Can a Nonprofit Also Have a For-Profit Division?

By Michelle Kaminsky, J.D.

Can a Nonprofit Also Have a For-Profit Division?

By Michelle Kaminsky, J.D.

One of the biggest challenges of running a nonprofit organization is maintaining its tax-exempt status while also generating enough funding to continue its mission. To achieve this balance, some nonprofits choose to operate a for-profit division, either within the organization or as a subsidiary.

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When running a nonprofit that coordinates with a for-profit, it is critical to pay close attention to tax and legal regulations so the nonprofit doesn't lose its preferred tax status.

Because of the potential pitfalls of such a setup, many companies now choose to create one of the several types of "hybrid" legal entities available in most states.

Differences Between Nonprofit and For-Profit

A nonprofit organization is created to provide a service for the public good. In order to qualify for preferred federal tax treatment, a nonprofit must meet the requirements set out in Section 501(c)(3) of the Internal Revenue Code, which lists the following as exempt purposes: “charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals."

A nonprofit raises money for these efforts through donations, membership fees, or other fees charged for services to clients. It then reinvests money not needed to cover operating expenses back into the organization, funds other nonprofits, or purchases program-related investments (PRI) to further the mission of the nonprofit.

A for-profit corporation, on the other hand, exists to generate income, which it does through selling goods or services.

Nonprofit Collaborating with For-Profit

Within a for-profit division, a nonprofit can generate some income from trade or business activities unrelated to the tax-exempt purpose and pay unrelated business tax (UBIT) on those revenues. The potential problem that arises, however, is that the Internal Revenue Service (IRS) does not explicitly define when it considers an activity to be unrelated to the nonprofit's tax-exempt purpose or how much activity could be considered too much to push the nonprofit into for-profit territory.

Accordingly, a nonprofit may decide to create a for-profit company to provide a revenue stream. One way to accomplish this goal is to have the nonprofit own a for-profit company with the latter as a subsidiary. Another option is to run two companies side-by-side.

The companies' compositions may have some overlap, but each must have its own board of directors and bylaws. The for-profit can funnel funds into the nonprofit and even donate and receive tax deductions. Moreover, the for-profit can bring in additional types of investors and also compensate employees in different ways, including through higher salaries and equity shares.

Still, running two organizations can be administratively burdensome, and if the nonprofit doesn't adequately separate its operations from the for-profit's, it can run into problems with taxes and other liabilities.

Nonprofit and For-Profit Hybrid Options

Many states allow hybrid legal entities that operate as both businesses and charitable organizations, though laws vary greatly on the specifics.

A “benefit corporation," available in a majority of states and the District of Columbia, is a for-profit corporation that also serves a charitable or social purpose. Various states offer similar alternatives, such as California's "flexible purpose" corporation and Delaware's “public benefit corporation."

Some states also permit a “low-profit limited liability company" known as an L3C. As with other LLCs, both individuals and other corporations may be owners of an L3C, which is simply another type of for-profit corporation, albeit with a social mission as its primary purpose. L3Cs attract private investments and must distribute a portion of their earnings to the charitable purpose or face potential federal tax penalties. An L3C may also generate income—and even distribute profits to members—but this must remain a secondary function of the business.

Today's nonprofits have more choices than ever regarding business structure, but they still must be careful to follow all applicable rules in order to retain their federal tax-exempt status.

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