By Mike Sorrells, CPA and Joyce Underwood, CPA
As nonprofits grow larger and their missions expand, many organizations structure their activities through a variety of related organizations, often because a particular structure may not work at all if the activity were carried out in the main nonprofit organization. We commonly see structures involving 501(c)(3), 501(c)(4) or (6), Political Action Committees (PACs), for-profit corporations, and single member Limited Liability Companies (LLCs), as well as partnerships or LLCs with both nonprofit and for-profit partners—either domestic or foreign. Within these complex structures, there are a number of tax issues that can arise, including those related to tax-exempt status and unrelated business income. Here are eight of the most common issues nonprofits encounter, as well as some best practices regarding tax issues for complex nonprofit organization structures.
1. Separation of Entities
One of the most important starting points for tax considerations for related organizations is legal and operational separation. If proper separation is not maintained among related entities, the Internal Revenue Service (IRS) may attribute the activity of the related entity to the parent nonprofit, sometimes with dire results. Related organizations should be separate legal entities (usually corporations) with separate bank accounts and books, and the corporate status must be maintained by filing annual registrations with the state. It’s acceptable for the books of related organizations to be kept on one general ledger system as long as it is possible to easily separate the records of one entity from another. Corporate formality must be maintained with separate board meetings and minutes, although having overlapping boards is generally permitted. For a number of reasons, it is highly recommended that there be written contracts between related organizations as well as between organizations and third parties (i.e., the contract should be with the entity receiving services and not with the main organization). Expense reimbursement arrangements between related organizations should be documented in writing.
2. Provision of Services
It is common and often efficient to share employees and administrative resources among related organizations as this practice can avoid duplicate staff and unnecessary administrative costs. A proper method of allocating costs should be developed and applied consistently using timesheets and other such cost allocation documents. It is important to determine if an employee sharing arrangement is classified as a common paymaster or leased employee arrangement, since the type of agreement can impact employee benefits, tax information reporting and disclosure on IRS Form 990. Beware that providing services for affiliated organizations, whether they are administrative or program related, can result in unrelated business income tax (UBIT). Additionally, the terms of the agreement cannot put the nonprofit in a disadvantageous position. This is particularly important when the nonprofit is a public charity, as the IRS does not allow charitable assets to be released for less than fair market value. It is equally true when the arrangement involves a for-profit affiliate, particularly one that is not wholly-owned. It is also important that “due to” and “due from” accounts be settled frequently so large balances don’t build up that cannot be repaid.
3. 501(C)(3) Charity Relationships With Other Nonprofits
When structuring complex organizations, it is important to remember that 501(c)(3) organizations cannot be involved in political campaign activities and must be isolated from such activities by their affiliates. They also cannot have a PAC (political action committee) directly associated with them. The 501(c)(3) organizations must avoid links on their website to affiliated organizations’ content regarding political activities as well as to other organizations with political or lobbying content. A 501(c)(3) may make grants to a 501(c)(4) or 501(c)(6) organization (affiliated or unaffiliated) in support of their programs, but the funds must be used exclusively for educational or other purposes appropriate for a 501(c)(3), and the 501(c)(3) should require reports (expenditure responsibility) showing that this requirement has been honored. Although they can support certain affiliate activities, the programs of the entities should remain separate to avoid any potential confusion as to which organization is conducting which activities. The 501(c)(3) cannot, under any circumstances, provide grant funds to a 501(c)(4) or 501(c)(6) for use to support partisan political activities.
4. Political Action Committees (PACS)
A political organization (organized under Internal Revenue Code (IRC) Section 527) is used primarily to fund activities designed to influence the nomination or election of candidates for public office. These organizations are frequently associated with 501(c)(4)s and 501(c)(6)s using a PAC in the form of a separate segregated fund (SSF). SSFs have tax-exempt status and are treated as an entity separate from the connected 501(c)(4) and/or 501(c)(6). They must obtain a separate employer identification number (EIN) and maintain a separate bank account. The PAC typically must report periodic receipts and disbursements to the Federal Election Commission (FEC) or state equivalent, instead of filing a Form 990. A sponsor cannot donate directly to a PAC, but employees or members can contribute funds. A PAC cannot loan money to its sponsor, although the sponsor may pay the administrative expenses of a PAC, as such administrative expenses are not considered political expenditures of the sponsor. Often, a PAC will be included in consolidated financials, but it cannot be included in the sponsor’s Form 990 financial information.
5. Single Member Limited Liability Companies (LLCS)
In the past several years, the nonprofit arena has seen a proliferation of the use of single member LLCs. This kind of entity provides the owner or single member significant protection from various liability issues while not requiring separate tax reporting. Single member LLCs are so-called disregarded entities under tax law, meaning that unless they elect otherwise, their activities are considered to be those of the single member and are reported on the member’s tax return as such (in the case of a nonprofit, on its Form 990). LLCs may elect to be treated as a corporation for tax purposes and thus, are taxed and file tax returns under C-corporation rules. If a 501(c)(3) has a single member LLC, then contributions to the LLC will be considered as being made to the parent charity, so it is not necessary for an LLC conducting charitable activities to obtain separate exempt status. However, states may treat single member and other LLCs differently with regard to sales, property, payroll and sometimes, income tax. Therefore, it is advisable to research applicable state laws when setting up such an entity.
6. Controlled C-Corporations
Many nonprofit organizations own controlled C-corporations (requiring greater than 50 percent ownership) for a variety of reasons, including having enough unrelated activity that it might endanger the nonprofit’s exempt status. The IRS ruled many years ago that a controlled C-corporation, if the corporate formalities are observed, will not have its activities attributed to the parent organization and thus, will not endanger the exempt status of the parent. However, the IRS has a special rule that can catch the unwary nonprofit organization: Under IRC Section 512(b)(13), passive income such as rents, royalties and interest (which are normally excluded from taxable UBIT) generally become taxable to a greater than 50 percent nonprofit owner of a C-corporation if that corporation takes a deduction for the related expense. There are exceptions and complexities with this provision, so organizations with controlled C-corporation subsidiaries should carefully examine these issues prior to engaging in intercompany transactions.
7. Exploitation of Nonprofit Assets
It is important to avoid the exploitation of nonprofit assets when structuring an arrangement between affiliates. There must be fair compensation to the nonprofit, especially when the transaction is with a controlled C-corporation. Royalty and service agreements must be in writing with all terms concisely outlined. The dual-use of property (i.e., property used partly for an exempt activity and partly for an unrelated activity) requires proper allocation and substantiation. It is important to note that there may be exemption issues when partnering with a for-profit entity, especially in the healthcare industry. The nonprofit must have control, at least with regard to any activity endangering exempt status of the nonprofit.
8. Form 990 Reporting
Of course, complex structures require special reporting on Form 990. First of all, with the exception of single member LLCs, all activities and balance sheet amounts for related organizations are not included on the parent organization’s Form 990. These other entities will generally have to file their own tax returns. All related organizations, including single member LLCs, have to be listed on Schedule R along with certain financial and other information. “Related,” for purposes of the Form 990, generally means an organization that controls another organization or is controlled by one; or are brother/sister organizations under common control. However, a careful reading of the Form 990 instructions is required to understand the nuances of this definition. Transactions between the reporting organization and related organizations are generally required to be detailed on Schedule R if transactions exceed certain thresholds. Related organizations controlled by insiders may also need to be reported on Schedule L for certain transactions. If related organizations are foreign entities, then expenditures to them, including grants, will generally need to be reported on Schedule F.
In addition to the most common issues regarding related organizations described above, there can be many additional situations and fact patterns that should be considered in establishing such complex structures. Before setting up related entities, it is prudent to consult with an experienced advisor who can provide the specific facts and circumstances of the new entity structure and the activities of the new entity that are being contemplated.
For more information, contact Michael Sorrells, national director, Nonprofit Tax Services, at msorrells@bdo.com or Joyce Underwood, director, at junderwood@bdo.com.
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Fall 2015). Copyright © 2015 BDO USA, LLP. All rights reserved.www.bdo.com