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The Lure of the For-Profit Subsidiary

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For-profit subsidiaries of not-for-profit organizations are strikingly diverse. Consider these real-life examples: In one part of the country, a not-for-profit 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 the last recession – with a drop in public grants and private donations – for-profit endeavors can have a magnetic appeal as not-for-profit survivors look for new sources of revenue.

What’s the Draw?

What factors should a not-for-profit 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 not-for-profits decide to create a for-profit enterprise. As a not-for-profit, 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 not-for-profit can usually transfer its UBI activities to a for-profit subsidiary, which will conduct those activities under a separate 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 not-for-profit’s mission.

Care must be taken to keep the not-for-profit and the for-profit separate, with a board of directors for each entity. And neither the subsidiary nor the not-for-profit should distribute the proceeds to the not-for-profit’s board members or key employees. That action could be considered private inurement and is strictly prohibited for not-for-profits.

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 Odd Pets (ASPCOP) has a profitable publishing arm in the nontraditional-pets field, and draws over 15% of its revenue from the publishing operation. The not-for-profit might create a for-profit subsidiary to handle its publishing activities – or may risk endangering its tax-exempt status if publishing profits continue to grow.

Are There Other Incentives?

Additional reasons why a not-for-profit might want to launch a for-profit subsidiary include:

More leeway in setting compensation. Let’s say that the ASPCOP 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-exempt entities — for example, through stock compensation and profit-sharing.

Better outlet for research. If the not-for-profit conducts research, it would automatically have a commercial outlet for marketing its discoveries. Taking the ASPCOP example further, if the organization developed a nutritionally balanced snack for pet ferrets, it could market the snack via the subsidiary.

Reduced liability. Imagine, for instance, that a not-for-profit leases employees with criminal backgrounds to area businesses and, thus, faces some risk of recidivism. The not-for-profit may want to contain that activity within a subsidiary and protect itself from the related liability.

Additional privacy. The for-profit entity won’t be required to disclose the same information that is required for not-for-profit tax filings. Names and compensation of all key employees and directors don’t become public as in the not-for-profit arena.

Availability of financing. As a start-up venture, many businesses require capital infusions over and above what might be available from the parent. A for-profit business could obtain traditional bank loans or even venture capital funding that might be unavailable to its not-for-profit parent.

What Are the Drawbacks?

Despite the potential pluses, running a for-profit subsidiary comes with pitfalls. The not-for-profit shouldn’t allocate too much of its resources to the for-profit or it will endanger its tax-exempt status. Additionally, the not-for-profit 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 not-for-profit?

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 not-for-profit subsidiaries – C corporations and, to a lesser extent, limited liability companies — is right for your goals. And look carefully at the ownership structure. There are advantages to including other investors and owning less than 80% of the subsidiary’s stock. 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.

The Road to Success

Not-for-profit executives who’ve successfully created for-profit subsidiaries cite two key actions:

  1.  Hire employees with relevant corporate experience. Not-for-profit employees — skilled  and talented as they may be — often lack business experience and a profit-driven  focus.
  2. Maintain a management structure that’s independent from the parent organization. A parent company’s involvement in everyday decision making, they say, can expose the parent to UBIT and ultimately be a recipe for failure.