The Pros & Cons Of Starting A For-Profit Subsidiary
I continue to see that more and more nonprofits are creating for-profit subsidiaries. These types of entities have grown in popularity for several reasons, including the fact that they allow nonprofit organizations additional ways to generate revenue while diversifying their funding sources. Rather than being forced to rely on public support (donations) alone, a for-profit subsidiary allows nonprofits to become self-sustaining through social enterprise. Additionally, a for-profit subsidiary can be a great solution for many of the numerous challenges a nonprofit organization faces every day – such as insufficient funding or harsh regulatory rules. However, establishing and managing a for-profit subsidiary requires preparation and expert guidance. This article will provide you with valuable insights on the key concerns when choosing to create a for-profit venture.
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A Closer Look
Operating a for-profit subsidiary brings about significant costs and responsibilities that every nonprofit should closely consider before pursuing one. Going through and reviewing the positives and negatives of this option is a great place to start. For your convenience, I’ve laid out a few important aspects to consider.
Positives
- Protection Of Exempt Tax Status: This is the most common reasons nonprofit leaders choose to pursue a for-profit subsidiary. Such an arrangement should be considered by nonprofits that have (or plans on having) significant unrelated business activities that generate unrelated business income that is taxed by the IRS.
Yes, these unrelated business activities can be a great source of additional funds, but it’s important to remember that your tax exempt status could be revoked if the IRS deems the unrelated activities to be too significant. If you move these activities to a for-profit subsidiary, it mitigates this risk.
- Liability Reasons: The for-profit subsidiary is also a great way to protect your management team against liability by allowing the exempt parent organization to own the subsidiary by holding all or a majority of its ownership.For example, a nonprofit organization, whose mission it is to lease employees with prior criminal records to other businesses, opens itself up to risk. However, to further protect itself, a nonprofit may put this type of activity inside its for-profit subsidiary.
- Attracting Talent: With a for-profit subsidiary, a nonprofit organization can provide employees with equity compensation and other profit-sharing opportunities. Being able to offer these options to employees could prove to be important for attracting and retaining talent in a competitive job market. Additionally, a for-profit subsidiary isn’t regulated by the same state and federal compensation laws, making far easier to pay employees.
- Additional Privacy: Concerning taxes, a for-profit subsidiary doesn’t have to provide the same information that would be required from a nonprofit organization. Unlike nonprofit filings, the names and compensation of key employees don’t have to be public knowledge when they fall under the umbrella of a for-profit subsidiary.
Negatives
- Jeopardize Tax Exempt Status: As mentioned earlier, a nonprofit that allocates too many resources and places too much emphasis on the for-profit operations can jeopardize their tax exempt status. This is not extensively defined by the IRS, but generally, five percent of revenue is safe while 20 percent may be considered too excessive.
- Additional Costs: Operating two entities is more expensive than one; and corporate regulations must be maintained to protect the separation of the two entities. Those would include separate board and committee activities, bank accounts, etc. Furthermore, additional management, personnel and professional fees will oftentimes be required. In the end, you may find it much cheaper to run the same functions within your nonprofit organization, but again, this activity cannot be deemed significant.
With for-profit subsidiaries, there are a lot of moving parts that need your attention and shouldn’t be handled lightly. If your organization is considering creating a for-profit subsidiary structure, seek legal and CPA advice at the onset. Contact Rea & Associates’ nonprofit services team or call me directly at 614.923.6542.
By Ben Antonelli, CPA (Dublin office)
Check out these resources for more valuable not-for-profit insights:
Webinar | Nonprofit Compliance Overview
New Tax Rules Will Hit Nonprofits Hard
State and Local Filing Requirements of Tax-Exempt Organizations