A B-Corporation could nicely fit within the overall corporate structure of a tax-exempt organization, maintaining the tax exemption by limiting unrelated business income and, at the same time, aligning with the organization’s mission-driven standards.
For example, many churches are currently considering revenue-producing mixed-use real estate development projects. Those projects might include administrative and programming spaces for the congregation, along with retail space and condominiums or leasing to other commercial ventures. All in all, churches have pursued these opportunities to acquire better real estate and improve cash flow, allowing them to create spaces in expensive urban areas. Others simply need a way to save a distressed property from foreclosure.
Let’s review some fundamental concepts in connection with exempt organizations. Then, we can think about how the B-Corporation might be used.
Exempt Organizations and Unrelated Business Income Tax
The Internal Revenue Code specifies certain types of organizations that are exempt from federal income tax. The most common types are charitable, religious, and educational organizations. Others include: civic associations, labor organizations, business leagues, social clubs, fraternal organizations, and veterans’ organizations. The main benefit of exempt status is that the organization does not pay federal income tax on income related to its exempt purpose. More particularly, a 501(c)(3) organization must engage in activities that further its exempt purposes or it jeopardizes its tax-exempt status and its eligibility to receive tax-deductible contributions.
Nonetheless, a 501(c)(3) tax-exempt organization may engage in income-producing activities unrelated to its tax-exempt purposes as long as the unrelated activities are not a substantial part of the organization’s overall activities. Yet, the net income from such activities will be subject to the Unrelated Business Income Tax if three conditions are met:
- The activity constitutes a trade or business.
- The trade or business is regularly carried on.
- The trade or business is not substantially related to the exercise or performance of the organization’s exempt purpose.
In addition to tax liability on unrelated business income, a 501(c)(3) organization with substantial unrelated trade or business income jeopardizes its exempt status. There is no bright line test to define how much unrelated business income is “substantial,” but anecdotally, the generally held position is that it should not exceed 10-20% of the organization’s income.
An Example
Now, consider an Arizona nonprofit corporation, who received 501(c)(3) tax-exempt status, a corporation whose exempt purpose is to stimulate and foster public interest in the fine arts by promoting art exhibits, sponsoring cultural events, and furnishing information about fine arts. Suppose that this organization leases studio apartments to artist tenants and operates a dining hall primarily for these tenants. Under the current tax law, these two activities do not contribute importantly to accomplishing the organization’s exempt purpose. Therefore, they are unrelated trades or businesses.
This does not necessarily mean, however, that the organization should discard its idea to provide studio apartments and a dining hall. But it must thoughtfully plan how to implement the project without risking its hard-earned tax-exempt status.
Generally, a separate business entity might be formed to operate the new venture.
Then, the question is how the income received by the exempt organization, from the operation of the separate entity, will be characterized. The income could be unrelated business income. The answer will turn on the tax characterization of separate entity.
B-Corporation Subsidiary as a Solution
One strategy would be to form a subsidiary, a company that is partly or completely owned by the exempt organization, and have the exempt organization hold a controlling interest in the subsidiary company. They key is that dividends are excluded when computing an exempt organization’s unrelated business income.
Briefly, dividends are generally excluded from unrelated business income for two reasons. First, the exempt organization as shareholder is acting, generally, as an investor, not engaged in a trade or business, negating the first element of unrelated business income. Second, the subsidiary corporation who earned the income pays tax. And so, in this scenario, the IRS is ultimately able to receive its share.
Let’s return to our fine arts organization, from our example above. Applied there, the exempt organization could retain control of the studio apartment and dining hall project and receive dividends from its subsidiary who operates that project, without garnering any unrelated business income tax. As an aside, the subsidiary in this case would operate for-profit and pay income tax to the federal government, and the exempt organization would not pay tax in connection with dividends received. As a result, the primary goals would be met: [1] preserving the exempt organization’s tax-exempt status and [2] minimizing tax liability.
This strategy could be implemented with either a B-Corporation or a C-Corporation. On the other hand, an entity with partnership tax treatment such as certain limited liability companies, would not be a proper choice of entity for the subsidiary, as the unrelated business income would pass through from that company to the exempt organization, causing a tax liability and jeopardizing its exempt status.
The exempt organization may consider using a B-Corporation to convey the message that the subsidiary is transparent and accountable — and that it will produce benevolence for the community, just as the exempt organization does. And legally, the directors and officers of the B-Corporation subsidiary would owe fiduciary duties to pursue those benefits.
Both corporate forms can achieve the tax-minimization goal. But a B-Corporation might better align with the exempt organization’s story and values.