Q&A #173 – Can a 501(c)(3) nonprofit organization convert to for-profit status?
Question: I lead a 501(c)(3) organization that has been developing different fee-for-service revenue streams in recent years and relying much less on funding from grants and donations. We are considering transitioning to become a for-profit entity. Is a 501(c)(3) organization permitted to give up its tax-exemption and convert to for-profit status?
Answer: In theory, there are ways for a 501(c)(3) public charity to transition to operating as a taxable for-profit business entity. However, this is a difficult process with many legal pitfalls, including the excess benefit transaction, inurement, and private benefit rules under federal tax law, and state laws governing nonprofit corporations and the use of funds received for charitable purposes.
Technically, “converting” or “merging” a 501(c)(3), nonprofit entity into a taxable, for-profit entity is rarely available as an option under state nonprofit corporation law (though in some states this may be possible with the approval of the state’s Attorney General or Secretary of State).
More often, a 501(c)(3) organization that wishes to become a taxable for-profit business entity would implement this transition by: (1) forming a new for-profit entity; (2) working to move the nonprofit organization’s activities and/or assets to the for-profit entity in a manner consistent with applicable law; and (3) dissolving the nonprofit organization. However, this process faces numerous compliance hurdles.
Note that this discussion is focused on 501(c)(3) public charities, and additional requirements and restrictions will apply in the case of 501(c)(3) private foundations.
As a general principle, assets received by a 501(c)(3) organization must be permanently dedicated for charitable, educational, scientific, religious or other purposes consistent with 501(c)(3) status. This stems from the “organizational test” that is a condition of 501(c)(3) status, which must be reflected in purpose and dissolution language in an organization’s Articles of Incorporation. This is one of the main factors that makes conversion to for-profit status difficult.
Conflict of interest rules impose another challenging restriction. If the intended owners of for-profit entity are or were Board members, officers, management employees, or otherwise qualified as “disqualified persons” with respect to the nonprofit organization, any transfer or use of the nonprofit’s assets for the benefit of these owners will be prohibited under federal excess benefit transaction and inurement rules unless the organization receives fair market value in exchange. The organization would also need to be able to document this treatment using proper due diligence and conflict of interest processes.
Even if disqualified persons are not in a position to benefit from the transition to for-profit status, the process would need to be closely scrutinized under “private benefit rule” that prohibits 501(c)(3) assets from being used for the benefit of private interests more than incidentally, a standard that we discussed further in Q&A #84.
State laws governing the operation of nonprofit corporation and the use of funds held for charitable purposes present another compliance challenge. Depending on the laws and processes of the particular state, the approval of the Secretary of State, Attorney General, or a court may be required before using a nonprofit organization’s assets in a manner not consistent with charitable purposes or donor intent. Similarly, written notice to and/or approval from the Secretary of State or Attorney General may be required before transferring all or substantially all of a nonprofit organization’s assets to another entity. State officials typically also have jurisdiction to monitor dealings between an organization and its directors and officers, particularly those that raise conflict of interest issues.
Nonetheless, it may, under certain circumstances, be possible to implement a transition to for-profit status by granting certain assets to a newly formed for-profit entity, and/or by spending down charitable assets on programs within the nonprofit entity before dissolving. In the latter approach, the for-profit entity would commence similar or new programs, without the use of charitable assets, during or after the dissolution of the nonprofit.
Note that any grants or transfers of assets (including intangible assets such as trademarks, website content, and URLs) to a for-profit entity must be subject to restrictions that avoid excess benefit transactions and inurement, and ensures the granted funds are used only for permissible 501(c)(3) purposes (consistent with conflict of interest processes and other rules described above). The IRS provided guidance on grants to non-charitable entities in Revenue Ruling 68-489, which requires the 501(c)(3) granting organization to the 501(c)(3) organization: (1) limit distributions to specific projects that further its own exempt purposes; (2) retain control and discretion as to the use of the funds; and (3) maintain records establishing that the funds were used for section 501(c)(3) purposes. We further discuss application of this Revenue Ruling in Q&A #120.
Planning Tip – Before embarking on any major organizational change such as a merger, acquisition, or change in tax-exempt status, the Board of Directors should document in contemporaneous meeting minutes the research, due diligence, and thought process that led to the decision. It can be especially important to show that the Board thoughtfully considered alternatives to the course of action that was ultimately chosen, such as by delegating research of various options to one or more committees or third-party independent professional consultants and having them present these findings to the Board.
Regardless of the approach used, any transfer or transition of a 501(c)(3) nonprofit organization’s activities or assets to a for-profit entity is likely to attract heavy scrutiny and suspicion from federal and state officials as well as the public, particularly if the for-profit entity is owned or controlled by the Board members, officers, or founders of the nonprofit. Such a course of action should never be attempted without guidance from the organization’s attorneys, CPAs, and other expert advisors.
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