Starting a Related Nonprofit: 7 Initial Considerations

If your for-profit company is interested in starting a related nonprofit, here are 7 initial considerations to take into account before moving forward:

1. Are you properly intentioned?

A nonprofit exempt under 501(c)(3) of the Internal Revenue Code must have a charitable, educational, or other 501(c)(3)-consistent purpose and must not be operated for the benefit of private interests. The related nonprofit may create benefits for the for-profit but only if the benefits are merely incidental, quantitatively and qualitatively, to furthering of the charitable purpose. The nonprofit may not qualify as tax-exempt under 501(c)(3) if its purpose is to expand the for-profit’s market or to subsidize the for-profit for lower fees charged to certain groups of individuals.

2. Will the nonprofit’s activities be consistent with 501(c)(3)?

This is an often unrecognized concern accompanied by the thought that any activities resulting in some public good should suffice. However, every business, whether nonprofit or for-profit, must provide some public good in order to be viable. And that doesn’t necessarily make the activities of the business charitable, educational, or otherwise consistent with 501(c)(3). A 501(c)(3) nonprofit must serve a charitable class of individuals. It must not provide prohibited private benefits. It must not engage in any political intervention activities (like endorsing candidates for public office). It may only engage in insubstantial amounts of lobbying. And if the nonprofit engages in or supports business activities in competition with for-profits, particularly in a traditionally for-profit space, such activities should be vetted carefully to see if they would be considered unrelated business activities. A 501(c)(3) nonprofit may only engage in an insubstantial amount of unrelated business activities.

3. What types of transactions between the for-profit and related nonprofit are contemplated?

Generally, for-profits that want to create related nonprofits intend to provide funds and/or other assets to the nonprofit. But it’s not uncommon for the for-profit to desire something back in return from the nonprofit. While it may be possible for the nonprofit to pay the for-profit for goods or services (but no more than fair market value) or to provide goods or services to the for-profit for a payment (but no less than fair market value), such transactions and arrangements must be entered into carefully to avoid any violations of law. Consider how to manage transactions with interested parties to avoid prohibited self-dealing, private benefit, private inurement, and excess benefit transactions.

4. Who will own the intellectual property (IP)?

This issue may arise if the nonprofit will be developing and/or using the for-profit’s IP and thereby increasing the IP’s value. Such activities may be in violation of the 501(c)(3) operational test or private inurement/private benefit doctrines. And if any payment is made by the nonprofit to the related for-profit in exchange for a license or ownership of the IP, the issues referenced in consideration 3 above may apply.

5. Will the nonprofit’s board members be able to meet their duty of loyalty?

If the nonprofit’s directors are all owners, directors, officers, employees, and/or significant contractors of the for-profit, this may be a difficult problem, particularly if the nonprofit provides anything of value to the related for-profit. Ideally, the nonprofit will have at least a few independent directors to allow for arm’s-length approval of transactions with the for-profit or that will benefit the for-profit. Remember, board members of the nonprofit, when acting in such capacity, must act in the best interests of the nonprofit above all other interests, including those of the related for-profit.

6. How will the related organizations evidence their separateness?

It will be imperative to keep the for-profit and related nonprofit distinct as separate legal entities with separate boards of directors (even if there are several overlapping directors who serve on both boards), separate officers (even if there are overlapping officers), separate books and accounts, and separate marketing materials. Where the organizations are sharing resources (e.g., facilities, equipment), such arrangements should be entered into at arm’s length by the nonprofit and documented in a resource sharing agreement and/or other agreements. Where the organizations are sharing staff, confer with an appropriate lawyer about possible arrangements. Diligently observing corporate formalities is important in ensuring that the organizations are not treated as a single organization for liability purposes and in ensuring that the nonprofit’s 501(c)(3) status is not jeopardized.

7. Will the nonprofit qualify as a public charity?

Most 501(c)(3) organizations must pass a public support test in order to qualify as a public charity. If such an organization fails the public support test, it will be recognized as a private foundation, a classification that will subject the organization to an additional array of rules and restrictions. If the nonprofit does not seek outside funding, there is a strong possibility that it will be a private foundation. The for-profit must assess this risk and consider whether it would be adversely impacted by its classification as a private foundation or public charity.

We strongly recommend conferring with a knowledgeable expert to guide you through these initial considerations related to starting a related nonprofit. While the goodwill associated with having a related nonprofit may be an important factor, it should not be the driving factor.

Stay tuned for future posts on starting a related nonprofit focused on the nonprofit’s board of directors, prohibited transactions, the private foundation-public charity options, and alternatives including fiscal sponsorship.