SETTING UP SEPARATE ENTITIES TO ISOLATE FOR-PROFIT ACTIVITIES

By Rick Shields, CPA, CFE - Director

In certain situations where nonprofits are struggling to maintain unrestricted resources and funding for administrative purposes, there may be opportunities for the organization to obtain this funding through taxable activities such as cafeterias, gift shops, service revenues, and other revenue streams.

When the nonprofit organization (NPO) has this opportunity, it may be beneficial to set up a separate entity in order to clearly separate the activities between taxable and nontaxable. Typically, the separate entity is either a limited liability company (LLC) or a corporation. The separate entity receives the revenues from the taxable activities, pays the corresponding expenses, and can then transfer excess profits to the nonprofit organization in the form of a contribution. However, if this occurs the transfer must be voluntary in order to maintain the separation between the two entities. The activities of the taxable entity can potentially be structured in such a way as to limit the legal exposure of the nonprofit organization. This requires a clear separation of assets and financial transactions as well as contractual arrangements related to the activities of the taxable entity.

If the taxable entity is setup as an LLC with the NPO as the sole member, it is considered a disregarded entity for purposes of Forms 990 and 990-T. The activities of the taxable entity would be included on Form 990-T as well as applicable sections of the Form 990. Its assets and liabilities would be included on the NPO's (parent organization) Form 990. Also, state and local tax returns may apply. If the taxable entity is setup as a corporation, it would file a separate tax return (Form 1120 and related state and local returns). The activities of the taxable entity which may have been consolidated for financial reporting purposes would need to be de-consolidated for the Form 990.

In addition to receiving contributions from the taxable entity, the NPO can also charge rent for use of land and facilities. The rental income may be excluded if it is not affected by revenues or profits of the taxable entity and if certain other criteria are met. Additional discussion can be found at Internal Revenue Code Section 512 (b).

Sharing of employees between the for-profit and nonprofit organization can also be a factor. The allocation of employees' time should be well-documented in order to provide defensible evidence for taking the related deductions against taxable income. If other resources are shared such as equipment, those allocations need to be documented as well. If the NPO charges rent for equipment, that is subject to Unrelated Business Income Tax (UBIT).

An advantage of setting up the taxable entity as a single-member LLC is reduced administration. There are fewer tax forms as a disregarded entity. Also, the LLC is not subject to double-taxation as is the case with a corporation. However, double-taxation is not necessarily a factor if the dividend is issued to an NPO. A disadvantage of setting up the taxable entity as an LLC is that the activities of the LLC would be included on the NPO's Form 990 and corresponding Schedule A. Therefore the income from the LLC would reduce the public support percentage on Schedule A. An advantage of setting up the taxable entity as a corporation is that the income is reported on a separate tax return. Therefore it is not included in the computation for public support on Schedule A of the NPO's Form 990. This can be useful for the NPO to maintain its required percentage levels for public support. Contributions from the taxable entity to the NPO would be subject to the 2% limitations for excess contributions.