Legal counsel for nonprofit organizations
and social entrepreneurs

Why and How Should a Nonprofit Create a Subsidiary?

Posted on by bentakis

One of the most common issues that comes up in my practice involves the formation of nonprofit subsidiaries. In other words, the creation of independent entities that are controlled (to some degree) by a parent nonprofit, tax-exempt organization.

Why would a nonprofit organization would consider creating a subsidiary rather than simply pursuing the activities on its own? The answer is usually one of the following:

Tax-Exempt Status: Sometimes creation of a subsidiary is necessary to protect the tax-exempt status of the parent organization. For example, a 501(c)(3) parent organization may wish to engage in business activities, lobbying, or political activities that are prohibited or limited for 501(c)(3) organizations. Other times, a for-profit company, 501(c)(6) trade association, or another type of nonprofit may wish to create a 501(c)(3) subsidiary to pursue grant funding or tax-deductible contributions for educational or other proper 501(c)(3) activities.

Liability: An organization may also wish set up a subsidiary to engage in high-risk activities for which the parent organization does want to be liable in the event of a lawsuit. While much of this risk can be managed or eliminated by purchasing insurance, forming a subsidiary corporation can provide additional protection.

Independence: A third common reason for forming a subsidiary is to ensure that a new project will be governed independently, without too much involvement or interference from the parent organization. This is often necessary when an organization pursues a new project in collaboration with other organizations or companies. With a subsidiary, the collaborating organizations can be given a seat on the Board of Directors, and any funds transferred to the project will remain under the subsidiary’s control (rather than used by the parent to offset its other budget priorities).

Once the decision has been made to form a subsidiary, the question is how the new entity will be structured in relation to the parent. The key challenge is to find the right balance between providing the desired level of the control to the parent, while maintaining enough independence so that the separateness of the entities will be respected for tax and liability purposes. Generally, the two organizations will be treated as separate so long as different individuals run the day-to-day management of the subsidiary.

With this principle in mind, the most common structure is to have a majority or more of the same individuals who serve on the Board of Directors of the parent organization also serve on the Board of Directors of the subsidiary, but with a different President/CEO/Executive Director running the subsidiary’s day-to-day operations. In some cases, the inverse design can also work — a majority of different individuals on the Board, but with the same President/CEO/Executive Director. In either case, the parent organization may retain control by having the right to appoint and remove directors on the Board.

Regardless of the Board of Directors structure, the subsidiary must be treated as a separate organization for financial and accounting purposes. Any dealings between the two organizations (such as employee or office sharing arrangements) should be carried out pursuant to arm’s length agreements for fair market value. And, most importantly, all staff, directors, and officers must clearly understand the different roles, missions, and activities of the two organizations.

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