While it may seem contradictory, a non-profit can own all of the ownership interest in a for-profit entity, whether such entity is a corporation or limited liability company.

Why Create a For-Profit Subsidiary?

A tax-exempt organization is allowed to generate income from unrelated trades or businesses so long as it pays income tax on the profits and the commercial activity is insubstantial. If the commercial activity becomes substantial, the IRS may revoke the organization’s tax-exempt status. Housing the unrelated business activity in a for-profit subsidiary can protect the exempt organization from losing its tax-exempt status. The for-profit subsidiary’s activities also are not subject to disclosure because it is not required to submit Form 990 each year.

How to Create a For-Profit Subsidiary

A non-profit can create a subsidiary by incorporating a corporation in which it is the majority shareholder or by creating an LLC in which it is the sole member. Corporate formalities for each entity must be observed. The non-profit and subsidiary should have their own board meetings, file their own annual reports, and avoid commingling assets. Any transaction between the two should be conducted at arm’s length and reduced to writing. Although not necessary, having separate board members or managers may help avoid breaching the duty of loyalty. Failing to adequately separate the two entities may lead a court or regulator to consider them as a single organization. This may result in tax and liability issues.

Capitalizing the For-Profit Subsidiary

Capitalizing the for-profit subsidiary presents more difficult issues than creating the subsidiary. Generally, non-profits may freely make investments that primarily further a charitable purpose rather than an investment purpose. An investment in a for-profit subsidiary is unlikely to qualify as furthering a charitable purpose as opposed to an investment purpose. A non-charitable investment by a non-profit must be a “prudent” investment under the Uniform Prudent Management of Institutional Funds Act (UPMIFA). UPMIFA governs investment of institutional funds, which are funds held by an institution exclusively for charitable purposes.

UPMIFA requires that a non-profit consider the following factors in managing and investing institutional funds:

• General economic conditions
• The possible effect of inflation or deflation
• The expected tax consequences of investment decisions
• The role that each investment plays within the overall investment portfolio
• The expected total return from income and the appreciation of investments
• The institution’s other resources
• The institution’s needs to make distributions and preserve capital
• An asset’s special value or relationship to the institution’s charitable purposes

The UPMIFA also requires that institutions diversify their investments unless the institution reasonably determines that the purposes of the fund would be better served without diversification due to special circumstances. The general rule requires diversification though. Therefore, it would be a violation of UPMIFA for a non-profit to invest all of its institutional funds in a single for-profit business. When making decisions about funding for-profit subsidiaries, a non-profit must be careful to abide by all governing investment laws including any requiring diversification. By following these requirements, non-profits will likely make “prudent” investments.

Davis Law Group Can Help

If you have any questions about creating, managing, or investing in a for-profit subsidiary as a non-profit, contact our qualified non-profit attorneys today.