Adding a Non-profit to the Family — Thinking Through For-Profit and Non-Profit Affiliates
Continuing our blog’s series walking through how to launch a non-profit, we have already talked about what activated us to want to start a nonprofit and whether it actually makes sense to start one – now, we’re going to start… with a detour about affiliated structures (yes, this series is going to take a long time).
Like many people that come to us to form a nonprofit, we are not starting our plan from a blank canvas. We have a for-profit law firm whose work could potentially overlap in personnel and subject matter with the 501(c)(3) nonprofit’s plan to provide legal and educational support to progressive charities targeted for their DEI efforts and social justice work. We have a 501(c)(4) nonprofit that we use to carry out the charitable and advocacy missions of our employees – and the 501(c)(4) is allowed to do things that a 501(c)(3) is not.
How do we make sure the 501(c)(3) nonprofit remains compliant and operates with integrity, while still leveraging support from our existing structure?
If you have or have considered a for-profit/non-profit affiliate relationship, this post is intended to illustrate how we work through that question with clients (and ourselves).
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Wait, Are There Rules That Apply to This? Definitely. And I’m not going to explain them all to you or give you citations – this isn’t legal advice and you don’t want to hear it anyway. What I will say is that I think you can boil down all of these into two tests: a “Big Picture” test and a “Small Picture” test. (I sometimes call these the “Macro” test and the “Micro” test, like in this resource that covers a lot of the same ground -- I’m really bad at naming tests.)
Let’s start with the Small Picture Test. This says that every single transaction between the 501(c)(3) nonprofit and the for-profit needs to pass muster (same basic rule if it is a 501(c)(3) affiliated with a less regulated non-profit, like a 501(c)(4) social welfare organization or a 501(c)(6) trade association).
If our 501(c)(3) was a private foundation (e.g. if the vast majority of funding was coming from our firm), that would be a hard challenge. In that context, most transactions between a foundation and an affiliated for-profit are going to be prohibited under the self-dealing rules. Let’s just do ourselves a favor and assume that our new nonprofit is a public charity – we’ll talk more about why and what the self-dealing rules are in a later post.
If our 501(c)(3) is going to be a public charity (e.g. because we expect the money to come from a sufficiently broad array of sources), then the test is relatively simple: the transaction needs to be “fair market value” or better from the 501(c)(3)’s perspective. So, our charity can get stuff for free or at a clear discount from the for-profit and pass this test. The charity can even buy goods or services from the for-profit up to “market price”. Vice versa, the charity could sell goods or services to the for-profit, but it needs to get at least “market price”. For public charities, the Small Picture test is basically that the charity always needs to come out “even” or “ahead.”
In my experience, the easiest to manage for-profit and non-profit affiliate relationships are ones where the parties keep it simple: for-profit gives stuff to the charity for free – charity uses it stuff to carry out its mission. The second-best structure is one where the charity effectively pays ‘at cost’ – either through a cost-sharing agreement (non-profit pays the share of employees and stuff it uses) or at a heavily discounted price that no one could argue is overpriced.
Once you start trying to charge “full price” to the charity, you have to start assigning value to goods or services that may be hard to value. And where a regulator (or donor) could argue that you got the valuation wrong and you’re breaking the law by diverting charitable funds and exposing your for-profit to excise taxes or other harm as a result. Those valuation concerns come up all the time — e.g, how do you value your for-profit’s core intellectual property that it has never put on the market but it wants the non-profit to pay for? It can be done, but proceed cautiously if you’re setting up an affiliate structure where the non-profit is paying the for-profit.
Applying to ourselves: We’re going to keep this simple by avoiding all that. Our for-profit law firm will share its lawyers, paralegals, and administrative team with the charity without charge. Our 501(c)(4) will probably make grants to the charity using some of the profits we distribute to it each year, but nothing going in the other direction. The most I could imagine is our for-profit getting reimbursed for out-of-pocket costs (e.g. filing fees) it advances for the charity’s benefit.
So, great – I think we’re carrying little-to-no risk on this. And, for the most part, most of the affiliate structures we see are in a similar boat. Thankfully, most people do not set up a charity for the explicit purpose of overcharging it. And, even when they want the nonprofit to pay some of its way, most are either willing to do it at cost or on a discounted basis. Of the two tests, this is the easier one to talk about…
Which brings us to the Big Picture test. You can google this test, but you won’t find it. What I’m referring to is the requirement, in order to be a 501(c)(3) that a nonprofit exclusively operate for charitable, educational, scientific or religious purposes – exclusively here means not having any other “substantial purpose”. When you see rejections of charities affiliated with for-profit, the IRS is often citing this standard and saying “Whatever charitable stuff you are doing, you are operating with a substantial purpose of benefitting the for-profit – so you do not get 501(c)(3) status, even if you don’t have any improper transactions per se.” So, the Big Picture test is that the charity cannot have a substantial purpose of benefiting the for-profit – the charity’s decisions and activities must be based on its own best interests and the advancement of its mission, with any benefit to the for-profit being incidental (e.g. goodwill arising as a by-product of the charitable work but not a benefit the non-profit is actively trying to provide).
That all sounds great, but after I explain that and a client asks how exactly that is measured, I usually start with a shrug and mumble something about “well… it’s based on all of the facts and circumstances…”
Unfortunately, that really is the answer – the IRS considers everything about the relationship and what the nonprofit is doing and assesses whether any benefit to the for-profit is incidental (good) or intentional (bad). Let’s re-enact some of the common Q&A that proceeds from there, and see how it applies to us:
Can I Give Them the Same Name? The exact same name? No, please don’t do that – they need to be two separate entities.
But the IRS is clearly fine with for-profits and charities sharing part of their name and logo such that the charity’s name itself raises awareness of the for-profit. I often point out that “Fidelity Investments Charitable Gift Fund”) is the largest charity in the country. And there are countless “[Name of Company] Foundations” out there, most of which typically incorporate the company’s logo in the charity’s logo.
Does that feel like free advertising? Maybe. But a consistent principle in the IRS guidance here is that it’s generally going to put the “halo effect” or increased name recognition for the donor in the “safe” benefit category. Name your charities after your companies, name your buildings after your donors, slap those company logos all over your conference… that all generally is going to fly. And of course, this is why many companies do the charitable giving that they do.
Applying to Ourselves. We’ll deal with it in the next post, but we’re going to leave our firm’s name out of it. Our firm’s name is Mill Law Center and we often go by “MLC,” which is why we named our 501(c)(4) “MLC Collective”. That feels OK because we are expecting to be the primary funder there, and it reflects that it is run by our firm’s employees. But this new charity is a different thing and something we want to be more public-facing and collaborative. Just because we could slap our name and logo on it, doesn’t mean we should do that. Real name to come, but it won’t be MLC Foundation or anything similar.
Can I Have My Company Appoint the Board? Well, yes you can.
Sometimes this surprises people. But non-profit corporate law allows “members” or “designators” to appoint a non-profit’s Board. No one can “own” a non-profit, but you can “control” it, or, technically, at least control who is on the Board, the body that has ultimate power over the organization.
Whether it is wise to give your for-profit that control is another question:
If It’s an Easy Structure… If your structure involves no real risk under the Big Picture Test (e.g. your for-profit just makes grants to the non-profit and the non-profit goes off and things unrelated to the for-profit’s business, without paying the for-profit anything), I usually say “Yes, you SHOULD at least consider having the company appoint the charity’s Board to protect against mission drift.” That may be counterintuitive, but I usually find that a charity’s founders are the ones who know what it’s supposed to be about – moreso than whatever mix of volunteer donors they manage to add to the Board. Those Board members need to make final decisions for the organization and exercise their fiduciary duties, but I tend to think that the founders are in a better position to know what the “mission” is supposed to be and to use their power to appoint and remove the Board to protect against mission drift. Not true all the time, and just my opinion.
Otherwise… My answer is very different if the charity has actual things to worry about under the big-picture test. If I am having any economic transactions between the two entities other than “free stuff to the non-profit,” I at least want enough independent directors (i.e. directors who have no financial interest in or role at the for-profit) to form a committee to have final authority to review, evaluate, and approve or reject those transactions. I think that independence is much more plausible if they are not appointed by the for-profit. And perhaps the whole thing fares better under the ‘smell test’ (which is what the Big Picture test really is…) if at least a majority of the Board is independent.
So, you CAN have your for-profit appoint the Board, but the Board’s independence (or lack thereof) is often a key factor under the Big Picture test, and should be factored in accordingly.
Applied to Ourselves: Because we are doing a relatively risk-free structure otherwise, we are actually going to have our 501(c)(4) appoint the charity’s Board. Our 501(c)(4)’s Board consists of all employees of the firm, and its CEO is our Managing Paralegal. From the perspective of making sure this new charity does what we all agreed we want it to do, we’ll start by keeping this power close. As the charity takes on its own life and we have a Board we trust to carry on the mission, we can always give up that power later.
Can We Share Intellectual Property? Well, you can share it in one direction easily: the for-profit almost always licenses its logo and any existing IP to the charity for free. And the charity will own anything that it creates. That’s the easy part.
This is one of the issues that gets tricky quickly though. What happens if the charity spends its resources to carry out its mission but, in doing so, improves the value of intellectual property used by the for-profit? It’s easy to say that the for-profit needs to pay fair market value, but what if the for-profit works off of open-source software that the charity is also using in carrying out its charitable activities and building on it through that use? Or what if the non-profit publisher of children’s educational materials is using characters created and still monetized by the for-profit? Doesn’t that start to look like the non-profit has a substantial purpose of benefiting the for-profit?
Maybe! Honestly, this is one of those things that needs its own post, but I’ll just say for now that I think this is one of those areas where many non-profit and for-profit affiliates need to slow down and calibrate everything so that they stand behind the idea that the for-profit isn’t benefitting “more than incidentally” when it comes to what the non-profit is doing. In my experience, the more you can separate the two organizations’ activities as distinct or dealing with entirely separate groups, the lower the risk. The more overlap in the Venn diagram of what the two organizations do and who they work with, the greater the risk of the nonprofit being disqualified for having a substantial non-exempt purpose.
Applied to Ourselves: I am not expecting an issue here for the charity we are starting… the for-profit will share its stuff for free and the charity will probably not spend money to create anything – nothing the law firm will use anyway. And I’m guessing that everything the non-profit does is material that we will make publicly and freely available. We will have to keep an eye on this as it evolves – for example, if the non-profit does spend resources to create anything, we need to find a way to “cabin” that to the non-profit’s work. We’ll write about this more down the road, but OK for now.
What If I Want my Non-Profit to Hire or Buy Things from my For-Profit? Like… a Lot? Let’s assume it passes the Small Picture test and it’s a fair price, are we OK the non-profit spending a significant part of its resources to be a customer of the for-profit? Doesn’t that look like the non-profit has a purpose of benefitting the for-profit?
I think so. But, it’s a tough one. There are examples out there of non-profits that hire a for-profit management company and pay it fees representing a majority, even a significant majority, of their operating expenses. There is a wide range of examples, but consider again the commercial donor-advised fund sponsors. These are organizations that outsource all of their operating costs (mostly investment management fees) to the related for-profit for market (or close-to-market) rates. That relationship represents immense value to the for-profit, providing it with a major built-in customer and a value-add to their investment management services to individuals that they tend to present as “just another account” in the portfolio. Is that an example of a non-profit having a substantial purpose of benefiting the for-profit?
The IRS appeared to say “no” when it approved those commercial donor-advised fund sponsors’s exemption applications. Still, I would advise caution before assuming it’s never a problem. After all, the bulk of the cashflow for those entities are “billions of dollars in donations in, billions of dollars in investment income, and billions of dollars in grants out” – the cashflow to the affiliated for-profit (in the mere many tens of millions) reads as a pretty small percentage.
If your charity affiliate’s entire budget is a management services contract fee to your for-profit, I think you probably should fail the Big Picture test. And if your non-profit carries out its mission by distributing goods for free to the needy, but it pays the for-profit full fair market value for those goods, I’d also that it probably should fail the Big Picture test. The non-profit in these examples may have a charitable purpose, but it also has a purpose of using donated dollars to drive business to a particular for-profit. It’s a subjective test, but I have certainly seen examples where this rises to a “substantial non-exempt purpose”.
So, if you are going to have payments from the charity to the for-profit, I often recommend trying to (A) limit the amount of the non-profit’s spending that is just ending up in the for-profit to a manageable portion of the non-profit’s budget, (B) have a policy of reconsidering the contract and exploring alternative service providers, (C) strengthen the case as much as possible that the for-profit is the right vendor for the job, and (D) consider reducing your risk in the other categories (more clearly distinguishable name, more independent board, making sure that independent board is carefully reviewing the price of the contract with the for-profit).
Applied to Ourselves: Again, none of the money raised by the charity is going back to our for-profit here, so I’m not too worried for ourselves here.
Wrapping up the Tests: So, if you can confirm all of your transactions will satisfy the Small Picture test and you feel like you pass the Big Picture test because you’re establishing a structure where the non-profit has its own mission and purpose, without appearing to exist to benefit the for-profit, your affiliate structure may well work.
If you can’t do both of those, then that’s a sign that, whatever the good, charitable activity you want to do is, probably best to keep it in-house at your for-profit. Within the for-profit, you can be as self-serving as you want. Once you set up a charity to conduct the activity, you really should be actively steering away from advancing your for-profit’s interests. When we explain that, some for-profits decide against starting a non-profit affiliate after all.
So What Have We Landed on Here For Ourselves?
There are a lot of different ways to have an affiliate structure, but here’s what we have:
A relatively simple affiliate structure all things considered…
In our next post, we’ll finally get around to actually forming (and naming!) this new charity.
