The quick and admittedly general answers (because there are exceptions) are: (1) yes, a nonprofit can own a for-profit; and (2) no, a for-profit cannot own a nonprofit, but it can select all of the nonprofit’s board members and thereby largely control the nonprofit.
Can a Nonprofit Own a For-Profit?
A nonprofit can own all of the ownership interest in a for-profit entity, whether such entity is a corporation or limited liability company. However, there are rules related to any investment the nonprofit makes in the startup or acquisition. For purposes of this post, we’ll limit our discussion to situations in which a nonprofit public charity (which we’ll refer to simply as a “nonprofit”) is the sole owner of the for-profit entity. We will save the discussions of private foundations (which are subject to excess business holding laws, jeopardizing investment laws, and other tax laws not applicable to public charities) and of nonprofit joint ventures with other nonexempt parties for another day.
Why Would a Nonprofit Own a For-Profit?
A nonprofit might own a for-profit as a result of a gift of a business to the nonprofit or an investment it makes to create or acquire a business. The business might or might not advance the nonprofit’s 501(c)(3) purposes (“mission”), but presumably the value of the business assets or its profits can be distributed to the nonprofit which can then deploy them to advance its mission.
Prudent Investor Rules / UPMIFA
A nonprofit may invest in either starting a for-profit or acquiring one, but there are laws governing such investment. First, state laws provide for prudent investment rules. 49 states (Pennsylvania is the hold out) and the District of Columbia have adopted versions of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). The following is what UPMIFA (download available here) provides about managing and investing institutional funds (a fund held by an institution exclusively for charitable purposes, not including, among other things, program-related assets held by an institution primarily to accomplish a charitable purpose of the institution and not primarily for investment):
(a) Subject to the intent of a donor expressed in a gift instrument, an institution, in managing and investing an institutional fund, shall consider the charitable purposes of the institution and the purposes of the institutional fund.
(b) In addition to complying with the duty of loyalty imposed by law other than this [act], each person responsible for managing and investing an institutional fund shall manage and invest the fund in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances.
(c) In managing and investing an institutional fund, an institution: (1) may incur only costs that are appropriate and reasonable in relation to the assets, the purposes of the institution, and the skills available to the institution; and (2) shall make a reasonable effort to verify facts relevant to the management and investment of the fund.
(d) An institution may pool two or more institutional funds for purposes of management and investment.
(e) Except as otherwise provided by a gift instrument, the following rules apply:
(1) In managing and investing an institutional fund, the following factors, if relevant, must be considered:
- general economic conditions;
- the possible effect of inflation or deflation;
- the expected tax consequences, if any, of investment decisions or strategies;
- the role that each investment or course of action plays within the overall investment portfolio of the fund;
- the expected total return from income and the appreciation of investments;
- other resources of the institution;
- the needs of the institution and the fund to make distributions and to preserve capital; and
- an asset’s special relationship or special value, if any, to the charitable purposes of the institution.
(2) Management and investment decisions about an individual asset must be made not in isolation but rather in the context of the institutional fund’s portfolio of investments as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the fund and to the institution.
(3) Except as otherwise provided by law other than this [act], an institution may invest in any kind of property or type of investment consistent with this section.
(4) An institution shall diversify the investments of an institutional fund unless the institution reasonably determines that, because of special circumstances, the purposes of the fund are better served without diversification.
(5) Within a reasonable time after receiving property, an institution shall make and carry out decisions concerning the retention or disposition of the property or to rebalance a portfolio, in order to bring the institutional fund into compliance with the purposes, terms, and distribution requirements of the institution as necessary to meet other circumstances of the institution and the requirements of this [act].
(6) A person that has special skills or expertise, or is selected in reliance upon the person’s representation that the person has special skills or expertise, has a duty to use those skills or that expertise in managing and investing institutional funds.
Generally, it would be a violation of UPMIFA for a nonprofit covered by the Act to invest all of its substantial investment funds in a single for-profit business which does not engage in activities related to advancing the nonprofit’s mission. This would be the case even if the for-profit was very profitable and the nonprofit planned to make use of all of the distributed profits to fund its mission-related activities. The problems are related to the lack of diversification in investments and the failure to maintain a balanced portfolio of investments. However, note the donor restriction and special circumstances exceptions.
The issue becomes more difficult if a nonprofit invests all of its investment funds in a single for-profit business whose activities may be considered related to advancing the nonprofit’s mission. For example, the for-profit might be an incubator and accelerator for organic food businesses and the nonprofit’s mission may be to promote health through educating the public about the nutritional benefits of organic foods. If the investment is considered to have been made primarily for a program-related purpose, UPMIFA would not apply. But otherwise, where the investment was made partly for a program-related purpose and partly for investment purposes, UPMIFA would apply. In such case, one of the considerations would be the for-profit’s special relationship or special value, if any, to the nonprofit’s mission. However, there are also other enumerated considerations and little guidance on how each individual item of consideration should be weighted. The comments to UPMIFA offer the following guidance: “The degree to which an institution uses an asset to accomplish a charitable purpose will affect the weight given that factor in a decision to acquire or retain the asset.”
A nonprofit must also consider whether any transaction to acquire a for-profit business could be a prohibited self-dealing transaction under state law. For example, under the California Nonprofit Public Benefit Corporation Law, a self-dealing transaction is defined as a transaction to which the corporation is a party and in which one or more of its directors has a material financial interest and which does not meet the requirements of certain enumerated exceptions which each provide evidence to support that the nonprofit did not unjustly enrich one of its directors. See California Nonprofit Law: The Self-Dealing Prohibition.
Private Benefit / Private Inurement / Excess Benefit Transactions
A nonprofit must further ensure that any transaction to acquire a for-profit business would not constitute a prohibited private benefit transaction, private inurement, or an excess benefit transaction under federal tax laws. Generally, these rules help to protect a nonprofit from providing an excessive benefit to another party (unrelated to advancing its mission) at the expense of the nonprofit. In egregious cases, and especially when an insider (like a board member) is unjustly benefited, the nonprofit may have its 501(c)(3) exemption revoked. In addition, the insider may be required to return of any excessive amounts received and pay substantial penalty taxes.
Diversions of Charitable Assets
State laws also prohibit nonprofits from diverting their charitable assets away from the purposes for which they were received or earned. Nonprofits seeking to deploy any restricted assets to invest in a for-profit must be very careful that such use does not violate any applicable restrictions. In addition, it would be highly problematic for the nonprofit to invest its charitable assets in a for-profit engaging in activities that are in conflict with the nonprofit’s mission.
Operational Test Issue
If the for-profit is a pass-through entity (e.g., LLC or S corporation), the activities of the for-profit will be treated as the activities of its nonprofit parent. Consequently, if more than an insubstantial part of the combined activities of both entities is not in furtherance of a 501(c)(3) exempt purpose, the nonprofit will fail the Operational Test and could lose its tax-exempt status. Further, if the for-profit’s business activities are not substantially related to furthering the nonprofit’s mission, the income from such activities will be unrelated business income and may result in unrelated business income tax (UBIT) liability for the nonprofit.
If the for-profit is not a pass-through entity (e.g., C corporation), the activities of the for-profit will not be attributed to the nonprofit. In addition, distributions of profit from the for-profit to the nonprofit owner will generally not be taxable. However, while a nonprofit can also generally avoid UBIT when receiving income from rents, interest, and royalties from another entity, these incomes are taxable when received from an entity that the nonprofit controls.
Can a For-Profit Own a Nonprofit?
A for-profit cannot own a nonprofit because a nonprofit has no owners. However, a for-profit can set up a structure in which it effectively has control over the nonprofit, subject to applicable laws, including those regarding private inurement, private benefit, and corporate self-dealing. Such control structures are perhaps best known between big for-profit companies and their corporate foundations and also between big financial services companies and their donor-advised fund (DAF) sponsoring organizations.
Control may be important to the for-profit for several reasons. The for-profit may have caused the creation of the nonprofit in order to advance a charitable purpose that has some relation to the for-profit’s charitable goals and values. It may also be the nonprofit’s principal funder. Moreover, the nonprofit may be using the name and other assets of the for-profit, which may be providing the for-profit with an important and generally permissible goodwill benefit. It makes sense then that the for-profit will want to be able to ensure that the nonprofit does not pursue activities that are inconsistent with the for-profit’s activities or the for-profit’s vision for the affiliated nonprofit.
But control of the nonprofit by a for-profit also raises some problems. Perhaps the most serious problem is the possibility of the nonprofit being operated for the interests of the for-profit rather than for the broader public’s interests. The greater the control that the for-profit may exercise over the nonprofit, the more scrutiny the nonprofit may receive regarding prohibited private benefit transactions benefiting the for-profit or any owners, board members, or employees of the for-profit.
A for-profit may have practical control over an affiliated nonprofit by virtue of having the right under the bylaws of the nonprofit to select a majority or all of the board members of the nonprofit. The for-profit might have such right as the sole member of the nonprofit with all the statutory rights of a member (which generally include the right to elect and remove the board members, approve changes to certain provisions of the governing documents, and approve any major corporate changes). Alternatively, it might have such right as a designator of some number of nonprofit’s board members. Generally, a designator has the right to designate (appoint) one or more board members and the right to remove or approve the removal of any designated board member but does not possess other rights relative to the corporation.
If the for-profit and nonprofit will be entering into transactions with each other beyond the for-profit providing funds to the nonprofit, it may be very important for the nonprofit to have at least some independent board members with respect to the for-profit. Because the other board members may have a significant conflict of interest in deciding upon such inter-organizational transactions, the nonprofit is best protected by the presence of independent board members. In some cases, a majority of independent board members may be particularly valuable to allow the nonprofit board to approve inter-organizational transactions without counting the votes of any conflicted board members.
Other Forms of Control
A for-profit may also exercise control over an affiliated nonprofit through conditions on its funding and provisions of other resources. For example, a for-profit may provide in a grant agreement to its affiliated nonprofit that the grant can only be used to further a particular charitable purpose or activity and/or that it cannot be used to pay for certain types of programs or expenses. The for-profit might also expressly or implicitly condition future grants on whether it believes that the nonprofit is pursuing activities and obtaining results desirable to the for-profit. A license agreement to use the for-profit’s name, a lease, and other agreements may also contain clauses that provide the for-profit with certain controls.
Can a Board Member of the Nonprofit Own a For-Profit that Does Business with the Nonprofit?
Sometimes, a nonprofit may not be able to create and own a for-profit entity even if the for-profit’s activities would advance the nonprofit’s charitable mission. For example, a nonprofit may be restricted in funding a for-profit subsidiary because of a lack of discretionary funds that can be deployed to forming or acquiring a for-profit and/or prudent investment limitations. In such cases, one or more of the nonprofit’s board members may choose to start or acquire a for-profit entity whose principal purpose may be to advance the same charitable mission as the nonprofit’s or to generate revenue that will be donated to the nonprofit.
If the for-profit and nonprofit do not and will not enter into any agreements and the relationship is merely a donor-donee relationship in which the for-profit donates funds and other assets to the nonprofit, there may be little issue with the board member’s ownership of the for-profit. One exception may be if such board member attempts to exercise their influence as a donor in influencing how the other board members vote, particularly if that was directed toward the benefit of the for-profit.
If, however, the for-profit and nonprofit are or will be entering into agreements or arrangements with each other beyond a donor-donee relationship, the nonprofit must be careful of some of the issues described above in the Can a Nonprofit Own a For-Profit section: self-dealing, private benefit / private inurement / excess benefit transactions, diversions of charitable assets.