Revenue-Generating
Activities and Nonprofit
Organizations: Using
for-profit subsidiaries
David A. Levitt
Adler & Colvin
235 Montgomery Street, Suite 1220
San Francisco CA 94104
(415) 421-7555
www.adlercolvin.com
www.nonprofitlawmatters.com
© Adler & Colvin
Charity Tax Exemption
Requirements
•  Organized for exempt purposes
•  Operated for exempt purposes
•  No private inurement
•  Limited lobbying (if a public charity)
•  No partisan political activity
Sources of Income
•  Gifts, grants and contributions
 Individuals, corporations, foundations,
government, membership dues
•  Program-related earned income
•  Unrelated business income
 Active or passive (e.g., rent, royalties)
•  Investment income (e.g., dividends, interest)
Unrelated Business Income Tax
(UBIT)
•  501(c)(3) organizations generally do not pay taxes,
but they do pay tax on unrelated business income
•  3-part test:
1. A trade or business
2. Regularly carried on
3. That is not substantially related to the
organization’s exempt purpose.
Unrelated Business Income Tax
(UBIT)
•  Is the activity substantially related?
 Can be hard to tell
 Consider manner in which activities conducted
 How differ from purely commercial activity?
•  Even if related, some useful exceptions apply:
-  Interest and dividends
-  Capital gains
-  Rents from real property
-  Royalties
UBIT Can be a Rock in the
Road
Unrelated Business Income Tax
(UBIT)
•  “Exceptions to the exceptions” (e.g., debt-financed
unrelated income is taxable, even if passive)
•  Too much unrelated activity can jeopardize taxexempt status of an organization
•  How much is too much ?
•  One solution is creating a subsidiary to conduct the
business activity…
What the heck is a “subsidiary”?
Why Use a Subsidiary?
Advantages:
•  Protect tax-exempt status
•  Expand activities
•  Limit liability
•  Keep charitable mission and incomeproducing objectives separate
Why Use a Subsidiary?
More advantages:
•  Equity investment opportunities
•  Equity compensation to attract or provide
incentives to employees
Why NOT to use a Subsidiary:
•  Less complexity / expense
•  Retain charity name and goodwill
•  No prudent investment concerns
•  Services, rents and royalties taxable if charity
owns more than 50% of subsidiary
Why NOT to use a Subsidiary:
•  Could use losses to offset other UBIT
•  Easier to terminate activity
•  No dissolution process
•  Avoid tax liability on liquidation
The U.S. Entity Toolbox
•  Nonprofit Corp
•  For-profit Corp
•  “Hybrid” Corp
•  Social Purpose
•  Benefit
•  General Partnership
•  Limited Partnership
•  Limited Liability Company
•  L3C
•  Unincorporated Association
•  Nonprofit Unincorporated Association
•  Trust
•  Cooperative
That’s a lot of tools . . .
What do we really need?
The Three Most Useful
Old-Fashioned Tools
The Three Most Useful
Old-Fashioned Tools
•  Nonprofit, tax-exempt corporation
•  For-profit, taxable corporation
•  Limited liability company
Corporation vs. LLC
•  Limited Liability
•  Management and control: by
Code vs. by contract
•  Ability to attract investors
•  Ability to attract tax-exempt
investors (including PRIs)
Corporation vs. LLC
• 
Chapter C corporation:
Isolates unrelated activity
Dividends not taxable to tax-exempt parent
Rents, royalties, and interest may be UBIT
•  LLC or partnership:
Pass-through entity for tax purposes
UBIT flows through as well
Passive income may avoid tax
LLC’s, Partnerships and S Corps
•  Will not help solve UBIT problems
•  In many cases, they will generate UBIT for
the charity (e.g., by receiving an allocated
share taxable income).
•  May incur taxable income even if do not
receive a distribution of cash (“phantom
income”)
Types of Tandem Structures
• For-profit subsidiary of nonprofit
• Nonprofit under control of for-profit
• Brother/sister relationship
• Independent but aligned (board member
overlap, contractual relationships)
Key Tandem Legal Issues
• Control and board composition
• Private benefit, especially for insiders
• Unrelated business income tax
• Insider transactions / Conflicts of interest
• Respecting corporate separation
Emerging Hybrid Entities
•  Benefit Corporations
•  Social Purpose Corporations
•  L3Cs
•  What about “B Corporations”?
Emerging Hybrid Entities
•  Blend business purpose with
social or charitable purpose
•  Directors can take certain noneconomic issues into
consideration when making
business decisions
Benefit Corporations
Must create a general public benefit:
A material positive impact on
society and the environment,
taken as a whole, as assessed
against a third-party standard.
Benefit Corporations
•  General public benefit / 3rd party standard
•  Specific public benefits?
•  Director fiduciary duties
•  Transparency / Reporting
•  Accountability: benefit enforcement
Benefit Corporations
How do I become a benefit corporation?
•  Articles of Incorporation
•  Minimum Status Vote
•  Select a 3rd party standard
Social Purpose
Corporation
•  Specialized purpose in Articles
•  Protect director decision-making
•  Anchor mission
•  Dissenter’s rights
•  Transparency / Reporting
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Benefit vs. Social Purpose
•  General public benefit vs. specific
special purpose
•  3rd party standard vs. transparency
•  Director fiduciary duties
•  Right of enforcement
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The L3C
• Significantly further a charitable purpose
• No significant purpose to produce income
• No political or legislative purpose
• Vehicle for program-related investments
(PRIs)