(a) Form of Relationship

The relationship between the two organizations can take many forms. Typically, the board members overlap. Though it is acceptable for both boards to be identical, they may be totally separate. If public status as a supporting organization is desired, the link must be evident and the purposes and organizational documents must meet very specific governance requirements.⁶ Regardless of structure governance, it is imperative that the separateness and differences between the activities of related organizations qualified under different categories of tax exemption be respected and distinguished.

When one category of tax-exempt organization associates with another category, it is important that the activities of the different categories be kept distinctly separate.⁷ The electronic age has added a new dimension to this issue: sharing a website and/or linking from one site to another. There is no specific IRS guidance on this issue. There exists, nonetheless, a burden that a (c)(3) organization, for example, not use its resources to promote the interests of its related (c)(4) or (c)(6) organization. Materials on a shared site should clearly identify that portion displayed on behalf of each entity. The cost of establishing and maintaining the site can be shared based on adequate records evidencing costs attributable to space used by each entity. Another question that arises is whether it is acceptable for associated organizations in different §501 categories to have the same name. Can the Save the Cats Foundation operate alongside a Save the Cats Advocacy Fund and a Save the Cats PAC? In an annual training article, the IRS said, “The mere fact that an IRC 501(c)(4) organization has a similar name to an IRC 501(c)(3) organization is not sufficient to cause the activities” of one to be attributed to the other.⁸

(b) Category of Public Charity

Public charity status is an important question in structuring this type of relationship. Though affiliated charities formed by business leagues and other non-(c)(3)s are often called foundations, such charities can normally qualify as public charities rather than as private foundations. The appropriate type of public charity is dictated both by the anticipated sources of funding for the foundation and by the scope of its activities. If support will be received from the related organization or a small group of members, formation of a supporting organization under IRC §509(a)(3) is indicated. If donations are expected from a wide segment of the membership and the public, the new organization can also qualify for public status under IRC §509(a)(1) or (2). When the new entity can qualify under more than one category of IRC §509, a choice must be made. The §§509(a)(1) and (2) categories allow the new organization to operate and be controlled more independently than it could as a supporting organization under §509(a)(3). The fact that no public-support test calculations are required may make the §509(a)(3) category more desirable. The difference between §§509(a)(1) and (a)(2) is usually mathematical and dependent on the sources of revenue. A school, church, hospital, and others may also qualify under §509(a)(1) because of their specific listing in §170 (b)(1)(A).⁹

(c) Donation Collection System

A subset of the public support question arises when the professional entity, civic league, or union solicits donations as a part of its annual dues-collection process. Typically, the donations to the separate charitable foundation are optional for members. The notice may suggest an amount or allow members to add whatever amount they choose. The non-(c)(3)collects the donations and periodically pays them over to the charity. A question may arise as to who is making the gift, the individual member or the non-(c)(3). Particularly for optional gifts, there should be evidence of donative intention on the member's part, not the collector's. Such donations should be segregated and recorded on the collector's books as a liability held as agent for the charity. Guidelines provided by the accounting profession and the Internal Revenue Service (IRS) can be applied in distinguishing payments collected by one organization on behalf of another.¹⁰

(d) Grants to and from the (c)(3)

The (c)(3) organization raises the funds to carry out educational, scientific, or other charitable activities on behalf of or in concert with the organization that creates it. The interesting question is whether the (c)(3) must disburse the funds itself and directly undertake charitable projects, or whether it can grant funds to the (c)(4), (5), or (6) to enable it to undertake the activities. Both scenarios are permissible. If the funds are paid over to the parent non-(c)(3) organization, the grant should be restricted under a written agreement specifying the qualifying charitable purposes for which the moneys are spent, with reports made to the funding charity.

Often, the member-entity donates office space, personnel, and other necessary operating overhead items to its affiliated charity. Reimbursement of expenses incurred by either organization is permissible.¹¹ However, the charity has the burden of proving that the expenditures do not benefit the non-(c)(3) and its members. When it is financially possible, payment of the expenses by the non-(c)(3) without reimbursement eliminates questions of this sort.

For example, a related foundation of a (c)(6) business association was found not to be engaging in appropriate tax-exempt activities, because it operated primarily for the benefit of the association. The foundation's only activity was to provide a no-rent lease to the related membership association. Such a nonsignificant charitable activity indicates that the charity operates to further the interest of the parent organization and thus cannot qualify for exemption.¹² Loaning the foundation's non-(c)(3) parent money to conduct lobbying, or for any other noncharitable purpose, is also not acceptable.¹³

Respecting the separateness of the (c)(3) is very important. The projects it sponsors should be discrete and identifiable as its own, though they may focus on issues of concern to the affiliate business league or union. Particularly when the (c)(3) was created by a (c)(4) that conducts extensive lobbying, it is imperative that adequate records be maintained to evidence allocation of moneys and separateness of activity.¹⁴

(e) Creation of a Triumvirate

Due to the limitations on expenditures for lobbying and political campaign activity,¹⁵ a triumvirate of organizations may also be created to accomplish a publicly spirited group's mission. The §501(c)(3) educational organization provides information by conducting classes, gathering data with research, writing papers for publication,¹⁶ and being eligible to receive deductible charitable contributions to support its work. The §501(c)(4), (5), or (6) can focus on improvement of civic, labor, and business conditions and lobby (without limitations) persons in legislative positions. Lastly, a §527 political action committee (PAC) is established to finance efforts to elect persons to public office. Often, such a triumvirate is united behind its advocacy of better working conditions, the environment, relief of the poor, or some other social cause.

The need to maintain separateness between the organizations is strategic because the (c)(3) can have absolutely no campaign participation and only limited lobbying activity.¹⁷ Careful consideration must be given to the propriety of the three organizations having separate, or overlapping, boards.¹⁸ If one of the noncharitable entities controls and uses that position to cause the charity to operate for its benefit, the charity's status could be jeopardized.¹⁹ The IRS says it is important that PAC activity not be identified or ratified in minutes or other documents as official actions of the (c)(3).²⁰ The PAC should not use the (c)(3)'s letterhead, nor should the charity's representatives be identified as responsible for PAC activity.

Record-keeping systems must be implemented to capture the direct costs attributable to each member in the related group. Personnel, facilities, and other costs can be shared so long as a cost allocation system is maintained to arrive at a fair and reasonable portion attributable to each separate entity. The expense reimbursement policy shown in Exhibit 14.2 might be used to evidence the group's intention to properly allocate its expenditures and activities. Some question whether the organizations can all share the same name and, if they do, whether there is the need to compensate each other for the use of such an intangible, but sometimes very valuable, asset. The IRS has traditionally encouraged the creation of such a group and has not in the author's experience questioned the use of similar names.²¹ Under the self-dealing rules applicable to private foundations, the use of a name is considered to provide “incidental and tenuous benefit” that is not valued and does not cause self-dealing.²² Nonetheless, the goodwill associated with a charity's name might have value for the use of which the (c)(4) and the PAC should compensate it.²³

(a) Exempt Organization as General Partner

Originally, the IRS ruled that an exempt organization was completely prohibited from serving as a general partner with private limited partners. Because the general partner has an obligation to maximize profits for the benefit of the limited partners, the general partner role violates the basic private inurement standards and automatically causes loss of exempt status. The IRS said that “the arrangement is inherently incompatible with being operated exclusively for charitable purposes.”²⁵

By 1980, the IRS relaxed its prohibition and agreed that an exempt organization could serve as a general partner if, and only if, the venture is one that serves its charitable purposes. The terms of the partnership agreement must evidence that the venture serves the underlying exempt purposes of the exempt organization (EO). Building ventures have been condoned when they attract and keep qualified physicians at a charity hospital.²⁶ Acquisition of new equipment necessary to serve the community with home health care, made possible with investor funds, has also been condoned.²⁷

Not only must exempt purposes be those primarily served, but the exempt organization must also not bear unreasonable risk to its financial condition. Insulating the exempt partner's assets from venture liabilities is equally important. Among the factors that provide such insulation are the following:

• Contractual limitation of liability.²⁸
• Right of first refusal or option to purchase on dissolution or sale granted to the EO.²⁹
• Limitation or ceiling on returns to limited partners.³⁰
• Presence of other general partners or managers with responsibility to serve the limited partners.³¹
• Organizational control exercised by the exempt partner and attention paid to the charitable mission carried on by the partnership.³²
• Methods for calculating profit sharing, asset purchases, and cost reimbursements designed to protect the EO's interests.

The factor of primary concern is protecting the exempt organization's assets. The test for continued charitable exemption requires that the assets be dedicated to charitable purposes and that earnings be similarly used. Consequently, liabilities associated with any joint venture must be identifiable and limited to isolate the (c)(3)'s underlying assets. Insurance coverage and an indemnity agreement specifying the extent of exposure and the nature of the activities can provide such protection For example, a student dormitory building project has lower inherent risk than a research laboratory and may provide lower exposure to an exempt general partner.

Terms of partnership profit/loss sharing should ensure that the limited partners do not reap unreasonable compensation or gain at the expense of the EO. Conversely, the exempt organization taking the risk of serving as general partner should be appropriately rewarded with the greater share of the return. Another method of protecting the EO's interest is a provision for repurchase of the venture asset or to specifically limit the profits.³³ The following discussion of management contracts has examples of fair compensation.³⁴

An important IRS objection to exempt general partners is the conflict between their responsibility to create gain for the limited partners and the fiduciary responsibility to serve their exempt constituents. In some cases, the exempt organization requires a dual general partner to manage the venture to suitably limit its role. Facts indicating lack of impermissible benefit include financial arrangements that are at fair market value, profits and loss allocations based on investments made and risks assumed, and the existence of mutually binding termination and buyout agreements.

Additional forms of organization—limited liability companies (LLCs), limited liability partnerships (LLPs), and in some states a low-profit limited liability company (L3C)—add another dimension to this issue. Such entities are to be judged by the same criteria used to judge partnership arrangements.

(b) Ongoing Evolution of Standards

A brief history of partnerships in the health-care industry illustrates how the rules have evolved. Since 1983, when Medicare changed its cost-based reimbursement system for inpatient hospital services to fixed, per-case, prospective payments, health-care organizations have been challenged financially. Cost recoupment became dependent on the number of patients served, and hospitals began to adopt policies to enhance patient population. Consequently, the emphasis shifted to admissions and physician referrals. To give tangible encouragement to the doctors, hospitals designed incentive profit-sharing arrangements based on patient revenue. When the total compensation to the doctor is reasonable, incentive compensation is not necessarily prohibited.

One version of such plans attracted IRS attention: joint ventures to operate certain departments that were set up between the hospitals and the physicians. Both the exempt hospital and the doctors invested funds. The transferability of interests for the doctor partners was restricted; in some situations, there was a mandatory repurchase agreement. Basically, the patients would still be served in the same manner, with the hospital retaining the equipment, overhead, and so on. The net revenue stream, discounted to present value, from the department was sold to the venture up front, sometimes with and sometimes without investment by the doctors.

The IRS initially approved such ventures.³⁵ In December 1991,³⁶ it reversed its position in a memorandum that reviewed three net revenue stream ventures and found that the exempt status of the hospital ventures should be revoked. The complex facts and elements of these ventures can be studied in another excellent Wiley guide.³⁷

(c) Trouble-Free Relationships

A joint venture between exempt organizations of the same §501 category, to own and operate exempt function assets or to sponsor a charitable program, poses no threat to either organization's status. A trouble-free example might have three museums buying a Georgia O'Keeffe painting, each receiving an undivided one-third interest. The costs are shared equally, and each museum exhibits the work one-third of each year. This joint ownership is established to reduce the funds expended by each museum and to enable them to reduce their storage requirements, and thus serves an exempt purpose.

What if the venture borrows money from a private individual to buy the painting? Assume that the loan is to be paid back over a four-year period, as fund-raising permits. Interest on the debt is paid at the prevailing prime rate. If the loan is unpaid at the end of four years, the painting can be foreclosed on by the lender in return for any principal payments made against the loan, adjusted for any increase in value as determined by an independent outside appraiser. Because (1) purchasing and exhibiting artwork advances the educational purposes of the museums, (2) their underlying endowments are not used to purchase the painting (i.e., limited liability), and (3) the museums reap any increase in the value of the artwork, this venture involving a private investor should not pose a threat to their exempt status.³⁸

Another arrangement is possible when an exempt organization needs to expand. Assume that it needs to acquire a building to provide additional space. After meetings with major donors, they find that funds cannot be raised entirely through donations. Some of the donors, however, offer to build the facility and lease it back to the organization. If the building serves exempt purposes and the four factors previously discussed are present, a tenant–landlord relationship should be permissible.³⁹

(d) Unrelated Business Income Aspect

Conduct of an income-producing activity by a partnership does not shelter an EO partner from receipt of unrelated business income. The activity and resulting income earned by a partnership, LLC, or similar venture passes directly through to the partners, retaining its same character. The partnership itself pays no tax and submits Form 1065 to report each partner's distributive share of profits or losses. The EO partner reports its share of profits or losses directly on Form 990 or 990-T and pays any applicable tax directly.

One must also determine whether the business activities of the partnership will be attributed to the exempt organization, and, if so, whether the exempt status of the organization will be jeopardized because of the activity. The primary purpose of the EO cannot be to participate in the venture. The IRS applied a “more-than-incidental” test in private rulings. When no more than 15 percent of its computerized database users would be nonexempt users, an organization qualified for exemption.⁴⁰

(a) Maintaining Separate Corporate Identity

Attribution of the subsidiary's activities back to its exempt parent might defeat the purpose for its formation. Thus, it is important to structure the subsidiary to ensure its separate corporate identity. If the exempt organization owns less than 100 percent of the stock,⁴² the outside owners provide separateness.⁴³ When the exempt organization owns all of the stock, proof of identity includes a separate board of directors and officers and independent management of daily affairs.⁴⁴ Actual evidence of separate operation should be maintained, such as minutes of board meetings, operating budgets, and financial reports. The fact that the parent corporation retains control over significant corporate actions, such as dissolution, does not constitute interference with the subsidiary's day-to-day affairs.⁴⁵

The makeup of the board of directors can be evidence of the subsidiary's independent operation. Although there is technically no requirement for it, independent and nonemployee members of the board are a positive factor. A hotel-operating corporation established by a historic village foundation was ruled to be autonomous and “operated at arms' length” partly because of the outsiders sitting on the board of directors.⁴⁶ A for-profit subsidiary in a hospital conglomerate group was also found to be valid because of its independent board.⁴⁷ Two private rulings, one attributed to the American Association of Retired Persons⁴⁸ (AARP) and another involving the creation of a for-profit subsidiary to operate an Internet portal, enhanced the list of factors which indicate that the subsidiary is indeed a separate entity, the operation of which does not jeopardize the tax-exempt parent. Regarding governance of the subsidiary, it is desirable that most of the following characteristics be present:

• Majority of the subsidiary's board members are not officers or directors of the nonprofit parent.
• Subsidiary's board is its sole governing and policy-making body.
• Subsidiary's officers and employees are responsible for daily activities.
• Subsidiary's board holds regular meetings (in one ruling, three times a year).
• Subsidiary's board was composed of five persons.
• Subsidiary kept complete and accurate records of its meetings.

The subsidiary must be established for a valid business purpose to avoid its being considered merely a guise to allow the exempt organization to conduct excess business or other impermissible activity. The subsidiary should not be merely an arm, an agency, or an integral part of the parent.⁴⁹ The creation of a subsidiary by a business league to “isolate in[to] one single taxable entity” all of its unrelated activities was condoned.⁵⁰

The facts and circumstances are important to prove the separateness of an exempt organization and its subsidiary when customers are referred by the nonprofit to the for-profit. Exempt organizations involved in such relationships will be well served by studying the complex and extensive rules found in IRC §482, “Allocation of Income and Deductions among Taxpayers.” The IRS is empowered by the section to “distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among” two or more organizations owned or controlled directly or indirectly by the same interests. The regulations contain 12 different factors that may indicate a basis for reallocations.⁵¹

(b) Subsidiary Pays Its Own Income Tax

As a separate taxpayer, the subsidiary files its own Form 1120 and pays its own income tax. Dividends are therefore paid to the exempt parent with after-tax profits. To avoid circumvention of this rule, payments to a controlled parent (owning 50 percent or more of the stock) in the form of rent, interest, or royalty are taxed to the parent.⁵² In other words, tax on unrelated business income cannot be escaped by paying it back to an exempt parent as a deductible expense. Additionally, a transfer of assets upon sale or liquidation from the taxable subsidiary to the exempt parent may be taxable.⁵³ As a for-profit business entity, the corporate subsidiary will also be subject to local and state taxes.

(c) Sharing Facilities and/or Employees

Combining exempt organizations of more than one category of §501(c), private foundations, and/or nonexempt organizations into sharing arrangements for office space, employees, group insurance, project management, or a variety of other operating necessities may be permissible. There is no absolute prohibition if the following conditions are met:

• Activity (rental of office space, hiring of employees, etc.) serves an exempt purpose of the organization.
• Organization reaps cost savings by combining with others in securing the shared items or services.
• Documentation is maintained to evidence each organization's allocable portion of each expenditure. This may be done through
  • Time sheets
  • Space utilization
  • Asset cost (e.g., “We buy the copier, you buy the phones”)
  • Automobile and travel logs.
• Arrangement does not allow unfair advantage to any of the parties, unless such advantage inures to the 501(c)(3)s involved.
• Exempt organization assumes no risk of loss on behalf of the other organization(s).
• For private foundations, the organization pays its share directly to the outside vendors and carefully structures the arrangement to adhere to the self-dealing rules.⁵⁴

The first of the preceding conditions is of primary importance in evaluating a sharing relationship between an EO and either another EO or a nonexempt organization. The primary motivation for the expenditure of the organization's funds must always be to serve its own exempt purposes, not those of another. The proof may not be simple, but is vital. Space in which to operate the exempt organization is necessary. Why not accept the use of space in a major contributor's building? Significant equipment not owned by the organization may be made available at little or no cost; a lease and/or a deposit may not be required. Often, the rent is below market value because it is space not otherwise rentable at the time, although payment of full fair market value is not prohibited.

Another common arrangement is the sharing of employees. If a new charity needs only a part-time secretary, it may engage the available time of an associated organization's employee. As long as the compensation paid to such workers is fairly allocated among the organizations for which each person performs services, there again is no reason why staff cannot be shared.⁵⁵ Evidence of the time actually devoted to each organization must be maintained as a basis for allocating salary and associated costs.

Combining related organization employees into one group for health insurance has been specifically sanctioned by the IRS.⁵⁶ In a hospital conglomerate group, the (c)(3) charitable hospital, its (c)(3) supporting organization, its fund-raising arm, and two for-profit subsidiaries (a health equipment rental company and an administrative services provider) combined their employees into a self-funded, self-insured major medical plan. The inclusion of the subsidiary employees increased the number of plan participants and resulted in decreased cost of insurance, spreading the risk of loss over more participants. The per-participant cost for all entities was the same. The IRS found that providing employee benefits was consistent with the hospital's exempt purposes. It also noted that the insurance trust was separate from the EOs. Presumably, this fact was important because the §501(c)(3)s were not assuming any unforeseen risks on behalf of the for-profits.

(d) Individual or Outside Shareholders

For a variety of reasons, an exempt organization's for-profit subsidiary may issue or sell shares to others. An employee stock option plan may be desirable to offer incentive compensation to employees.⁵⁷ Investment capital may be raised by selling shares, or the corporation may be formed as a joint venture with others. Such relationships serve the economic or business purposes of the subsidiary; the question is whether the exempt purposes of the nonprofit shareholders are served by it. Selling shares to investors and issuing incentive shares to employees may serve the purposes of the EO as long as the shares are sold and issued at their fair market value.⁵⁸ The presence of outside ownership may be useful to prove that the subsidiary has separate corporate identity. The IRS astutely pointed out that this issue should be judged in view of the reasonableness of the executive compensation and whether the prices being paid for the shares are at fair market value.⁵⁹

(a) Criteria for Approval

The exempt organization must satisfy itself that two important criteria exist before entering such a relationship. The issues of primary concern are as follows:

1. Are exempt purposes served by the relationship? Can the EO more effectively promote its mission by engaging the commercial manager to set up and administer the new facility?
2. Is the compensation reasonable? Are terms equal to similar commercial arrangements? Is there other evidence of private inurement in the relationship?

Proof that exempt purposes are served could include a broad range of factors. The ability to secure, on a part-time basis, the medical staff, development personnel, and insurance claims staff necessary to operate a proposed health-care facility, at an estimated cost savings equal to one-half of the organization's reserves, and allowing the facility to obtain licensing and begin serving the public six months earlier than otherwise, are good examples of factors indicating that an arrangement serves the organization's underlying exempt purpose. In the case of a blood bank's joint venture with a commercial laboratory for a plasma fractionation facility, costs were lower and plasma was more effectively furnished, and thereby the project served the exempt organization's goals.⁶⁰

Particularly if the manager is supervised by representatives of the EO, ensuring adherence to the EO's standard of care for charitable constituents, there should be no constraint against an EO operating efficiently and with a high level of expertise and professionalism. A university that lacked the skills to operate a first-rate university press and wanted to avoid the financial risks inherent in publishing purely academic works served its purposes in engaging a commercial publisher. It retained 5 percent of the gross revenues and proprietary rights in the publications.⁶¹ A charitable health-care provider can contract with a for-profit medical group to provide its needed radiology services.⁶² A day care center can hire a for-profit center operator.⁶³

An educational TV production company was permitted to undertake a project to be financed partly with funding from a commercial network.⁶⁴ It was noted that the amount was comparable to the typical investment in a commercial animated series on the network's part. In return, the network received exclusive broadcast rights for one year; renewal rights for four years; a percentage of the revenues from home video sales, if any; and programming control for purposes of meeting standards and practices required by the broadcasting industry.

The purchase and resale of a beachfront golf course to private developers, subject to a conservation easement, was found to serve the objectives of an organization focused on preserving the environment. The easement retention ensured protection of the natural habitat for fish and wildlife. Benefits to the developers were incidental to the mission-oriented goal accomplished.⁶⁵

(b) Factors to Evaluate Reasonableness

Several factors can indicate reasonableness of the compensation of a commercial vendor. An excessive amount, however, cannot be paid to secure such services. To test for reasonableness, another series of questions can be asked:

• Are the outside managers or professionals totally independent of the organization? Is the compensation being negotiated at arm's length? Are there interlocking directorates or family relationships? In other words, does the exempt organization retain ultimate authority over the activities being managed?⁶⁶
• Are the terms equivalent to (or more favorable than) similar commercial arrangements? Is the price equal to the fair market value? Were competitive bids or comparable price studies obtained? Were CPAs, economists, appraisers, or others capable of determining the value engaged?
• Does the relationship prevent earnings from accruing to the benefit of the private individuals, or does it provide economic gain to the manager(s) at the expense of the exempt organization's charitable public interests?
• How is the compensation calculated: a fixed fee, percentage of gross or net income, or some other basis?
• Does the contract provide for sufficient funds to the exempt organization to compensate for its allocation of resources, the capital it is investing, and the risks it assumes?
• Is the contract period too long or too short to provide economic benefit to the EO?
• Are services rendered for constituents who are unable to pay? Will the credit policies of the manager recognize the organization's charitable nature and lack of profit motive in conducting the operation?

(c) Net Profit Agreements

A longstanding IRS policy frowns on net profit agreements. On one hand, maximizing profits ensures efficiency and may provide the funds for the exempt organization as well as for the manager, which is usually a desirable result. On the other hand, the quality of services rendered to the exempt constituency must not be compromised by the manager's desire to produce profits. The IRS condones net profits–interest contracts if they contain a ceiling, cap, or maximum amount that the for-profit company or individual is to receive. The cap prevents windfall benefit to the managers.⁶⁷

In any arrangement, it is advisable to require by contract that the compensation terms be alterable, if necessary, to retain tax-exempt status, along with self-serving language that the relationship must be conducted in a fashion that serves the exempt constituents of the engaging organization. Regarding pricing, the IRS has required (perhaps unreasonably) that charitable services be provided at the least feasible cost.⁶⁸ Again, the contract must require the manager to operate the project in a fashion that serves the organizational objectives.⁶⁹ If it is determined that excess benefits are paid in a net profit agreement, penalties called intermediate sanctions can be imposed.⁷⁰