Establishing and Operating Taxable Subsidiaries: A Primer for Associations
January 20, 2020
One of the most useful planning tools available to associations is the use of taxable subsidiaries to carry on unrelated business activities. Whether it is to preserve tax exemption, generate revenue, limit legal liability, or for other legal, political or practical reasons, associations are increasingly establishing taxable subsidiaries. Properly utilized, such subsidiaries can reap enormous benefits for the parent association. At the same, though, the legal terrain in which they operate is fraught with traps and pitfalls, as described below.
I. Principal Reasons for Establishing a Taxable Subsidiary.
A. Tax-Exemption-Threatening Activities. If the gross revenue, net income, or staff time devoted to an unrelated business becomes "substantial" in relation to the tax-exempt function of an organization (thereby jeopardizing its tax-exempt status), the association can "spin off" the activity into a separate but affiliated entity, commonly referred to as a taxable subsidiary. Such a taxable subsidiary will pay income tax on the net income from the activity but can remit the after-tax profits to the parent (tax-exempt organization) as tax-free dividends.
B. Providing Administrative and/or Marketing Services in Connection with Association Product/Service Endorsements. When associations endorse or lend their name to third-party products and services, the income received under such arrangements is only tax- exempt to the extent it can be classified as a royalty (payment for the licensing of property such as an association's name and logo). However, if the income is in part a royalty and in part a payment for services (e.g., administrative or marketing services), then the IRS will treat all of the income as unrelated business taxable income ("UBTI"). Consequently, to ensure tax-free royalty treatment of endorsement income, some associations do not conduct any services at all in connection with such endorsements, some "outsource" such services to unrelated third parties, and others conduct such services through their taxable subsidiaries. Under this latter alternative, the association enters into a contract with the vendor for the licensing of its name and logo, and the taxable subsidiary enters into a separate contract with the vendor to provide administrative and/or marketing services. The association's income is treated as tax-free royalty income; the taxable subsidiary pays tax on its income (the after-tax profits can then be transferred to the association in the form of tax-free dividends). Associations utilizing such a structure must be careful to ensure: (i) that the income is divided between the association and the taxable subsidiary on a fair market value basis; and (ii) that the arrangement is conducted on an arm's length basis (e.g., financial separation, employee time records, etc.).
C. Reducing UBTI. In some cases, the IRS will only let a tax-exempt organization deduct the expenses of the unrelated part of an activity from the income of the unrelated part of an activity. For example, advertising income is considered unrelated business income. The IRS applies a complicated formula to determine what expenses of an association's publication can be deducted against the advertising income to compute net taxable income from advertising. In many cases, the formula permits only advertising expenses (not other publication expenses) to be deducted from advertising income. This means that a publication as a whole could be losing money, but the tax-exempt organization could be paying substantial income tax on its advertising income, because the expenses that are directly related to the generation of the advertising income are nominal.
If the entire publishing activity is put in a separate taxable entity that is affiliated with the tax-exempt organization, all expenses will be deductible from the total revenue generated by the publication to determine whether the publication is operating at a profit or loss. The very same revenue and expenses that can result in significant taxable income when an advertising activity is conducted in a tax-exempt organization can result in little or no taxable income when the entire publishing activity is carried on in a taxable subsidiary.
In addition, beyond advertising revenue, there is another significant tax advantage to housing unrelated business activities in a taxable subsidiary. For tax-exempt organizations, the expenses of a particular unrelated business can only be used to offset the gross unrelated business income of that particular unrelated business in calculating net income and the corresponding UBIT. However, if the same activities are conducted in a taxable subsidiary, all of the subsidiary’s expenses can be used to offset all of its gross income before any corporate income tax is imposed on its overall net income, meaning that losses from one activity can be used to offset gains from another activity.
D. Protection from Legal Liability. Sometimes new ventures carry potential legal liability, especially if a product is being sold or other business activity is being undertaken. Common examples include legal claims for breach of contract (including debts), copyright or trademark infringement, defamation, and other tort (injury) claims. Carrying on the activity through a separate legal entity (e.g., taxable subsidiary) can protect the assets of the sponsoring tax-exempt entity from liability, even if the two entities are affiliated.
A. To establish a taxable subsidiary: (i) articles of incorporation are filed with a state government; (ii) if the subsidiary's principal place of business will be located in a state different than the state of incorporation, then a certificate of qualification to transact business in the other state is obtained from that state's government; (iii) a federal tax identification number ("EIN") is obtained from the IRS; (iv) bylaws are created and approved by the subsidiary's board of directors; and (v) a corporate record book and corporate seal are obtained. Certain of these filings are subject to filing fees. The subsidiary must file annual reports with the state in which it is incorporated, as well as with any state(s) in which it has qualified to transact business. Furthermore, the subsidiary must file annual federal and state tax returns and pay annual federal and state taxes, like all other taxable corporate entities, to the extent that it generates taxable income.
B. The tax-exempt parent may capitalize the subsidiary through a transfer of cash and assets to the subsidiary in exchange for subsidiary stock that is issued. Ordinarily, the tax-exempt parent would own most or all of the stock that will be issued by the subsidiary, and can receive tax-free dividends on this stock from the subsidiary.
C. A separate bank account, separate financial books and records, separate letterhead, etc., must be established for the subsidiary, and strict financial and operational separation must be maintained (e.g., no commingling of assets, no subsidiary correspondence written on parent letterhead).
D. The board of directors of the subsidiary should be appointed by the parent (i.e., by the parent's board of directors); the subsidiary's officers are then appointed by the subsidiary's board. The directors and officers of the subsidiary should be somewhat different from those of the parent. An initial meeting of the subsidiary's board of directors, separate from a meeting of the parent's board, must be held, and separate minutes must be recorded (although the subsidiary's board can meet on the same date and at the same place as the parent's board, with one meeting immediately following the other).
E. The subsidiary can have its own employees (as long as withholding and other employer obligations are met) or the parent's staff can work on subsidiary matters (with their services in essence "leased" to the subsidiary). In the latter scenario, which is generally recommended (at least initially), the subsidiary must reimburse the parent — at the parent's cost — for the staff time (including salary and benefits) that the parent provides.
F. The subsidiary can be housed in the parent's existing offices, provided that the subsidiary reimburses the parent — at the parent's cost — for its allocable share of rent, office equipment and supplies, utilities, etc.
G. The parent and the subsidiary should enter into an arm's length written agreement covering all aspects of the shared facilities, equipment, supplies, services and employees.
H. If necessary, the parent's articles of incorporation and/or bylaws should be amended to permit business endeavors or the establishment of a taxable subsidiary by the parent.
I. A business plan, including attention to the details of financial and legal separation between the parent and the subsidiary, should be drafted and approved by the parent's board of directors.
J. The name of the subsidiary may include the parent's name, but this is not a legal requirement. If the parent's name is included in the subsidiary's name, the terms of a trademark license should be part of the written agreement discussed above. Although it is not required, the subsidiary may pay the parent — on a regular basis and at fair market value — a royalty for the right to use the parent's name (and logo, if desired).
At this point, the subsidiary will be a separate, taxable corporate entity, distinct from the parent. It can own property, sue or be sued, be taxed, etc. Obligations incurred by the subsidiary will not become the responsibility of the shareholders (i.e., the parent) in the event of a default on those obligations by the subsidiary unless: (i) the obligations are guaranteed by the parent; or (ii) a court "pierces the corporate veil" between the parent and the subsidiary, finding that they are not separate and distinct entities, but that the subsidiary is a "mere instrumentality" of the parent. The latter will generally not occur if the entities maintain the strict financial, management and operational separation discussed above.
A tax-exempt organization may form, own and receive dividends from a taxable subsidiary that operates a commercial business(es), so long as the taxable subsidiary operates separately and apart from the tax-exempt organization and the tax-exempt organization continues to engage in its tax-exempt activities. The separate existence of the subsidiary will not be disregarded for tax purposes where it is organized with the bona fide intention of performing some real and substantial business function. The separate corporate form of the subsidiary will be ignored only if the parent corporation controls the affairs of the subsidiary so pervasively that the subsidiary becomes a "mere instrumentality" of the parent. A subsidiary will be deemed the alter ego of its parent only where "the facts provide clear and convincing evidence that the subsidiary is in reality an arm, agent, or integral part of the parent."
IRS rulings in this area also indicate that no one factor determines whether a subsidiary will be respected as a separate entity. Instead, the IRS will consider several different factors and reach a conclusion based on their significance taken together. These include whether a valid business purpose exists for forming the taxable 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. Each of these factors is discussed below:
A. Business Purpose. A tax-exempt organization can easily establish a legitimate business purpose for forming a taxable subsidiary. A tax-exempt organization's incorporation of a taxable subsidiary has been regarded by the IRS as valid whenever the purpose was to: isolate unrelated business activities in order to safeguard the parent's tax-exempt status; limit liability; generate funds to support the parent's tax-exempt activities; or facilitate the management of, and separate accounting for, activities unrelated to the parent's tax-exempt purposes.
B. General Relationship. Most IRS rulings indicate that, in order for the taxable subsidiary to be treated as a separate entity, the tax-exempt parent organization must not be involved in the day-to-day management of the subsidiary. However, the IRS does permit the parent to establish long-range plans and policies for the subsidiary without jeopardizing the parent's tax-exempt status. In addition, as noted below, the parent may provide substantial support to the subsidiary through the sharing of employees and facilities. However, the distinct separate corporate identity of the subsidiary should be made clear to third parties through, for example, the use of separate letterhead and by the subsidiary entering into contracts in its own name (not that of the parent), and signed by one of its own officers, as an officer of the subsidiary.
C. Common Directors. Ideally, the board of directors of the taxable subsidiary should consist, as much as possible, of persons who are not directors or officers of the parent, even though the parent would elect all of the board because of its (generally) 100 percent voting stock ownership. The fact that all, a majority, or even a substantial minority of a subsidiary's board are not directors, officers or employees of its parent is often cited as a positive factor in IRS rulings holding that the subsidiary's activities are not attributable to the parent. Thus, for example, the parent could elect representatives of parent member companies that do not currently sit on the parent's board to fill some of the seats of the subsidiary's board. Further, some overlap is clearly permissible, such as giving the current Chair of the Board and President of the parent seats on the subsidiary's board.
Indeed, under certain circumstances, it is permissible to have substantial overlap between parent and subsidiary directors. Even if most or all of the subsidiary's directors were directors or officers of the parent, the parent's tax exemption would not be jeopardized so long as other factors indicated that the parent was not involved in the day-to-day management of the subsidiary and dealt with the subsidiary at arm's length.
In any event, the parent's board should limit its discussion of the subsidiary to policy (as opposed to day-to-day management) issues, and the parent's and the subsidiary's boards should hold separate meetings and record separate minutes (although the meetings can be held on the same date and at the same place, with one immediately following the other).
D. Shared Officers and Employees. A more substantial problem would arise if officers of the parent were also officers of the subsidiary. In that scenario, it is more likely that the subsidiary's activities would be attributed to the parent because the overlap between officers tends to show that the parent is managing the subsidiary on a daily basis (since officers, as opposed to directors, are generally charged with more day-to-day management duties). However, where a majority of the subsidiary's board consists of "outside" directors (i.e., directors other than officers of the subsidiary), overlap of officers between the parent and the subsidiary has been permitted. In addition, as a practical matter, there is a tradeoff between having common directors and common officers; the less the overlap in one category, the more the overlap may be in the other.
Because business expenses deductions — including deductions for salaries — are more valuable to a taxable entity than to a tax-exempt organization, there is an incentive for more of the compensation of not-for-profit executives to be "paid by" the taxable entity and less by the tax-exempt group. But as such compensation shifting is subject to reallocation by the IRS to accurately reflect the income of the organizations involved and to prevent evasion of tax, if there is overlap between paid officers, for example, care should be taken to ensure that compensation received by the parent's officers for services to the parent is paid solely by the parent, and vice-versa.
In addition, compensation from related organizations must be reported on the tax-exempt organization's IRS Form 990 when total compensation paid by all related organizations to an officer, director or key employee of the filing organization exceeds $10,000, and such individual's total compensation exceeds $100,000. A related organization is any entity that (directly or indirectly) owns or controls, or is owned or controlled by, the filing organization, or that supports or is supported by the filing organization. For these purposes, "owns" means holding (directly or indirectly) 50 percent or more of the voting membership rights, voting stock, profits interest, or beneficial interest. "Control" means that: (i) 50 percent or more of the filing organization's officers, directors or key employees are also officers, directors or key employees of the second organization being tested for control; (ii) the filing organization appoints 50 percent or more of the officers, directors or key employees of the second organization; or (iii) 50 percent or more of the filing organization's officers, directors or key employees are appointed by the second organization. Finally, a related organization includes a supporting or supported organization whether or not any elements of ownership or control are present.
In contrast to overlapping officers and directors, sharing of employees between the parent and the subsidiary is less of a problem. In a number of situations, the IRS has ruled favorably where the subsidiary contracted with the parent to "lease" all or some of the parent's employees to the subsidiary for particular services. Charges for any such contract employees must be at arm's length, for example, based on reimbursement of the allocable share of their actual salaries and benefits. This type of reimbursement arrangement generally results in lower payroll taxes than having each employee employed part-time by two separate employers.
It is critical for shared employees to keep detailed, contemporaneous time records of their work for each corporation to substantiate the allocation of costs. If possible, shared employees should be paid at the identical rate when working for the parent or the subsidiary. This would negate any perception that one entity was subsidizing the other, thus demonstrating the absence of an arm's length relationship. Parent and subsidiary employees may participate in the same health and benefits plans if the costs borne by each corporation are proportionate to the respective time worked for each corporation.
E. Shared Facilities and Services. The parent and subsidiary may share office space, equipment, supplies and facilities so long as reimbursement is calculated on an arm's length basis. For example, the parent may sublease office space to the subsidiary at its cost (i.e., pass-through of a pro-rata share of the parent's actual lease payments). A requirement in the sublease agreement that the subsidiary insure its portion of the premises against risk of loss or damage would be a positive factor in demonstrating an arm's length relationship.
The parent also may share equipment, telephones and supplies with the subsidiary, so long as the costs are allocated fairly and accurately, based on actual usage. Additionally, the parent may provide administrative, data processing, or other non-management services to the subsidiary so long as the fees charged for such services are based on their fair market value.
The parent and the subsidiary should enter into an arm's length written agreement covering all aspects of the shared facilities, equipment, supplies, services and employees. The agreement should, of course, be followed in practice. It is critical that strict financial separation be maintained (i.e., separate financial books and records, separate bank accounts, separate tax returns, and avoidance of any commingling of assets).
If, in the future, the subsidiary’s activities grow to the stage where the subsidiary would require significant use of one or more parent employees, it is generally recommended that one or more individuals be made employees of the subsidiary, not the parent. This would help to minimize any risk of jeopardizing the parent’s tax-exempt status.
IV. Taxation of Payments from Subsidiary to Parent.
The discussion above concerned the organizational and operational rules that a parent and its subsidiary must follow to protect the parent’s tax-exempt status. The discussion below now turns to the question of whether funds or assets received by the parent from the subsidiary would be characterized as unrelated business income that would be subject to tax, even though the parent would retain its tax exemption for its other activities.
As stated above, a tax-exempt organization may engage in incidental business activities unrelated to the purposes for which it was granted tax exemption; however, the net income derived from such activities may be subject to tax. The net unrelated income is taxable if the activities constitute a trade or business that are conducted on a regular basis and are not substantially related to the performance (i.e., do not contribute importantly to the accomplishment) of the organization’s tax-exempt purposes. Finally, regardless of whether an activity is substantially related to tax-exempt purposes, certain types of “passive” income are generally excluded from unrelated business income (“UBI”), including dividends, interest, annuities, royalties, and certain rents.
However, the otherwise-applicable passive income exclusion is unavailable when interest, annuities, royalties and certain rents are received by a tax-exempt organization from a "controlled" subsidiary. Code Section 512(b)(13) provides that although such interest, annuities, royalties and certain rents are generally excluded from UBI, that exclusion will not apply and such payments from the subsidiary to the parent tax-exempt organization will be taxable as UBI: (i) when the tax-exempt parent owns more than 50 percent, directly or indirectly, of the voting power or value of the subsidiary's stock; and (ii) to the extent that the payments reduce the net unrelated income, or increase the net loss, of the subsidiary. This special rule does not apply to dividend distributions from the subsidiary to the tax-exempt parent.
Applying these rules to the common example of a Section 501(c)(3) or 501(c)(6) trade or professional association that establishes a taxable subsidiary, it is useful to identify the various forms of potential payments from the subsidiary to the parent. As noted above, with regard to dividends paid by the subsidiary to the parent, because Section 512(b)(13) does not apply to dividend distributions, and because dividends are excluded from UBI as passive income, dividends paid by the subsidiary can be received tax-free by the parent.
With regard to payments by the subsidiary to the parent for administrative services and the "leasing" of employees, such payments would not qualify as excludable passive income, nor would they qualify as payments for services that are substantially related to the performance of the parent's tax-exempt purposes. As such, such payments would be UBI to the parent. However, all such income received by the parent could be offset through the allocation of corresponding costs (deductions reflecting the parent's actual expenditures), resulting in no unrelated business income tax ("UBIT") liability for the parent.
With regard to payments by the subsidiary to the parent for rent for shared office space and equipment, while rents for such property are often excludable from UBI as passive income, because of the application of Section 512(b)(13), if the parent maintained more than 50 percent "control" of the subsidiary, such rents would be UBI to the parent. However, as explained above (with regard to payments for services and staff), the rents from the subsidiary for shared office space and equipment can be "netted" against the actual cost of that office space and equipment to the parent, resulting in no UBIT liability for the parent.
The "netting" of revenues from the subsidiary against expenses deductible by the parent would not be suspect unless the payments from the subsidiary were not on an arm's length basis. For example, an arm's length price would be established where a payment by the subsidiary for office space and equipment is calculated as a pro rata share of what the parent actually pays to an independent party for that space and equipment (e.g., rent paid to the owner of the parent's building, prices paid to third-party vendors), or where a payment for the services of a parent employee is calculated as a pro rata share of his or her actual salary and benefits (allocated pursuant to contemporaneous time records).
Note, however, that while the "netting" process will be available to offset much UBI paid from a "controlled" subsidiary to the parent (e.g., rent, salaries, administrative fees), if the subsidiary begins to earn considerable income and desires to transfer more of that income (beyond what can be "netted") to the parent on a tax-free basis, it would have to pay the profits as dividends — which, while tax-free to the parent, are not deductible to the subsidiary. Of course, if the subsidiary was not a "controlled" entity (i.e., if the parent owned, by vote or value, directly or indirectly, 50 percent or less of the subsidiary's stock), payment of some of those profits to the parent as a royalty (e.g., in exchange for the licensing of the parent's name and logo) would be deductible to the subsidiary and tax-free to the parent. From a practical perspective, however, parent tax-exempt organizations generally insist on holding more than 50 percent of their subsidiaries' stock (and the new anti-avoidance "constructive ownership" rules make prior options, such as "second-tier" subsidiary ownership, no longer available).
If an association is not prepared to do the detailed recordkeeping, cost allocation, and other administrative functions necessary to maintain the requisite financial, management and operational separation, then it should not establish a taxable subsidiary. It is burdensome to hold separate board meetings, maintain separate financial records and time sheets, and allocate joint program expenses and overhead, among other requirements. At the same time, there are significant benefits and opportunities to be derived from the creative use of taxable subsidiaries.
For more information, contact the author at jtenenbaum@TenenbaumLegal.com. Note that while this article discusses the formation of an association’s taxable subsidiary as a C corporation with capital stock, the other way to form a taxable subsidiary is as a limited liability company (“LLC”). While there are functional differences between C corporations and LLCs, the basic principles described in this article to C corporations would apply to LLCs (that are treated as corporations and not as disregarded entities) as well.