The CPA Journal

An important planning tool for tax-exempt organizations is the use of taxable subsidiaries to carry on unrelated business activities. Whether it is done to preserve exempt status, generate revenue, limit legal liability, or for other reasons, exempt organizations are increasingly establishing taxable subsidiaries. Properly utilized, such subsidiaries can reap enormous benefits for the parent. Nonetheless, the legal terrain in which they operate is fraught with pitfalls.

Exemption-threatening activities. If the gross revenue, net income, or staff time devoted to an unrelated business jeopardizes its tax-exempt status, a not-for-profit organization can spin off the activity into a separate but affiliated entity, a taxable subsidiary. This subsidiary will pay income tax on the net income from its activities, but can remit the aftertax profits to the parent as tax-free dividends.

Product and service endorsements. When exempt organizations endorse or lend their name to third-party products and services, the income received under such arrangements is generally only tax-exempt to the extent it can be classified as a royalty (payment for the licensing of property such as a name or logo). If the income is in part a royalty and in part a payment for services, such as administrative or marketing services, then the IRS will generally treat all of the income as unrelated business taxable income (UBTI). To ensure tax-free royalty treatment of endorsement income, some exempt organizations do not conduct any services associated with such endorsements, some outsource to unrelated third parties, and others use taxable subsidiaries.

In such cases, the organization contracts with the vendor for the licensing of its name and logo, and the taxable subsidiary contracts separately with the vendor to provide administrative or marketing services. The organization's income is treated as tax-free royalty income; the taxable subsidiary pays tax on its income (aftertax profits can be transferred as tax-free dividends). Organizations using such a structure must ensure that the income is divided between the association and the taxable subsidiary on a fair market value basis and that the arrangement is conducted on an arm's length basis.

Reducing UBTI. In some cases, the IRS will permit a tax-exempt organization to deduct only the portion of expenses incurred to generate the revenue from an unrelated activity. For example, advertising income for a publication is generally unrelated business income. To determine the deductions allowable against advertising income and compute net taxable income from advertising, the IRS applies a complicated formula. In many cases, the formula permits only advertising expenses (not other publication expenses) to be deducted from advertising income. This means that a publication as a whole could be losing money, but the tax-exempt organization could be paying substantial income tax on its advertising income, because the expenses that are directly related to the generation of the advertising income are nominal.

In this case, if the entire publishing activity is put in a separate taxable entity affiliated with the tax-exempt organization, all expenses will be deductible from the total revenue generated by the publication. The same advertising revenue that can result in significant taxable income when conducted in a tax-exempt organization can result in little or no taxable income carried on by a taxable subsidiary.

Legal liability. Sometimes new ventures carry potential legal liability in the form of legal claims for breach of contract (including debts), copyright or trademark infringement, defamation, and other tort claims. Carrying on the unrelated activity through a separate legal entity such as a taxable subsidiary can protect the assets of the sponsoring tax-exempt entity from liability even if the two entities are affiliated.

The subsidiary must file annual reports with the state of incorporation, as well as with any states in which it is qualified to transact business. Furthermore, like all other taxable corporate entities, the subsidiary must pay federal and state taxes to the extent that it generates taxable income.

The tax-exempt parent may capitalize the subsidiary through a transfer of cash and assets in exchange for subsidiary stock. Ordinarily, the tax-exempt parent would own most or all of the subsidiary's stock and would receive tax-free dividends on this stock from the subsidiary.

A separate bank account, separate financial books and records, separate business stationery, etc., must be established for the subsidiary, and strict financial and operational separation must be maintained (e.g., no commingling of assets, no shared stationery).

The parent's board of directors can appoint the board of the subsidiary; the subsidiary's board can then appoint the subsidiary's officers. The directors and officers of the subsidiary should differ somewhat from those of the parent. An initial meeting of the subsidiary's board must be held and minutes recorded. Although the subsidiary's board can meet on the same date and place as the parent's, the meetings and minutes must remain separate.

The subsidiary can have its own employees (as long as withholding and other employer obligations are met), or the parent can lease its staff to the subsidiary. In the latter scenario, generally recommended for start-ups, the subsidiary must reimburse the parent for its use of the allocable staff's salary and benefits. The subsidiary can be housed in the parent's existing offices, if the subsidiary reimburses the parent's cost for its allocable share of rent, office equipment, supplies, and utilities. The parent and the subsidiary should enter into an arm's-length written agreement covering all aspects of the shared facilities, equipment, supplies, services, and employees.

A business plan, including the details of the financial and legal separation between the parent and the subsidiary, should be drafted and approved by the parent's board of directors. If necessary, the parent's articles of incorporation and bylaws should be amended to permit establishment of the taxable subsidiary.

If the parent's name is included in the subsidiary's name (not a legal requirement), the terms of a trademark license should be part of the written agreement. Although it is not required (and not tax-free income to the parent if the subsidiary is majority-owned by the parent), the subsidiary may pay the parent-on a regular basis and at fair market value-a royalty for the right to use the parent's name and logo. Otherwise, the trademark license should be part of the parent's capitalization of the subsidiary.

A tax-exempt organization may form, own, and receive dividends from a taxable subsidiary that operates commercial businesses, as long as the taxable subsidiary operates independently and the tax-exempt organization continues to engage in its tax-exempt activities. The separate existence of the subsidiary will not be disregarded for tax purposes where it is organized with the bona fide intention of performing some substantial business function. The separate corporate form of the subsidiary will be ignored only if the parent controls the affairs of the subsidiary so pervasively that it becomes a mere instrumentality of the parent.

IRS rulings in this area indicate that no one factor determines whether a subsidiary will be respected as a separate entity. Instead, the IRS considers several different factors together:

Business purpose. A tax-exempt organization's incorporation of a taxable subsidiary has been regarded by the IRS as valid whenever the purpose was to-

General relationship. Most IRS rulings indicate that the tax-exempt parent must not be involved in the day-to-day management of a taxable subsidiary. However, the IRS does permit the parent to establish long-range plans and policies for the subsidiary without jeopardizing exempt status. In addition, the parent may provide substantial support through the sharing of employees and facilities. The distinct separate corporate identity of the subsidiary should be made clear to third parties by entering into contracts in the subsidiary's name, and having an officer of the subsidiary sign contracts in that capacity.

Common directors. Members of the exempt parent that do not currently sit on its board can be chosen to fill seats on the subsidiary's board. Furthermore, some overlap is clearly permissible, such as giving the parent's current board chair and president seats on the subsidiary's board. Even if most or all of the subsidiary's directors are directors or officers of the parent, the parent's exemption will not be jeopardized as long as other factors indicate that the parent is not involved in day-to-day management and deals with the subsidiary at arm's length.

Common officers and employees. The IRS is more likely to attribute the subsidiary's activities to the parent if officers of the parent are also officers of the subsidiary. In such cases, the overlap indicates to the IRS that the parent may be managing the subsidiary on a day-to-day basis. Where a majority of the subsidiary's board consists of directors that are not officers of the subsidiary, overlap of officers between the parent and the subsidiary has been permitted. Generally, there is a tradeoff between having common directors and common officers; the less the overlap in one category, the more permitted in the other.

Because business expense deductions-including deductions for salaries-are more valuable to a taxable entity than an exempt organization, there is an inherent incentive for the taxable entity to pay for the compensation of shared executives. Each entity should pay its appropriate share, however; the IRS will reallocate compensation to accurately reflect the income of the organizations and to prevent tax evasion.

Compensation from related organizations must be reported on a tax-exempt organization's Form 990 when total compensation paid by all related organizations to an officer, director, or key employee of the filing organization exceeds $10,000, and such an individual's total compensation exceeds $100,000. A related organization is any entity that (directly or indirectly) owns, controls, supports (or is owned, controlled, or supported by) the filing organization. For these purposes, ownership means directly or indirectly holding 50% or more of the voting membership rights, voting stock, profit interest, or beneficial interest. Control means that: 50% or more of the filing organization's officers, directors, or key employees are also officers, directors, or key employees of the second organization; the filing organization appoints 50% or more of the officers, directors, or key employees of the second organization; or 50% or more of the filing organization's officers, directors, or key employees are appointed by the second organization. A supporting or supported organization means a related organization whether any elements of ownership or control are present.

In contrast to the overlapping of officers and directors, the sharing of employees between the parent and the subsidiary is less of a problem. In a number of situations, the IRS has ruled favorably where the subsidiary contracted with the parent to lease all or some of the parent's employees for particular services. Charges must be at arm's length, reimbursing the allocable share of actual salaries and benefits. This reimbursement arrangement generally results in lower payroll taxes (and lesser administrative burdens) than if employees are employed part-time by separate employers.

It is critical for shared employees to keep detailed, contemporaneous time records of their work for each corporation. If possible, shared employees should be paid at the identical rate whether working for the parent or the subsidiary. Parent and subsidiary employees may participate in the same health and benefits plans if the costs borne by each corporation are proportionate to the time worked for each.

Shared facilities and services. The parent and subsidiary may share office space, equipment, supplies, and facilities if reimbursement is calculated on an arm's-length basis. For example, the parent may sublease office space to the subsidiary at cost (i.e., pass through a pro-rata share of the parent's actual lease payments). A requirement in the sublease for the subsidiary to insure its portion of the premises against risk of loss or damage would help demonstrate an arm's-length relationship.

The parent may share equipment, telephones, and supplies with the subsidiary, if the costs are allocated fairly and accurately, based on actual usage. Additionally, the parent may provide administrative, data processing, or other nonmanagement services to the subsidiary if the charges reflect fair market value.

The parent and the subsidiary should enter into and follow an arm's-length written agreement covering all aspects of the shared facilities, equipment, supplies, services, and employees. It is critical that strict financial separation be maintained. Separate financial books and records, bank accounts, tax returns, and assets are necessary to avoid the appearance of commingling of assets.

A tax-exempt organization may engage in incidental business activities unrelated to its exempt purposes, but the net income to the organization derived from such activities may be taxable if the activities constitute a trade or business conducted on a regular basis and they do not contribute substantially to the organization's exempt purposes. Regardless of whether an activity is substantially related to tax-exempt purposes, certain types of passive income are generally excluded from unrelated business income (UBI), including dividends, interest, annuities, royalties, and certain rents.

The passive income exclusion does not, however, apply to interest, annuities, royalties, and certain rents received from a controlled subsidiary. As amended by the Taxpayer Relief Act of 1997, IRC section 512(b)(13) provides that interest, annuities, royalties, and certain rents generally excluded from UBI will not be exempt if received from a subsidiary; when the tax-exempt parent owns more than 50%, directly or indirectly, of the voting power or value of the subsidiary's stock; and to the extent that the payments reduce the net unrelated income, or increase the net loss, of the subsidiary. This special rule does not apply to dividend distributions from the subsidiary to the exempt parent.

Payments by a taxable subsidiary to an exempt parent for administrative services and the leasing of employees would not qualify as excludable passive income, nor would they qualify as payments for services substantially related to the performance of the parent's tax-exempt purposes. All such income received by the parent could, however, be offset through the allocation of corresponding costs (deductions reflecting actual expenditures), resulting in no unrelated business income tax (UBIT) liability for the parent.

Under IRC section 512(b)(13), if the parent maintained more than 50% control of the subsidiary (as defined above), rents would be UBI to the parent. However, the rents from the subsidiary for shared office space and equipment can be netted against the actual cost to the parent, resulting in no UBIT liability.

The netting process would offset the UBI from a controlled subsidiary to the parent for its share of expenses. If the subsidiary begins to earn net income and desires to transfer it to the parent without tax, however, it would have to pay dividends that are tax-free to the parent but not deductible to the subsidiary. Of course, if the subsidiary is not a controlled entity, payment of some of those profits as a royalty (e.g., for licensing the parent's name and logo) would be deductible to the subsidiary and tax-free to the parent. From a practical perspective, however, exempt organizations generally insist on holding more than 50% of their subsidiaries' stock (and the anti-avoidance constructive ownership rules forbid prior options, such as second-tier subsidiary ownership).

If an organization is not prepared to perform the detailed record keeping, cost allocation, and other administrative functions necessary to maintain financial, managerial, and operational separation, then it should not establish a taxable subsidiary. It is burdensome to hold separate board meetings, maintain separate financial records and time sheets, allocate joint program expenses and overhead, use separate stationery, and maintain additional corporate structures. At the same time, there are significant benefits to the creative use of taxable subsidiaries.

Jeffrey S. Tenenbaum, JD, is an attorney with the association practice group of Venable, Baetjer, Howard & Civiletti, LLP, Washington, D.C. He is the author of Association Tax Compliance Guide, published by ASAE, and can be contacted at jstenenbaum@venable.com. Editor: Robert H. Colson, CPA, PhD The CPA Journal

Editor:
Robert H. Colson, PhD, CPA
The CPA Journal

This Month | About Us | Archives | Advertise| NYSSCPA

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.