Why and How Should a Nonprofit Form a Subsidiary?
The formation of subsidiaries is a consideration that surfaces during the lifetime of many nonprofit organizations as a strategy to expand operations, growth, and overall capacity to deliver more on mission. A subsidiary is a separate entity that is controlled (to some degree) by a parent organization, and subsidiaries are created by nonprofits for a wide variety of reasons.
When done right, the creation of a subsidiary can open the door to new funding opportunities, programs and services, and expanded capabilities that can have a powerful impact on an organization’s mission goals. However, in my experience there is much confusion among nonprofits about why and how to form a subsidiary, and numerous pitfalls to avoid.
The successful formation of a subsidiary starts with a careful review of three important fundamentals: (1) the reasons for forming a subsidiary; (2) the governance and management structure; and (3) the key operational considerations arising from a subsidiary’s relationship with the parent organization. These three matters are discussed below.
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1. Reasons for Forming a Subsidiary
When embarking on the process of forming a nonprofit subsidiary, the first question to consider is why. Making one organization successful, sustainable, and compliant with the rules applicable to nonprofit organizations is hard. Doing so with two or more organizations simultaneously is much harder. Therefore, the benefit of forming a new subsidiary must outweigh the time, effort, and cost of set-up and continued operational maintenance.
Nonetheless, there are a number of reasons why it may be necessary or advantageous to create a subsidiary, usually involving one or more of the following:
Tax-Exempt Status: Sometimes creation of a subsidiary is necessary to protect the tax-exempt status of the parent organization, or to provide a vehicle through which to enjoy the benefits of 501(c)(3) status. For example, a 501(c)(3) parent organization may wish to engage in business activities, lobbying, or political activities that are prohibited or limited for 501(c)(3) organizations. In other cases, a for-profit company, foreign non-governmental organization, 501(c)(6) trade association, 501(c)(4) social welfare organization, 501(c)(7) social club, or another type of nonprofit may wish to create a 501(c)(3) subsidiary in order to pursue grant funding or tax-deductible contributions for educational activities or other proper 501(c)(3) purposes.
Liability: An organization may also wish to set up a subsidiary to engage in high-risk activities for which the parent organization does want to be liable in the event of a lawsuit. While much of this risk can be managed or eliminated by purchasing insurance, forming a subsidiary corporation can provide additional protection by insulating the assets of the parent organization in the event the subsidiary corporation is sued or defaults on its debts.
Independence: A third common reason for forming a subsidiary is to ensure that a particular project or activity will be conducted and governed independently, without too much involvement or interference from the parent organization. This may stem from branding strategy to ensure that the public perceives the project or activity as unbiased by the parent organization. Or the parent organization may simply believe that the new project or activity would be more effectively governed by its own Board of Directors, which will be less influenced by the parent organization’s other priorities.
This also sometimes comes up when an organization pursues a new project in collaboration with other organizations or companies. With a subsidiary, the collaborating organizations can be given a seat on the Board of Directors of the subsidiary organization, and any funds transferred to the project will remain under the subsidiary’s control.
2. Governance and Management Structure
Once the decision has been made to form a subsidiary, the next key question is how the new entity will be structured in relation to the parent. The challenge is to find the right balance between providing the desired level of the control to the parent, while maintaining independence sufficient to ensure that the separateness of the entities will be respected for tax and liability purposes.
In a true parent-subsidiary relationship, the parent maintains majority control over the subsidiary’s Board of Directors. While the subsidiary’s Board members will have fiduciary duties to make decisions in the best interests of the subsidiary (rather than in the best interests of the parent), most parent organizations want to maintain control over the subsidiary’s Board to ensure that the parent organization is informed, involved, and influential, thereby helping to the keep the priorities of the two organizations aligned.
Parent organizations generally maintain control over the subsidiary’s Board in one or more of the following ways:
Appointment and Removal Power: With this structure, the parent organization’s Board of Directors appoints (and has the power to remove) the subsidiary organization’s Board of Directors. The parent organization can use this power by appointing its own Board members, the parent organization’s executive leaders or staff, or other individuals the parent organization desires to have on the subsidiary’s Board. To ensure this power cannot be taken away, the appointment/removal power is typically accompanied by the power to approve amendments to the subsidiary organization’s Articles of Incorporation and Bylaws. Depending on the applicable state nonprofit corporation law, this power can be codified either by making the parent organization the sole voting “member” of the subsidiary organization or simply by writing these powers into the relevant provisions of the subsidiary organization’s Articles of Incorporation and Bylaws.
Overlap of Directors: This structure, sometimes called a “brother-sister” subsidiary, is one in which the parent organization’s Board members directly hold seats on the subsidiary’s Board of Directors. Typically, there is at least a majority of these “overlapping” Directors, and the parent organization exerts control indirectly by ensuring the subsidiary’s Board includes individuals who are deeply immersed in the mission priorities of the parent organization. This structure can be implemented in different ways, such as by requiring in the subsidiary’s Articles of Incorporation and/or Bylaws that certain seats on the subsidiary’s Board are filled by the parent organization’s Directors ex officio (automatically), and/or by requiring that the subsidiary always maintain a certain percentage of the parent organization’s Board members when holding Board elections.
Overlap of Officers: A different means of exerting control over a subsidiary could include ensuring that certain officer positions in the subsidiary are held by officers of the parent organization. The highest executive officer (President, Chief Executive Officer, or Executive Director) and highest financial officer (Treasurer or Chief Financial Officer) are typical positions that may overlap between the parent organization and the subsidiary, and the most common means of providing for this overlap is to require in the subsidiary’s Articles of Incorporation and/or Bylaws that these officer positions are filled ex officio by the parent organization’s officers. These provisions are often used in conjunction with the methods for control over the subsidiary’s Board described above.
While the parent organization generally wants to use one or more of the above approaches to ensure there is sufficient control over the subsidiary organization, there is a risk of exerting too much control over a subsidiary. On relatively rare occasions, the Internal Revenue Service (“IRS”) has deemed that a subsidiary is so thoroughly controlled by a parent organization as to be a mere “arm, agent, or integral part” of the parent. See IRS Gen. Couns. Mem. 39326 (Jan. 17, 1985).
In such cases, it is possible that the IRS will disregard the separateness of the parent and subsidiary, thereby attributing all the activities and funds of the of the parent and subsidiary to each other for purposes of the rules governing tax-exempt organizations. If this happened, it would not only defeat the purpose of having a subsidiary, but cause a major accounting and operational mess in the process of correcting or undoing the initial structure. Thus, it is important to be aware of IRS guidance on this subject and strike the right balance.
Under longstanding IRS internal guidance, in order for a subsidiary to be recognized as separate from its parent organization: (1) the subsidiary must be organized for some bona fide purpose of its own; and (2) the parent must not be so involved in, or in control of, the day-to-day operations of the subsidiary that the relationship between parent and subsidiary assumes the characteristics of the relationship of principal and agent. See IRS Gen. Couns. Mem. 39598 (Jan. 23, 1987).
The “bona fide purpose” prong of the test is relatively easy to satisfy so long as the subsidiary carries out actual activities and was formed for one of the reasons discussed above in the first part of this article.
The second prong can be more difficult to grasp, but two basic structures have, in practice, been relatively safe from IRS scrutiny:
Majority overlap on the Boards of Directors of the parent and subsidiary, but with a different chief executive running the subsidiary’s day-to-day operations; and
Less than a majority overlap of the Boards of Directors (in other words, mostly different people serving on the Board of the subsidiary), but with the same CEO or Executive Director running the subsidiary’s day-to-day operations. In this case, the parent organization may still maintain control over the appointment and removal of the subsidiary’s Board members, but would appoint mostly individuals from outside of the parent organization’s Board.
It should be noted that it is fairly common that subsidiaries are formed with more overlap than described in the above two structures, since many organizations struggle to find qualified Board members and the capacity to hire different executive officers. It is often a matter of necessity to have the same CEO or Executive Director run the parent organization as well as a subsidiary, and to have majority overlap on the Boards at the same time. While there is some increased risk with these higher amounts of overlap, there are relatively few cases on record of the IRS disregarding the separateness of two related entities. And these cases tend to be egregious examples where very few formalities were observed. After consulting with your legal and tax advisors, you may decide that a more closely aligned structure presents an acceptable risk.
Planning Tip – If your organization’s subsidiary has a lot of overlap, look for other ways to demonstrate a subsidiary’s independence as to day-to-day operations. Some examples could include having processes for approval of certain transactions by two officers (one of whom should not be an officer of the parent organization), and/or creating an executive committee to guide future programing and oversee the executive manager of the subsidiary, with a majority of the executive committee made up of Board members who do not currently serve on the parent organization’s Board.
3. Key Operational Considerations
Once the structure has been decided, there are a number of important considerations regarding the operation of the subsidiary and any dealings with the parent organization. These operational issues can often prove to be more of a challenge than the governance structure, so it is important to think these through carefully.
Most operational pitfalls I have observed stem from a very fundamental issue: the failure of Board members, officers, and staff to have a clear understanding of why the subsidiary exists and what activities properly belong in the subsidiary as opposed to the parent organization. You must strive to avoid the common error of arbitrarily placing activities and expenses in the subsidiary based solely on where the funding for a particular project is coming from. This can very easily lead to confusion and improperly blurring the lines between the parent and subsidiary. Thus, it is very important to establish the programmatic and operational boundaries that separate the two entities, and communicate these boundaries clearly and frequently to Board members, officers, and staff.
Planning Tip – Moving some of a parent organization’s programs and activities into a subsidiary can be an emotionally fraught process, especially when the parent organization’s Board and committee members have personal attachments to running or overseeing these programs themselves. This is often seen when a 501(c)(6) trade association or chamber of commerce moves its educational programs into a related 501(c)(3) foundation. To help ease this process, consider a staged implementation process where programs or activities are move one at a time into the subsidiary over a set period of time (usually 18 to 36 months). Move programs that will have the least resistance to change first to build positive momentum and move the legacy programs that have previously been most strongly attached to the parent organization last.
Assuming you have succeeded in clearly establishing programmatic boundaries, you will also need to maintain clear boundaries for purposes of financial reporting and internal accounting control systems. Most commonly, this issue comes up with the sharing of resources between the two entities, including office space, technology, trademarks and other intellectual property, and staff members who perform work for both entities. It is important that to adhere to formal allocation processes that are properly documented, and always treat the parent and subsidiary as separate, distinct organizations.
The basic rule is that any financial dealings and/or sharing of resources between the parent and subsidiary must be carried out pursuant to arm’s length agreements for fair market value. This is especially important when one of the entities is a 501(c)(3) organization, as it is prohibited to use 501(c)(3) assets directly or indirectly for the benefit of non-501(c)(3) purposes.
These cost-sharing agreements must be based on a reasonable and properly documented allocation of costs based on objective factors. For example, an agreement by a 501(c)(3) subsidiary to reimburse a 501(c)(6) organization for the costs of shared staff members should be based on the actual time spent by these staff members on 501(c)(3) activities (or estimated time, with an adjustment at the end of the year to reflect actual time), documented by time sheets. Similarly, an agreement by a 501(c)(3) subsidiary to reimburse a 501(c)(6) organization for the use of office space or other overhead resources should be based on the proportion of 501(c)(3) employees using the space or resources, and/or the proportion time spent on 501(c)(3) activities, as compared to the 501(c)(6) organization. When it doubt, it is advisable to err on the side of being more generous to the 501(c)(3) organization (and if material, treat the excess as an in-kind contribution to the 501(c)(3) organization).
Lastly, it is recommended to address financial dealings and/or sharing of resources between the parent and subsidiary in the conflict of interest policies of each organization, ensuring that there are sufficient non-overlapping Board members to review and approve these transactions.
Conclusion
There are numerous other issues and considerations involving subsidiary organizations that are outside the scope of this article, such as taking steps to isolate lobbying and political activities from being attributed to a related 501(c)(3) organization, avoiding the triggering of unrelated business income tax through the flow of funds from a “controlled entity” under section 512(b)(13) of the Internal Revenue Code, considering using “supporting organization” classification as a way to maintain the public charity status of a 501(c)(3) subsidiary, properly reporting compensation from related organizations on the Form 990, and more.
Nonetheless, a careful front-end review of the reasons for creating a nonprofit subsidiary, the different governance and management structure options, and the key operational considerations arising from a subsidiary’s relationship with the parent organization the are crucial first steps. Organizations that navigate these first steps thoughtfully will be in a much better position to create a thriving and sustainable subsidiary while successfully advancing the mission on a broader scale.
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