One of the biggest challenges that nonprofits face is generating revenue for their vital missions. Because tax-exempt organizations cannot raise capital through traditional capital markets, they have tended to focus on donations as the sole or primary source of revenue and to ignore proactively pursuing capital. With the pervading misconception that nonprofits cannot make a profit, most tax-exempt organizations do not take full advantage of permitted "for-profit" and capital acquisition opportunities in order to accomplish their missions.
Not-for-profit, or nonprofit, is not synonymous with unprofitable. In fact, the term is not only a misnomer but has impeded many nonprofits from succeeding in their missions and being good stewards of the resources entrusted to them by donors. Nonprofits have been able to engage in for-profit activities, possibly even free of the unrelated business income tax (UBIT), as long the activities further their charitable purposes and do not constitute a substantial part of their activities. These efforts can be chancy because the entire burden, cost, and risk of failure remain on the nonprofit.
On June 1, 2004, however, the Internal Revenue Service (IRS) issued Revenue Ruling 2004-51, providing a model by which tax-exempt organizations may safely enter into joint ventures with for-profit corporations without fear of losing their exemptions or being subjected to UBIT. This ruling marks a decisive victory for tax-exempt organizations in their search to expand funding channels. It allows nonprofits to partner with for-profit entities on a limited basis, in furtherance of the nonprofits' tax-exempt purposes, while providing both organizations with an opportunity to establish stable revenue streams.
Under Rev. Rul 2004-51, 2004-22 I.R.B., a nonprofit organization can enter into a joint venture with a for-profit entity in order to form a domestic, for-profit Limited Liability Company (LLC). For example, in the IRS Ruling, a tax-exempt university and for-profit technology company formed an LLC to offer teacher-training programs at off-campus locations. The LLC is owned equally by both entities, and each organization made an equal initial capital contribution. Management comprises a governing board consisting of three members from each organization.
Using the example, the IRS provides a "safe-harbor" by which a new, for-profit LLC can be formed without jeopardizing the nonprofit organization's tax-exempt status or subjecting its revenues (or profits) to UBIT. The following seven elements must be present in this type of joint venture to prevent a nonprofit organization from either losing its 501(c)(3) tax-exempt status or subjecting itself to UBIT.
- The activities conducted by the nonprofit through the LLC cannot constitute a substantial part of the nonprofit's activities. It must still primarily engage in a tax-exempt purpose.
- Any activities that the nonprofit participates in or conducts through the newly established LLC must be substantially related to the nonprofit's tax-exempt purposes and functions; otherwise, profits will be subject to UBIT.
- The nonprofit organization must maintain control sufficient to ensure the furtherance of its charitable purposes. Essentially the nonprofit should retain sole discretion over all decisions contributing importantly to its exempt purpose.
- Any and all contracts that the newly formed LLC enters into must be at arm's length and for fair market value.
- The LLC's governing documents should limit the nonprofit's participation to only those activities that will not jeopardize the organization's tax exemption.
- The ownership interests in the LLC must be proportional to the respective capital contributions, and all revenue generated by the LLC or capital returns must be distributed according to these proportional ownership interests. It is important that any disbursement be to the nonprofit entity and not to a private individual, which would constitute private inurnment and place that nonprofit in breach of its tax-exempt status.
- There should be a showing that the LLC is in furtherance of the nonprofit's charitable purpose and that this venture will expand the nonprofit's ability to accomplish that purpose.
What is most encouraging about this entire model, however, is that for-profit organizations will be motivated to participate with 501(c)(3)s in developing successful LLCs with a social conscience. Nonprofits will be able to participate and share in the capital markets that have previously been almost exclusively limited to for-profit companies. Additionally, for-profit entities will benefit from both the risk reduction associated with traditional partnerships and the goodwill of being associated with a cause-oriented, tax-exempt organization. Most important, both entities can receive substantial returns on their respective investments.
The IRS's decision promotes a dynamic synergy between the powerful mission- and community-sensitive services provided by nonprofits and the experience and profit aspirations of for-profit entities. This type of relationship has the potential to help grow and sustain nonprofits and for-profit entities through the newly formed LLCs. Furthermore, it creates an atmosphere that fosters the creation and development of for-profit companies that are geared toward providing an array of services focused on the common good. Interestingly, the IRS has effectively endorsed the creation of for-profit organizations that have the community conscience of their nonprofit counterparts, and, at least in part, are directed toward fulfilling a charitable purpose on the local, state, or national level.
George T. Dillon and Matthew M. Wilkins, May 2005
© 2004, 2005, Advocatus, LLC
George T. Dillon and Matthew M. Wilkins are principals of Advocatus, LLC. Advocatus, LLC assists faith-based, community, and educational organizations through lobbying, public relations, and consulting.