The ever-present need for funds to augment your association's membership dues may lead it to pursue various money-making opportunities.   Perhaps your association provides administrative services for a fee to its members and non-members, or has developed a software program which it markets extensively.   Or perhaps your association is considering offering insurance or other financial products.   When should you consider spinning off the commercial activity into a for-profit subsidiary?  

WHY FORM A FOR-PROFIT SUBSIDIARY?

Liability protection.   Protecting the assets of the association from liability for the commercial activities is a frequent reason for moving those activities to a for-profit, taxable subsidiary.   A commercial endeavor conducted by an association may increase the association's liability exposure arising from contracts, additional employees or the services or product provided.   If the for-profit subsidiary is properly formed and operated, the association can be insulated from those liabilities.

Exempt status protection.   Concern about an association's tax-exempt status may arise when it engages in activities which do not contribute importantly to accomplishing the association's exempt purpose.   The association's tax exemption could be jeopardized if those activities become a “substantial part” of the association's activities.   However, if those commercial activities are placed into a for-profit subsidiary, they are not attributed to the association.

Other benefits.   Even though the commercial activities are segregated in a separate entity, the association may still maintain ultimate control over and receive revenue from its investment in the for-profit business.   After-tax profits generated by a successful for-profit subsidiary may be paid to the association as dividends, which are not taxable to the association.   However, it is important to remember that the association will be subject to unrelated business income tax (often referred to as “UBIT”) on interest, rent, and royalty payments from the subsidiary.  

The association also may have the opportunity to place more expense generating activities into its for-profit subsidiary, which can take advantage of the deduction for expenses that may not be available to the association.

If the association forms more than one subsidiary, the for-profit subsidiaries can file consolidated tax returns, offsetting losses in one subsidiary against gains in the other.  

Finally, a taxable subsidiary allows more flexibility for compensating executives.

FORMING A FOR-PROFIT SUBSIDIARY

To achieve the benefits of spinning off the commercial activities from the association, the for-profit subsidiary must be properly organized and operated, maintaining proper separateness from the association.

The formation process begins with the association's board of directors, which considers the reasons for and against forming a for-profit subsidiary.   The business purpose of the subsidiary and its activities should be identified.   The decision to form the subsidiary as an investment must be well documented in the corporate records.  

A corporation (a limited liability company may be appropriate in some circumstances) is then formed by filing articles of incorporation, appointing a board of directors, adopting bylaws and fulfilling all other requirements of corporate law.   The subsidiary must be adequately capitalized and stock issued to the association.   Assets necessary for the operation of the subsidiary, including employees, office space, and intellectual property, must be valued and leased, licensed or transferred to the subsidiary.

A common question of associations in forming for-profit subsidiaries is how much overlap between the subsidiary and the association's management is acceptable.   To protect the separateness of the entities, it is advisable that less than a majority of the subsidiary's directors are also directors of the association.   It is crucial that the association not be involved in the day-to-day operation of the subsidiary, so it is best that the subsidiary has its own officers.   The formation of the subsidiary also is a good opportunity to bring in management with industry experience.

OPERATING A FOR-PROFIT SUBSIDIARY

If the for-profit is not operated as a separate entity, its activities can be attributed to the parent association, exposing the association to liability and, in extreme cases, causing loss of exempt status.   To avoid this outcome, the association and subsidiary must be careful that they both respect the separateness of the organizations.   The subsidiary must conduct separate board meetings, maintain its own bank accounts, write letters on its own stationery, keep its own thorough and accurate financial records separate from those of the association, and negotiate and document all transactions with the association.

The association and the subsidiary can share office space, equipment and staff.   However, it is important (i) for the staff to keep contemporaneous time records of their time worked for the respective entities; (ii) to allocate costs attributable to each organization based on actual usage and always at fair market value; (iii) to ensure that the financial burden attributable to the subsidiary is borne by the subsidiary; and (iv) to maintain strict arm's length financial separation between the two entities.   The association and the subsidiary should enter into a contract covering the shared employees, services and assets.

If the association and subsidiary are willing and able to maintain their corporate separateness, the association can enjoy the financial benefits of having a successful subsidiary while avoiding exposure to its liabilities.

Barbara L. Berg is counsel in the Sacramento law firm of Downey Brand LLP.   Her practice emphasizes non-profit law.   She can be reached at bberg@downeybrand.com. The foregoing article was written for general information purposes only and does not constitute legal advice.