Many nonprofit organizations struggle to raise sufficient funding to help them meet their objectives as well as maintain their day-to-day operations.
While traditional fundraising techniques are the mainstay of nonprofit organizations, many nonprofits are also looking toward for-profit endeavors in an effort to generate much needed income.
The challenge of such a strategy lies in engaging in such endeavors without running the risk of losing the nonprofit organization's tax-exempt status under federal tax law.
Nonprofit vs. for-profit
Before examining ways in which a nonprofit organization might engage in for-profit endeavors, it's a good idea to keep in mind the differences between a nonprofit organization and for-profit organization.
The major difference between nonprofit and for-profit organizations lies in each organization's purpose. As its name indicates, a for-profit business has as its purpose the production of profit—that is, generating revenues that exceed its expenses.
A nonprofit corporation, on the other hand, does not seek to generate profit as its purpose. Instead, nonprofit organizations have a general purpose of providing a benefit or a service to its primary audience.
When starting a nonprofit, founders usually put together a mission or purpose statement that sets out what the nonprofit’s general purpose is, and the ways it intends to meet this purpose.
Unlike a for-profit venture, a nonprofit organization that's been granted tax- exempt status by the IRS is bound by certain rules that must be followed if the organization wishes to keep its tax-exempt status.
Therefore, while a nonprofit organization may carry out an unrelated trade or business which generates income, if such unrelated trade or business activities become too successful—that is, if they generate too much income—the nonprofit runs the risk of losing its tax-exempt status.
Profit vs. income that exceeds expenses
Another difference between a nonprofit organization and a for-profit organization lies in the distributions each is permitted to make. A for-profit organization can distribute its profit to its shareholders in the form of dividends.
A nonprofit organization that generates income exceeding its expenses, however, is restricted in the ways it can use this income: it may reinvest the money into the services it provides, it may fund other nonprofit organizations, or, in the case of a foundation, it may place the monies in program-related investments.
According to the IRS, a program-related investment (PRI) is one for which the primary purpose is the accomplishment of one or more of the foundation's exempt purposes.
While a PRI may incidentally make a profit, the generation of a profit cannot be a significant purpose of the PRI. A PRI also cannot have as a purpose the influencing of legislation or taking part in a political campaign.
PRIs are an important way foundations can meet their annual 5% payout requirement; this requirement must be met in order for a foundation to keep its tax-exempt status.
Working collaboratively with for-profits
One route nonprofits can take to earn income unrelated to its mission is through working collaboratively with for-profit businesses. There are two main ways in which this can be done.
A nonprofit can form a subsidiary for-profit company
Doing so helps the nonprofit keep its focus on its primary purpose, while the for-profit subsidiary carries out unrelated business activities.
In addition to helping the nonprofit maintain its tax-exempt status, there are a number of business advantages to having a for-profit subsidiary, such as the ability to offer different compensation arrangements to employees.
While the subsidiary may be a limited liability company (LLC), there are a number of complications associated with the pass-through tax nature of the LLC. The most common organization form for a nonprofit's subsidiary is the C corporation.
One important consideration in forming a for-profit subsidiary is the need to maintain the subsidiary as a separate entity. For example, while there may be some overlap between the membership of each company's boards, the boards must stay separate from each other and hold separate meetings.
A nonprofit organization may choose to work collaboratively with a for-profit organization
In order for this second method to work, the contracts should be arm's length transactions paying market rates for services and products.
Recent years have seen the rise of a number of different hybrid forms of organizations permitted to pursue both profit and nonprofit purposes. One might think of them as nonprofit for-profit or for-profit nonprofit organizations, although neither term is accurate nor generally used.
Hybrid organizations include organizations like the benefit corporation or the low-profit limited liability company.
The low-profit LLC, or L3C as it is known, is structured like an LLC but must have a nonprofit purpose, although it may also generate income. Additionally, an L3C which qualifies as a program-related investment may also be useful in attracting investments from private foundations.