Just because you run a not-for-profit organization doesn’t mean you can function on low or no income. Although your nonprofit’s tax-exempt status prohibits certain money-making activities, you may be able to create a for-profit subsidiary that isn’t hampered by such restrictions. In addition to producing income, a subsidiary can help you reduce taxable unrelated business income and limit legal liability.
Nonprofits must have a legitimate reason for forming a for-profit subsidiary. Fortunately, “legitimate” is broadly defined. You may create a for-profit subsidiary to generate revenue to support your nonprofit — whether surpluses are used for budget shortfalls, emergencies or new programs. For example, your historical museum may open an adjacent restaurant. After taxes and operating expenses, you may use surpluses from the restaurant for your nonprofit.
You just have to be careful not to distribute any of a subsidiary’s profit to board members or employees. That’s private inurement, and it’s illegal.
Forming a for-profit subsidiary can also be a good idea if your nonprofit is subject to unrelated business income tax (UBIT). This is particularly important if you’re at risk of losing your exempt status because the IRS considers your gross revenue, net income or staff time devoted to unrelated business activities as too “substantial.”
Many nonprofits with income-generating real estate holdings form subsidiaries for this reason. If, for instance, a donor has given you a piece of commercial real estate and you want to develop the property and rent it to retail businesses, a separate for-profit entity is recommended. You’ll owe corporate taxes on the subsidiary’s net income, but you can use the after-tax profits for your nonprofit’s activities without fear of losing your exempt status or owing UBIT.
You also may be motivated by legal concerns. If your nonprofit owns significant assets or offers services unrelated to your mission, a separate entity can insulate you from liability risks. This includes lawsuits alleging negligence and accidental injury that could prove financially devastating.
And if you run unique programs or initiatives with different management and staff requirements, a subsidiary can help prevent these sideline activities from overwhelming your nonprofit work. Finally, a for-profit subsidiary may provide your organization with funding opportunities that were previously inaccessible. For example, a subsidiary is generally in a better position to obtain bank loans and private investor money than a nonprofit.
If a subsidiary sounds like a good idea, be sure to take it up with your board. Board members must support the introduction of any subsidiary — and they may have valid objections that you haven’t considered. Also talk to financial and legal advisors who can help you decide if a subsidiary is the best option for boosting income, or whether better alternatives exist. Learn more how we support nonprofit organizations.