One of the most useful planning tools available to associations is the use of subsidiaries to carry on activities. Subsidiaries can preserve tax exemptions, generate revenue, limit legal liability, and perform a number of other functions.
Trade and professional associations generally form subsidiaries for one or more of the following reasons: (i) to protect an association’s tax-exempt status, (ii) to reduce unrelated business income, (iii) to protect the association from potential legal liability arising from certain activities, (iv) to receive tax deductible charitable contributions, (v) to obtain a nonprofit postal permit, and (vi) for other nonlegal or tax reasons.Taxable Subsidiaries
A taxable subsidiary is created by forming a for profit corporation (which is done by filing articles of incorporation with the secretary of state of the applicable state – usually the state in which the association’s principal offices are located) which then issues all or a substantial majority of its stock to the association (referred to as the “parent”) in exchange for cash or property. The subsidiary also will need to obtain an employer identification number (which is also referred to as a federal tax identification number) from the Internal Revenue Service and adopt corporate bylaws. The parent would then appoint the board of directors of the subsidiary, and the subsidiary’s board of directors would appoint the subsidiary’s officers.
At this point, the subsidiary will be a separate, taxable entity, distinct from the parent under state corporate law. The subsidiary may own property, sue or be sued, be taxed, and generally conduct business. Obligations incurred by the subsidiary generally will not become liabilities of the parent unless the obligations are guaranteed by the parent. In certain situations, a court may disregard the corporate separateness of the subsidiary under state law, but if the subsidiary complies with corporate formalities (such as holding annual meetings of directors and shareholders) and has received adequate consideration from the parent for its stock, this result is unlikely. Thus, if an association will be engaging in activities unrelated to its exempt purpose that could lead to significant liabilities, it should consider conducting those activities in a taxable subsidiary so that the association’s assets would not be at risk.
Another role the subsidiary may play is to protect the parent’s tax-exempt status. A 501(c)(6) organization must be primarily engaged in activities related to its exempt purpose or risk losing its tax-exempt status. Whether an organization is primarily engaged in exempt activities is determined by the IRS on a case-by-case basis, and although the percentage of unrelated business income to total income is an important factor, it is not the only factor. Accordingly, if an association receives a large portion of its revenues from unrelated business income, it should consider forming a taxable subsidiary from which to conduct the activities generating the unrelated business income.
Although a subsidiary is distinct from its parent under state law, the IRS may, in certain situations, disregard that separateness for purposes of federal tax law. The separate existence of a subsidiary will not be disregarded for tax purposes where it is organized with the bona fide intention of performing some real business function, it operates separately and apart from the parent, and the parent continues to engage in its tax-exempt activities. The separate corporate form of the subsidiary will be ignored for tax purposes only if the parent corporation controls the affairs of the subsidiary so completely that the subsidiary becomes a mere instrumentality of the parent. IRS rulings in this area indicate that no one factor determines whether a subsidiary will be respected as a separate entity, but that the IRS will consider several different factors and reach a conclusion based on the totality of the circumstances. These factors include whether a valid business purpose exists for forming the subsidiary, whether the parent is involved in the day-to-day management of the subsidiary’s affairs, the extent to which the two entities share directors, officers and/or employees, and the extent to which the two entities share facilities and services.
Although a taxable subsidiary may engage in incidental business activities unrelated to the purpose for which the parent was granted a tax exemption, the net income derived from such activities may be subject to tax. Net income of a tax-exempt organization is taxable if the activities constitute a trade or business that is conducted on a regular basis and is not substantially related to the performance of the organization’s tax-exempt purpose. Regardless of whether an activity is related to an association’s tax-exempt purpose, certain types of passive income are generally excluded from unrelated business income (e.g., dividends, interest, annuity, royalties, and certain rents). These passive income exclusions are unavailable if they are received by a tax-exempt organization from a controlled subsidiary (i.e., a subsidiary, 80% or more of whose stock is owned by the parent) to the extent that the subsidiary’s income would be taxable if received directly by the tax-exempt parent. It is important to note, however, that this special rule does not apply to net income of the subsidiary distributed to the parent through a dividend by the subsidiary, because such income is taxed at the subsidiary level (dividends are not deductible by the subsidiary).
If the taxable subsidiary begins to earn considerable net income and desires to transfer more of that income to the parent on a tax free basis (which would not be achieved by dividends, because the subsidiary would be paying taxes on such net income before it is distributed to the parent), the subsidiary could attempt to pay some of those profits to the parent as royalties (e.g., in exchange for the licensing of the parent’s name and/or mailing list). These payments would be deductible to the subsidiary as an ordinary and necessary business expense and tax free the parent if the subsidiary was not a controlled entity. This result could be achieved by the parent selling at least 21% of the subsidiary’s stock.Tax-Exempt Subsidiaries.
A tax-exempt subsidiary is created by forming a nonprofit corporation. This process is identical to forming a for profit corporation, except that the nonprofit corporation usually will not have stock, and accordingly, the parent will not be a shareholder. Although the parent will not have the right to elect the directors of the subsidiary by virtue of owning its stock, the bylaws of the subsidiary can be written to give the parent the right to appoint the directors of the subsidiary. In addition, most tax-exempt subsidiaries will want to apply for an exemption for federal income tax (it is possible, but rare, to have a nonprofit corporation under state law that is subject to federal income tax). Most tax-exempt subsidiaries will apply for an exemption from federal income tax under Section 501(c)(3) of the Internal Revenue Code, thus allowing persons to deduct their contributions to the subsidiary.
To qualify as a 501(c)(3) organization, subsidiary’s activities must be principally charitable, educational and/or scientific in nature. In addition, the subsidiary will want to qualify as a public charity (rather than a private foundation).
Often the simplest way to qualify as a public charity is to do so as a supporting organization. A supporting organization is an entity which is organized and operates exclusively for the benefit of one or more specified public charities; operated, supervised, or controlled by a connection with one or more public charities; and not controlled directly or indirectly by one or more disqualified persons, other than public charities. A Section 501(c)(6) organization, which would qualify as a publicly supported charity if it were a Section 501(c)(3) organization, is permitted to establish a supporting organization. Essentially, this means that a trade or professional association which (i) normally receives at least one-third its total annual support from government grants and contributions made directly or indirectly from the general public, or (ii) normally receives more than one-third of its total annual support from membership fees, program service revenue related to its tax-exempt function, government grants, and contributions and no more than one-third of its total annual support from investment income, rents, royalties, and unrelated business taxable income, may establish a supporting organization.
As with a taxable subsidiary, the tax-exempt subsidiary will be a distinct legal entity from the parent under state corporate law (thus, it also can be used to shield the parent from potential liability). For tax purposes, however, a parent of a supporting organization is permitted (and, in fact, required) to exert more control over the supporting organization that a parent would otherwise be permitted to exert over a subsidiary.
As a general rule, parents may make virtually unlimited contributions to their tax-exempt subsidiaries without jeopardizing their tax-exempt status or that of the subsidiary. This is because, in most cases, the activities of the subsidiary will also be in furtherance of the tax-exempt purpose of the parent. Conversely, the tax laws greatly limit a subsidiary’s ability to transfer funds to its parent because the conditions of tax-exemption under Section 501(c)(3) are more stringent and limited than those under Section 501(c)(6). The subsidiary may, however, use the funds which have been donated to it for activities that the parent would otherwise conduct, provided that such activities are in furtherance of the subsidiary’s exempt purpose. In addition, if the activities include a large amount of mailings, a 501(c)(3) subsidiary may obtain a nonprofit postal permit and conduct such mailings at less expense than could the parent.
Whether it makes sense to establish either a taxable or tax-exempt subsidiary for your organization will differ with the facts of each situation. You should, however, be aware of the potential benefits of taxable and tax-exempt subsidiaries.