a nutritionally balanced snack for pet lizards, it could market the snack via the subsidiary.

Reduced liability. Imagine, for instance, that a nonprofit leases to area businesses employees with criminal backgrounds and, thus, some risk of recidivism. The nonprofit may want to contain that activity within a subsidiary and thus protect itself from liability.

What are the drawbacks?

Despite the potential pluses, running a for-profit subsidiary comes with pitfalls. The nonprofit shouldn’t allocate too much of its resources to the for-profit or it will endanger its tax-exempt status. Additionally, the nonprofit must have a realistic idea of what taking on a for-profit endeavor will mean for the organization. Operating a separate entity has its own costs and complexities, such as management, personnel, tax, audit and other requirements. Ask yourself: Could the same function be done less expensively within your nonprofit?

Spinning off

If your organization is considering creating a for-profit subsidiary, seek legal and tax advice at the onset. You’ll need to decide, for example, if either of the most popular structures for nonprofit subsidiaries — C corporations and, to a lesser extent, limited liability companies — is right for your goals. Additionally, your CPA can help you conduct a feasibility study and, if your idea survives, form a business plan and work out how to capitalize your endeavor.