CHAPTER 26
Mergers, Bankruptcies, and Terminations

26.1 Mergers and Other Combinations

Strategic alliances, collaborations, networks, duplication of effort, modernization of facilities and methods, constituency changes, human disagreements, and countless other factors might indicate the need for a nonprofit organization to combine with another organization. Achieving economies of scale in the operations, eliminating duplicated services, integrating service delivery, acquiring needed skills and assets, and strengthening administrative capability are just a few of the reasons why one or more organizations might combine themselves through a merger or other type of organizational combination. In some instances, forming a partnership, engaging a professional management company, or undertaking some other type of collaboration with a for‐profit or nonprofit organization can accomplish the needed improvement without a change in the structure of the organization itself. Some of the tax issues to consider in such a situation are discussed in Chapter 22.

Once it is decided that an alliance or some other form of cooperating operation is not suitable, a formal combination with another organization may in some circumstances be appropriate. The terms used to describe such transactions are those normally applicable to businesses: merger or acquisition. This section briefly addresses the tax issues that arise when such combinations occur for tax‐exempt organizations. A wide range of management, operational, and legal issues involved in alliances, mergers, and other combinations are beyond the scope of this book, but good resources are available.1 The state and local laws regarding mergers must also be considered in conjunction with local advisors familiar with the rules.

First and foremost, any merger or combination must be entered into with cognizance of the fact that a tax‐exempt organization of any category is essentially required to devote its assets—both during its life and upon its demise—primarily to the purposes for which it is exempt. As discussed in Chapters 2 through 10, standards of formation apply to organizations qualifying for the various categories of exemption. A charitable organization's charter, for example, must specifically require that its assets be distributed upon dissolution only for charitable purposes. Applicable fiduciary responsibilities and responsiveness to members and past supporters must be considered in combinations of all types of tax‐exempt organizations. The bottom line in any merger is an obligation that the assets of a nonprofit ideally be distributed to an organization whose purposes will accomplish the goals for which moneys were accumulated by the organization going out of existence. From a federal tax standpoint, in a formal merger, one organization survives. In its simplest form, all of the assets of one organization are assigned, or transferred, to another.

What have been referred to as virtual mergers for hospitals are joint operating agreements, not true mergers.2

For the purposes of this discussion, it is presumed that in a merger there will be one surviving organization. The parties to the merger customarily have recognition of tax‐exempt status and normally are exempt under the same subsection of §501(c)—(c)(3), (c)(4), or (c)(6), for example. The assets of a (c)(3) should not be distributed to an organization that is qualified for tax exemption under some other category. However, a business league might, for some good reason, contribute its assets to a labor union of persons working in the same profession or to a charity.

(a) Tax Attributes

Concepts normally applicable to for‐profit business combinations can be referred to in evaluating tax attributes that are assigned or attributed to the successor organization in a merger.3 Conceptually, all of the tax attributes of the entity transferring its property carry over to the recipient organization.4

Carryover Basis. A merger is classically a nontaxable transaction, meaning no gain or loss is recognized upon the transfer of assets from one organization to another. This discussion assumes that the organizations participating in the merger are themselves tax‐exempt and therefore excused from tax on the transaction.5 Any unrealized gain inherent in the assets6 is allowed to go untaxed (even if an entity is taxable) because the tax basis of the assets of the transferee is carried over to the surviving organization. Particularly when unrelated business or private foundation assets are involved, this rule serves to permit the transfer. The tax impact comes when the recipient party to the merger disposes of the asset. The asset‐holding period of the entity ceasing to exist also carries over. Depreciation for assets transferred, for example, will continue to be calculated in the same manner as before the transfer.

Other Tax Attributes. Activities classified as an unrelated business to the expiring entity will very likely be considered as such for the recipient organization. Net operating loss, foreign tax, and contribution deduction carryovers and accumulated corporate earnings (ACE) accounts attributable to the unrelated business may carry over to the surviving entity.7

Public Charity Status. The ongoing public status of the surviving organization will depend partly on the category of Internal Revenue Code (IRC) §509 under which the surviving organization operates. A church, school, hospital, medical research organization, or college support organization that continues to conduct such activities after it receives assets of another organization can continue to so qualify.8 Although the author could find no ruling or procedures addressing the question, it seems logical that the combined, or surviving, organization might be required to calculate its public support test on a combined basis. Conceivably, the past revenues of the transferring organization would be added to those of the recipient (surviving) organization to determine qualification as a public charity. The unusual grant rules and facts‐and‐circumstances test can be availed of, if necessary, to achieve public status.9 A 2002 private ruling approved the merger of two §509(a)(1) organizations with no comment on the consequences to the public support test.10 What the merger rulings do not address is whether the revenue history of all merging organizations should be considered in calculating the public support test of the surviving organization.11 It seems reasonable that in considering the support of the surviving organization after a merger, one would include the history of all organizations that have now become a single entity. When a private foundation makes “a significant disposition of assets” to another private foundation, the recipient private foundation receives tax attributes such as undistributed income, excess business holdings, expenditure responsibility reporting, and cumulative contributions to define substantial contributors in proportion to the percentage of the assets it receives.12

Another key point to consider is control of the surviving organization. Suppose A and B are both public charities that decide to merge to form C. C's board of directors consists entirely of A's former board members. Conceptually, because A maintains control over the assets of C, B has essentially made a donation to A. In that case, it may not be appropriate to combine both A's and B's public support history for C. However, if A and B are represented equally on C's board, it makes sense that the public support test should include the history of both organizations.

A final approach might be to consider that the surviving organization is an entity separate from the previously existing organizations. Under that approach, the public support test would consider only the activity of the new organization and not rely on the history of any of the previous organizations. Admittedly, this would be difficult at the beginning because there would be no history to use in the calculation of the test.

(b) Seeking IRS Approval

The Internal Revenue Service (IRS) does not require advance approval for a distribution in termination of the assets of any form of §501(c) organization. The Forms 990, 990‐EZ, and 990‐PF annually ask whether there have been any changes in the organization's operations, purposes, or governing documents. A complete termination of a tax‐exempt organization is essentially accomplished under state law.13 Full information, including documents approved by appropriate state authorities, must be attached to the final Forms 990 filed by the terminating organization. Similar documents are attached to the Form 990 of the recipient, or surviving, organization. Private foundations have additional issues that are outlined in §12.4.

Since 2008, advance approval for a merger or other transactions involving transfers of significant assets may not be required by the IRS. In a complicated situation, particularly where there is some question as to the ongoing qualification of the survivor, an IRS ruling prior to completion of the merger might be requested. Full disclosures of the transaction should be submitted on Form 990 of organizations involved, with attachment of Schedule N designed for reporting a “liquidation, termination, dissolution, or significant disposition of assets.”14

(c) Other Types of Transformations

The inverse of a merger—creating a subsidiary or brother‐sister nonprofit—presents tax considerations like those pertaining to merging organizations. To provide protection from liability, for management reasons, to satisfy a regulatory requirement, or for other reasons, an existing nonprofit(s) might create a new nonprofit to conduct some aspects of its activities. A title‐holding company might be created to hold investments, buildings, or other long‐term assets.15 A service‐providing management company might be formed to consolidate administrative services.16 A nonprofit might be created in a neighboring state to facilitate an expansion of programs.17 Care must be exercised to ensure that the provision of services to an affiliated entity is not classified as unrelated business income.18

A nonprofit organization might also transform itself by splitting up into two or more parts. Sometimes the activities of the organization are of a sort that exposes the organization to liability for claims of damages. In such situations, a title‐holding company or a supporting organization might be created by transferring the organization's investment assets and permanent operating assets, such as buildings, into a separate nonprofit corporation. Such a holding company can qualify for independent tax exemption if it is dedicated to holding the assets and paying over the income generated therefrom to its parent organization.19 A new Form 1023 or 1024 is filed for the holding company.20

In a similar fashion, one organization might split itself into several parts for one of the reasons suggested at the opening of this chapter. Separate, independent organizations might be formed to conduct certain programs and hold certain assets. Again, a new Form 1023 or 1024 is required for any newly created trust or corporation receiving a distribution of assets, and the multitude of rules and procedures outlined in Chapters 2 through 11 must be taken into consideration in determining its proper tax status. Another possibility is for a local organization to reorganize itself to become part of a group exemption.21 This might be accomplished either with a spin‐off of a particular activity or with transformation of the entire organization. Private foundations have requested a slew of private rulings for split‐ups, as discussed in §12.4.

(d) Conversion to a For‐Profit

A tax‐exempt organization might also terminate its existence by converting itself into, or selling its assets to, a for‐profit business. This type of structure change occurs for many reasons. For example, many health‐care organizations during the late twentieth century took advantage of offers for new capitalization not available in the nonprofit sector. When a nonprofit wants to commercially exploit its activities on a level that would cause loss of tax‐exempt status,22 such a conversion might be desirable.

First and foremost, the assets of the tax‐exempt organization must continue to be dedicated to its exempt purposes. To qualify as a §501(c)(3) organization, the charter must require that assets be permanently dedicated to charitable purposes and that, on dissolution, its assets be distributed to another charitable organization.23 The proceeds of selling its assets or the nonprofit corporation itself must continue to be used by the selling entity for charitable purposes or be distributed to an existing or newly created 501(c)(3) organization. Another provision of the charter of most tax‐exempt organizations requires that none of the entity's assets be used to give benefit to private individuals. Thus, the price received for sale of assets, whether received as cash, notes, and/or shares, must be no less than the fair value of the property transferred. Care must be exercised in negotiating the deal to apply the standards for determining whether impermissible private benefit—or, in the case of insiders, private inurement—will transpire.24

Ongoing qualification as a public charity is sometimes problematic for the nonprofit survivor of an asset sale. Consider a hospital classified as a public charity under §509(a)(1)/§170(b)(1)(A)(iii) that sells its operating assets for cash. Assume that the proceeds are invested in bonds so that its primary source of revenue becomes interest income. Unless it undertakes a fund‐raising campaign or converts itself into a supporting organization, it will eventually fail the tests to avoid becoming a private foundation.25 Indeed, such transactions can take many different forms, have varying consequences, and require the assistance of lawyers versed in applicable tax rules.26

26.2 Bankruptcy

Despite the best intentions and dreams of their creators and managers, exempt organizations on occasion expend funds beyond their resources. Some organizations are fortunate enough to have philanthropists or other supporters who are willing and able to cover operating deficits they might incur. Sometimes, however, an exempt organization may become insolvent to the point that it must declare bankruptcy. In such cases, the interests of the (normally) for‐profit creditors and the nonprofit constituents of the organization can be in conflict, and issues arise.

A consideration of the federal Bankruptcy Code is also beyond the scope of this book. Any organization facing insolvency and considering bankruptcy should seek an attorney knowledgeable about the field. In most respects, the Bankruptcy Code provides the same rules for nonprofit and for‐profit organizations. The intention of the rules is to protect the insolvent organization, to prevent creditors taking unfair advantage, and to allow an orderly allocation among creditors of the proceeds of the asset liquidation.

The Bankruptcy Code is divided into chapters, with bankruptcy cases referred to by the numbers of the chapters they are brought under. A Chapter 7 bankruptcy allows the organization, under the supervision of a court‐appointed trustee, to sell off its assets, allocate the proceeds of such sales among its creditors, dissolve its legal existence, and cease to operate. The other common type of bankruptcy, Chapter 11, allows the organization to reorganize and remain in existence after providing a repayment plan for its indebtedness.

Bankruptcy may be voluntary or involuntary. A voluntary bankruptcy is filed by an insolvent organization to seek protection from unfriendly creditors. In contrast, an involuntary bankruptcy is filed by a group of three or more creditors. However, only a “moneyed, business, or commercial operation” qualifies for an involuntary bankruptcy, a significant matter on which the Bankruptcy Code provides different treatment for nonprofit corporations. “Moneyed” organizations are profit‐motivated ones operated to create income for their shareholders or members. Most tax‐exempt organizations would not continue to qualify for exemption if they could meet such a definition. Thus, it is generally the case that an organization qualified for tax exemption under one of the subsections of IRC §501(c) cannot be placed in involuntary bankruptcy. However, failure to qualify for the exception from involuntary bankruptcy can cause the organization to lose its tax‐exempt status, because it would show that the assets are not dedicated to exempt purposes.

(a) How Tax Status Is Affected by a Bankruptcy

All categories of IRC §501 organizations—§§(c)(1‐27) plus 501(d), (e), and (f)—must be organized and operated for their specifically defined category, as discussed in Chapters 2 through 10. To maintain tax‐exempt status, charities, social welfare organizations, business leagues, social clubs, and all other types of exempt organizations must permanently dedicate their assets under organizational documents to their specified exempt purposes and operate for such purposes throughout the life of the organization.

An insolvent exempt organization considering bankruptcy may face a challenge that it did or does not operate for exempt purposes. Any revocation of exemption would be based on the facts and circumstances of the case. There is no rule that automatically revokes exempt status upon the declaration of bankruptcy, and there are no revenue rulings or other statements of IRS policy on the subject. The questions that must be asked in reviewing a situation (all versions of the same theme) would include:

  • Were the activities in which the debt was incurred exempt‐function activities?
  • Why was adequate revenue not provided to pay for the exempt activities? Were revenues diverted to some other nonexempt purposes? Are there unrecorded liabilities attributable to restricted donors whose funds were diverted to other purposes?
  • If the debts were incurred in connection with an unrelated business activity, did that business subsume the exempt activities and therefore evidence lack of substantial exempt purposes?
  • Were exempt assets diverted to some nonexempt project, violating the requirement that assets be dedicated to exempt purposes? Were jeopardizing investments purchased? Particularly for a private foundation, this could provide the additional complication of excise taxes.27
  • How can assets be allocated to creditors when the organization's charter requires that assets be dedicated permanently to exempt purposes?
  • Were members of the governing body of trustees or directors in any way fiscally irresponsible in allowing the deficits to occur? Should any of the deficiencies be paid by such directors to preserve the organizational assets for the exempt constituents?

(b) Revocation of Exempt Status

The Bankruptcy Code automatic stay against collection, assessment, or recovery of a claim against the bankrupt organization does not prevent the IRS from revoking exempt status. In abusive situations (that is, when the debts were incurred in providing benefits to insiders rather than in serving the exempt public or membership), an attempt to revoke might be expected, but hamper any fund‐raising efforts to pay the debts. The revocation has been ruled to be a preliminary step or prerequisite to the collection of tax and not restrained by the filing of bankruptcy.28 The anti‐injunction provision of IRC §7421 prohibits the bankruptcy trustee or others from interfering in the revocation of exempt status when the IRS deems it appropriate. Whether the IRS can be successful in collecting any taxes assessed is another question to be answered by a bankruptcy specialist.

When exempt status is revoked, tax issues including forgiveness of indebtedness, deductions for bad debts, and recapture of tax attributes, among other issues, must be carefully considered. Even if the exempt status is not revoked, such issues would be of consequence in calculating any tax liability for unrelated business income.

(c) Filing Requirements

After the exempt organization voluntarily files bankruptcy, a new organization does not come into being. Under IRC §1399, the existing entity continues and normal filing requirements continue. As a matter of tax policy, the exempt status of the organization remains intact unless factors evident in the bankruptcy indicate that the exempt status of the organization should be revoked, as discussed previously.

The gross annual revenues of the bankrupt organization govern its annual federal filing requirements. As the bankruptcy proceeds, returns are filed as usual. Prior to the actual year of dissolution or termination, the filing requirements for other purposes—annual information, payroll, and all other types of federal returns—remain the same during the period of bankruptcy. Even though the organization ceases normal operations and receives no contributions, gross revenue for filing purposes includes proceeds from the sale of its assets. The parties responsible for filing information returns are either the board of directors and the organization's ongoing managers, or the bankruptcy trustee appointed to replace the directors or organizational trustees.

Information revealing the bankrupt status is reported on Schedule N of Forms 990 in response to two Part IV questions: (1) Did the organization liquidate, terminate, dissolve, or cease operations? (2) Did the organization sell, exchange, dispose of, or transfer more than 25 percent of its net assets?

IRC §6043 contains specific requirements for information to be reported in the year of dissolution of an exempt organization, which applies to organizations dissolving due to bankruptcy. Although the answer is full of innuendo, from the question of jeopardy to exempt status, this section specifically requires that the following information be reported in Forms 990 for the distribution year:

  • Names and addresses of persons receiving the terminating distributions.
  • Kinds of assets distributed.
  • Fact that the assets are distributed and dates of distribution.
  • Each asset's fair market value.

When the asset distribution and settlement with creditors takes place over a series of reporting years, the regulations should be carefully considered for determining when a “substantial contraction” occurs, to allow properly timed reporting.

Related Organization. What if one member of an affiliated group of exempt organizations becomes insolvent and is considering declaring bankruptcy? Particularly in a statewide or nationwide group whose reputation might be damaged by the bad credit rating of a related entity, questions in addition to those listed previously under §26.2(a) should be asked. Will the parent or other affiliates be held in any way responsible for the bankrupt affiliate's debts? Must the group intervene to provide services to ensure that the exempt purposes of the group are served? Should the crippled affiliate be given financial assistance? The systems for monitoring, assisting, and controlling related organizations should be reviewed and revised to avoid reoccurrence.

26.3 Terminations

An organization exempt under IRC §501(a) may cease to operate and dispose of its assets for many different reasons and in a variety of ways. Most tax‐exempt organizations, including private foundations, are free to terminate their existence so long as they do so in a fashion that serves their tax‐exempt purposes and respects any donor covenants for use of its assets. There is no procedure under the tax law that requires an organization to seek the permission of the IRS to terminate. A private foundation (PF) that has committed repeated and flagrant violations of the special PF sanctions discussed in Chapters may be involuntarily terminated by the IRS.29

Termination of an exempt organization is mainly a matter of local law that should occur with the assistance of a qualified attorney. Those exempt organizations formed as corporations seek permission to terminate from the appropriate state officials. Exempt organizations formed as trusts may be able to simply follow the provisions set out in their trust instrument. The IRS instructions to Forms 990 ask if there has been a termination or contraction, presuming that the reporting organization has followed the suitable procedures on a state or local level. A Form 990, 990‐PF, 990‐EZ, or 990‐N should be filed four months and 15 days after the date of the organization's termination. A blank on the front page is provided to be marked “final.” IRS Publication 4779 (May 2009), Facts about Terminating or Merging Your Exempt Organization, outlines the procedures and information requested in reporting information to the IRS.

(a) No Special Filings Required

Certain types of organizations do not have to provide reports of their dissolution, liquidation, termination, or contraction:

  • Any organization not required to file Forms 990, including all churches, as well as their integrated auxiliaries, or conventions or associations of churches.30
  • A private foundation terminating its status by converting to a public charity.31
  • Subordinate member covered by a group exemption where the central organization files Form 990 for the group.
  • Instrumentality of the United States created by an Act of Congress and the instrumentality's title‐holding companies.
  • Certain pension plans and credit unions.

(b) Substantial Contraction

A partial liquidation or other major disposition of assets must also be reported on Forms 990, 990‐EZ, or 990‐PF. The instructions stipulate that such a disposition occurs in two situations:

  • At least 25 percent of the fair market value of the organization's net assets at the beginning of the year are given to another organization.
  • Current‐year grants, when added to related dispositions begun in an earlier year or years, equal at least 25 percent of the net assets the organization had when the distribution series began.

Again, no IRS approval is required or given in response to filing such information.

Notes

  1. 1 Thomas A. McLaughlin, Nonprofit Mergers and Alliances, 2d ed. (Hoboken, NJ: John Wiley & Sons, 2010); Alceste T. Pappas, Reengineering Your Nonprofit Organization: A Guide to Strategic Transformation (New York: John Wiley & Sons, 1995); W. Marshall Sanders, “Legal and Tax Aspects of Nonprofit Mergers,” TAXATION OF EXEMPTS (September/October 2010).
  2. 2 IRS EO CPE Text 1997.
  3. 3 IRC §351.
  4. 4 IRC §381.
  5. 5 See §21.10(e) regarding distributions from a for‐profit subsidiary of a tax‐exempt organization.
  6. 6 See §12.4(e).
  7. 7 See §21.11.
  8. 8 Standards for qualification are outlined in Chapters 3, 4, 5, and 11.
  9. 9 Discussed in §11.2.
  10. 10 Priv. Ltr. Rul. 200236049; see Priv. Ltr. Rul. 201130005 to study other issues the IRS considered in approving of a merger of a hospital and a health‐care service company both of which were §501(c)(3) organizations.
  11. 11 Priv. Ltr. Ruls. 200348029 and 200541044.
  12. 12 Reg. §1.507‐3(a)(1); see §12.4(e).
  13. 13 See §26.3.
  14. 14 See §18.3 for discussion of this change in IRS policy.
  15. 15 Requirements described in §10.3.
  16. 16 See §21.8.
  17. 17 Priv. Ltr. Rul. 9840049.
  18. 18 See §21.8(b).
  19. 19 See §10.3(b).
  20. 20 Rules and procedures for seeking recognition for exemption with Form 1023 or 1024 are discussed in Chapter 18.
  21. 21 See §18.1(d).
  22. 22 Discussed in §§2.2(e) and 21.1.
  23. 23 Discussed in §2.1(b).
  24. 24 Discussed in §20.1.
  25. 25 Discussed in Chapter 11.
  26. 26 See the very helpful and thorough article by D. Mancino and F. Hill, “Converting an Organization's Status from Nonprofit to For‐Profit,” TAXATION OF EXEMPTS (January/February 2002).
  27. 27 See §16.2.
  28. 28 Bob Jones University v. Simon, 416 U.S. 725 (1974); In re Heritage Village Church and Missionary Fellowship, Inc., 851 F.2d 104 (4th Cir. 1988).
  29. 29 See §12.4.
  30. 30 Reg. §1.6043‐3(b).
  31. 31 Such a foundation would first have sought approval for its conversion under rules discussed in §12.4.
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