Don't Worry, Be Profitable

A Taxable Subsidiary Can Help
You Keep Your Tax-Exempt Status

By Julian H. Spirer

Not long ago, a community development corporation I know boldly entered the forprofit world of wealth creation by starting a real estate management business. The CDC had noticed that private developers were making money from the improved community environment which its social and economic programs had fostered; the organization believed it could manage local real estate more compassionately and more in keeping with its community development objectives. The CDC had also realized that a forprofit business could generate needed revenue.

The organization pondered the idea before it embarked on the plan. Why? It worried that operating a forprofit business would jeopardize its tax-exempt status.

The CDC had cause to be concerned. To the extent that activities do not further a nonprofits exempt purposes (except through the production of revenue), they can risk the organizations tax exemption. Forprofit business activities can expose a nonprofit to liability claims from creditors, from persons injured by defective products, from people asserting trademark or copy right violations, and more. Staff and board members may well be reluctant to have new projects put their organizations core activities at financial risk, and may feel that the management of these ventures is best left to profit-oriented executives or to executives more versed in the activities to he managed.

The CDC minimized its risk of difficulties by creating a taxable subsidiary. Taxable subsidiaries can pursue any business or service opportunity available to a forprofit venture. Unless an organizations investment in the subsidiary comes to dominate its affairs, its tax exemption should be safe. Additionally, the separate legal structure insulates the nonprofit from the liabilities of the subsidiary and offers an occasion for the hiring of a separate team of managers and executives.

Of course, nonprofits must still proceed carefully when establishing a taxable subsidiary. To ensure that the liabilities of the subsidiary do not jeopardize the finances ot the nonprofit, the operations of a subsidiary must be kept genuinely separate. This means that the subsidiary should be properly incorporated under state law, maintain its own set of hooks and records, ideally have its own personnel (or have the joint staff compensated separately under contract with the subsidiary), and have its own Board of Directors and officers (with minimal, if any, overlap with those of the nonprofit).

The DCD took these precautions. The operations of its real estate business are run out of separate but adjacent space. The subsidiary has a wholly separate group of officers and directors with the exception of the nonprofits chief executive officer, who serves as its board chairman, voting only to break or make ties.

Nonprofits interested in establishing a taxable subsidiary should also bear the following issues in mind: A taxable subsidiary can rent space from its parent nonprofit at fair market rates. Any relationship with the nonprofit, whether as tenant, licensee of trademarks, or purchaser of mailing lists, should he carefully documented with terms resembling those which would have been arrived at in negotiations between unrelated parties.

The operations of the subsidiary should not increase the overall tax payable by the combined venture. While the subsidiary will he liable for income tax on its profits, the nonprofit would most likely have paid the same amount in unrelated business income tax in the absence of the spin-off. The dividends distributed from the subsidiary to the nonprofit after the spin-off are exempt from additional tax under section 512 of the Internal Revenue Code.

Ultimately, if a subsidiary should become a great financial success, a 501 (c)(3) parent organization may have to consider the impact of the dividends on its required percentages of public, as opposed to investment, support. However, this is the kind of problem which most nonprofits would welcome.

Julian Spirer ( is
a senior lawyer with the firm of Spirer & Goldberg, P.C., in Washington, D.C.

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