Taxable Subsidiaries and Tax-exempt Entities Who Love Them: Reviewing the Affair

• Publication year: 2004
• Pages: 59
• Citation: Vol. 33 No. 5 Pg. 59

33 Colo.Law. 59 Colorado Lawyer 2004.

2004, May, Pg. 59. Taxable Subsidiaries and Tax-Exempt Entities Who Love Them: Reviewing the Affair

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59

Vol. 33, No. 5, Pg. 59

The Colorado Lawyer
May 2004
Vol. 33, No. 5 [Page 59]

Specialty Law Columns
Business Law Newsletter
Taxable Subsidiaries and Tax-Exempt Entities Who Love Them Reviewing the Affair
by Sherri D. Way

This column is sponsored by the CBA Business Law Section to apprise members of current information concerning substantive law. It focuses on business law topics for the Colorado practitioner, including, but not limited to, issues surrounding anti-trust, bankruptcy, business entities commercial law, corporate counsel, financial institutions franchising, nonprofit entities, securities law, and small business entities.

Column Editors:

David P. Steigerwald of Sparks Willson Borges Brandt & Johnson, P.C., Colorado Springs - (719) 475-0097, dpsteig@sparkswillson.com; Troy Keller, senior attorney at Qwest, (303) 992-6167, troy.keller@qwest.com

Sherri D. Way

About The Author:

This month's article was written by Sherri D. Way, Denver, a partner in the law firm of Krendl Krendl Sachnoff & Way, P.C., where she specializes in corporate, insurance, and securities law, frequently advising nonprofit entities regarding for-profit ventures - (303) 629-2600, SDW@krendl. com. A version of this article first appeared in Association Management Magazine (April 2002).

Tax-exempt entities often create taxable subsidiaries to meet multiple needs. This article addresses various tax, business, and legal issues that a tax-exempt organization should consider relative to for-profit ventures in an increasingly regulated environment.

Over the past several years, there has been significant interest by tax-exempt organizations in creating for-profit subsidiary entities. Although much of this activity has involved trade associations, other tax-exempt entities are evaluating such restructurings with increasing frequency. Motivating factors often include the goals of generating revenues, sharing in profitable ventures, and providing additional community services in view of shrinking governmental support. Tax-exempt entities also contemplate creating for-profit subsidiaries for such reasons as protecting themselves from potential liabilities and spinning off activities unrelated to their tax-exempt purpose.

This article addresses typical business considerations involved in a decision to pursue ventures with for-profit subsidiaries. Additionally, it discusses how tax-exempt entities contemplating a change in business activities should consider the numerous legal and tax issues that may arise with such a change. This article also discusses the structure for for-profit subsidiary endeavors, which can be fraught with pitfalls, particularly if the proposed activities involve the offering of Internet services or insurance, securities, or other financial products.

Tax Considerations and Business Activities

The prudent nonprofit should carefully consider the business activities in which the tax-exempt entity is engaged or in which it contemplates becoming engaged. As a threshold issue, Internal Revenue Code ("Code" or "IRC")1 §§ 511 through 515 impose tax on income of tax-exempt organizations if the income is determined to be unrelated trade or business taxable income.

Nonetheless, engaging in a business activity does not in itself subject the tax-exempt organization to unrelated business income tax ("UBIT"). Instead, the determination requires a detailed analysis of the business activity involved and a careful evaluation of whether this activity will contribute to achieving the entity's exempt purpose.2

The contemplated business activity must significantly contribute to the purpose of the tax-exempt organization. In the case of trade associations, such activity must benefit the industry as a whole, as opposed to benefiting individual members. If the contemplated business activity does not meet such criteria, the nonprofit organization will be subject to UBIT on revenues generated from the activity unless an exception applies.3 Further, the nonprofit organization may risk disqualification as a tax-exempt entity if the unrelated business activity becomes substantial in comparison to the nonprofit entity's tax-exempt purpose.4

It often can be difficult to determine how certain business activities impact the purpose of a tax-exempt entity. Speculating as to whether particular activities will further the entity's exempt purpose can be counterintuitive. For example, a tax-exempt museum's operation of a parking facility for patrons has been deemed consistent with its charitable mission, even though the general public also was permitted to use the facility.5

It may be prudent for tax-exempt entities to conduct certain business activities through subsidiaries. If such subsidiaries are properly organized and operated, the nonprofit parent likely will be shielded from the loss of its tax-exempt status as a result of the business conducted by the subsidiary.6 Assuming corporate formalities are observed, the parent entity also will enjoy insulation from the legal liabilities of its for-profit subsidiary.

Structural Considerations And Choice of Entity

Determining the best structure for a for-profit activity requires evaluation of several factors, including the tax, accounting, and regulatory implications.7 The activity could be conducted either directly in the tax-exempt entity or indirectly, through a separate partnership, limited liability company ("LLC"), or corporation. Each of these entities may offer its own alternative forms, such as limited or general partnerships. The entities also might be combined in some fashion. For example, a nonprofit entity considering a joint venture relationship with a for-profit entity to develop an Internet portal might consider forming a corporate subsidiary that would enter into a partnership, LLC, or joint venture relationship with the for-profit entity.

It is not possible to generalize as to which structure is best. In every situation, each legal structure must be evaluated on its own merits. However, the most common structure for spinning off a for-profit activity is a regular (or "C") corporation. The primary advantage of a C corporation is that for-profit activities are insulated from the tax-exempt purposes of the parent organization, assuming there are no "piercing-the-corporate-veil" issues. This avoids the necessity of dealing with unrelated business taxable income issues in the tax-exempt parent, and also ensures that the activities of the for-profit subsidiary will not jeopardize the parent's tax-exempt status.8

Moreover, dividends paid by the for-profit corporate subsidiary normally will not be taxed to the parent as unrelated business taxable income.9 Consequently, there will be only one level of tax on the profits of the subsidiary's activities, instead of a double tax (once at the corporate level and again at the shareholder level) that is typically imposed on corporate profits.

In some instances, the creation of a taxable subsidiary may not be warranted. A tax-exempt organization that will engage only in passive, low-risk activities and generate only royalty income not subject to UBIT10 may not justify the formation of a subsidiary of any type (assuming the entity is not concerned with its ability to insulate itself from liability as a result of these activities). Conducting business in a for-profit subsidiary in such an instance would, in fact, subject revenue to UBIT that otherwise may be excluded.

Conversely, a...