Even though non-profits can’t make money in certain ways because of their tax-exempt status, you might be able to start a for-profit subsidiary that makes money without these restrictions. This separate business can not only bring in money but also help you lower the taxes you pay on any unrelated money-making activities and limit legal liability.
Surplus Support
Non-profits must have a legitimate reason for forming a for-profit subsidiary. Fortunately, ‘legitimate’ is broadly defined. You may create a for-profit subsidiary to generate revenue to support your non-profit — whether surpluses are used for budget shortfalls, emergencies, or new programs. For example, your historical museum may open an adjacent restaurant. After taxes and operating expenses, you may use surpluses from the restaurant for your non-profit.
You just have to be careful not to distribute any of a subsidiary’s profit to board members or employees. That’s private inurement, and it’s illegal.
Unrelated Business Income Tax (UBIT) Issues
Forming a for-profit subsidiary also can be a good idea if your non-profit is subject to UBIT. This is particularly important if you’re at risk of losing your exempt status because the IRS considers your gross revenue, net income, or staff time devoted to unrelated business activities as too ‘substantial.’
Many non-profits with income-generating real estate holdings form subsidiaries for this reason. If, for instance, a donor has given you a piece of commercial real estate and you want to develop the property and rent it to retail businesses, a separate for-profit entity is recommended. You’ll owe corporate taxes on the subsidiary’s net income, but you can use the after-tax profits for your non-profit’s activities without fear of losing your exempt status or owing UBIT.
Legal Concerns
You also may be motivated by legal concerns. If your non-profit owns significant assets or offers services unrelated to your mission, a separate entity can insulate you from liability risks. This includes lawsuits alleging negligence and accidental injury that could prove financially devastating.
And if you run unique programs or initiatives with different management and staff requirements, a subsidiary can help prevent these sideline activities from overwhelming your non-profit work. Finally, a for-profit subsidiary may provide your organization with funding opportunities that were previously inaccessible. For example, a subsidiary is generally in a better position to obtain bank loans and private investor money than a non-profit.
Better Alternatives?
If a subsidiary sounds like a good idea, be sure to take it up with your board. Board members must support the introduction of any subsidiary — and they may have valid objections that you haven’t considered. Also talk to financial and legal advisors who can help you decide if a subsidiary is the best option for boosting income or whether better alternatives exist.