Separating Exempt-Purpose & Non-Exempt-Purpose Activities

Taxation of Exempts

Exempts may use a variety of structures to maximize any profitable activities and minimize tax liability. 

    Exempt organizations of all types are increasingly turning to activities outside of their exempt-purpose functions to support their charitable or other exempt-purpose activities. Traditional fundraising is being supplemented or replaced with a variety of business activities. As long as these activities are structured appropriately, the tax ramifications will be manageable and the support often will be obtained more efficiently than it could through the more typical fundraising letters, auctions, and other donor appeals. 

    It is now common for exempt organizations engaging in such activities to create various organizational structures to separate exempt-purpose and non-exempt-purpose functions, minimize tax liability, and accomplish other goals. Recognizing this trend, the Staff of the Joint Committee on Taxation prepared a study in 2005 regarding a variety of organizational structures for exempt organizations.1 The Committee's report observed that related organizational structures involving exempt organizations may serve a variety of business purposes besides separating exempt-purpose and non-exempt-purpose functions and minimizing tax liability. The Committee found that exempt organizations often use separate entities:

• For tort or contract liability purposes.
• To isolate unrelated business income, or other tax attributes in a separate entity.
• To conduct for-profit or dissimilar nonprofit activities in a separate entity for management, administrative, reporting, or other reasons.
• To participate in an investment.
• Because state or federal law, or a third party such as a lender, might require or encourage the use of a separate entity. 

    An exempt organization may, of course, be able to conduct non-exempt-purpose activities without jeopardizing its exempt status merely by reporting its unrelated business taxable income (UBTI) on Form 990-T and paying tax on that income. However, an organization's exempt status may be revoked if its unrelated trade or business activities become substantial in comparison to its exempt-purpose activities. To avoid this issue, there are a variety of models that allow an organization to carry on non-exempt-purpose functions without risking the loss of its exempt status.2 The key characteristic they share is a means to effectively separate the entity's non-exempt-purpose functions from its exempt-purpose functions.

Corporate subsidiary 

    One option is for an exempt organization to spin off its profitable non-exempt-purpose activity to a for-profit corporate subsidiary. Conducting an unrelated trade or business in a corporate subsidiary will provide the organization protection against the potential loss of its exempt status if the unrelated activities are excessive in comparison to its exempt-purpose activities. 

    For all types of exempt organizations other than private foundations, setting up a for-profit subsidiary is relatively straightforward. Assuming the business activity is readily separable from the organization's exempt-purpose function, the separation of the activities should be easily accomplished without running afoul of the excess benefit rules or private benefit/inurement rules. However, the controlled entity rules of Section 512(b)(13) may ultimately cause passive income to be taxed to the exempt parent as unrelated business income.3

Scenario—'Peace in Northern Ireland' 

    In 1980, a group of Irish-Americans organized and subsequently operated Peace in Northern Ireland (PNI), a nonprofit corporation recognized as exempt under Section 501(c)(3), in an attempt to foster peace in Northern Ireland. As a method of raising money to support PNI's charitable activities, it sold T-shirts with a variety of styles, many with anti-violence statements on the front or back of the shirts. Over the next 25 years, the T-shirt business became very profitable and began to overtake PNI's charitable activities in size and scope. Many of the shirts sold did not have slogans that were related to PNI's peaceful purpose, but were more general in nature. Therefore, PNI decided it needed to restructure the organization. After consulting outside counsel, PNI decided to spin off the T-shirt business into a taxable subsidiary wholly owned by PNI. 

    Because PNI will receive 100% of the stock of the for-profit subsidiary, "Irish T-Shirts," in exchange for contributing the T-shirt business to the subsidiary, there will be no excess benefit or inurement issues with the initial structure. The value of all of the assets transferred from PNI to Irish T-Shirts will constitute the value of the stock that PNI will receive in return from its new, wholly owned subsidiary. With this structure, net profits realized by Irish T-Shirts must be recognized and will be subject to corporate tax. The dividends that PNI ultimately receives from Irish T-Shirts, however, are not subject to additional taxes, although they are not deductible to Irish T-Shirts.4 

    Several other concerns must be explored, however. Primary among these are whether any of the payments from Irish T-Shirts to PNI would be subject to the controlled entity rules of Section 512(b)(13), and whether the allocation of shared expenses (e.g., shared facilities or personnel) between the organizations will need to be memorialized in shared services agreements and other similar agreements in order to ensure corporate separateness.5 How these details are resolved will depend on the extent of the relationship between PNI and Irish T-Shirts beyond PNI's ownership of Irish T-Shirts' stock.
    For example, if Irish T-Shirts uses PNI's intangible assets, such as its name or mailing list, the two entities will need to enter into a licensing agreement and Irish T-Shirts will need to pay PNI a fair market value royalty for the use of the intangibles. That royalty income could be subject to the unrelated business income tax (UBIT) under the controlled entity rules of Section 512(b)(13). For payments made during 2006 and 2007, the only portion of the passive income that is subject to UBIT is the portion that is in excess of fair market value—i.e., in excess of the amount that would be determined as fair value under a Section 482 analysis.6 Congress may extend this provision in future legislation, but until it does so, all subsequent royalty payments from a controlled entity to its tax-exempt parent will be subject to UBIT. 

    There is, however, an alternative structure that allows royalties to be received by the exempt parent tax free, avoiding the Section 512(b)(13) regime. It was set out by the IRS in a remarkable ruling involving the American Association for Retired Persons (AARP) and a third-party insurance provider.

Subsidiary with UBIT 'blocker'—The AARP model 

    In 1999, the IRS issued a private letter ruling to a Section 501(c)(4) organization that was organized for the purpose of promoting the interests of older persons. An article in The Wall Street Journal confirmed that the subject organization was AARP.7 AARP had developed a very large group health insurance program, and the IRS ruling had the result of separating that highly profitable insurance program from the social welfare organization itself, by splitting it off into a wholly owned, for-profit corporate subsidiary. The key to this separation is that the resulting structure retained the tax-exempt nature of the royalties AARP received for its very valuable intangible assets. AARP had previously contracted with third-party service providers for the health insurance contracts, but was performing substantial services in connection with marketing and servicing the insurance contracts, which created UBIT exposure. 

    The exposure to UBIT was removed through use of a UBIT "blocker." After the for-profit corporate subsidiary was established, the intangible assets, including AARP's name and trademarks ("the Marks") were licensed to a third-party contract provider. The for-profit subsidiary was not transferred any rights to the Marks. Instead, the for-profit subsidiary performed all of the services that were associated with the insurance business. In that manner, the licensing agreement for the intangible assets was between AARP and the third-party contract provider. The royalty income remained tax-free to AARP because it would not be subject to the controlled entity provisions of Section 512(b)(13). The third party acted as a type of blocker entity, in that it shielded AARP from tax on its royalty income. 

    The for-profit subsidiary was to be paid for its service operations at fair market value by the third-party service provider insurance companies. AARP initially transferred its mailing list on a no-fee basis, and also transferred certain employees, tangible assets, and other resources that were used to provide the services for the health insurance program to its subsidiary. AARP subsequently went back to the IRS for a second ruling, terminating the no-fee license to its subsidiary and instead structuring the mailing list in the same way as the Marks, with tax-free rental income coming to AARP from the third-party service providers.

    The key to these relationships is that the exempt organization is not performing any services to produce the income, but is providing services through its for-profit subsidiary. This is consistent with a long line of cases in which the courts uniformly looked to the party that was performing services.9 If the exempt organization was not performing services, but merely receiving passive income, the income was excluded from UBIT under Section 512(b)(2) absent the controlled entity rules of Section 512(b)(13). If it was performing services, the unrelated business was deemed to be actively conducted by the organization and the income was subject to UBIT. 

    Although the IRS rulings and court cases are explicit that fair market value needs to be paid to the subsidiary for the services provided, the subsidiary service provider presumably will operate as closely to a break-even basis as possible, so as to minimize the taxes that will be payable by the for-profit subsidiary. The profits lie in the passive income realized by the exempt organization from the use of its intangible assets and mailing list. Structuring the transaction so that this income can remain tax-free and outside the reach of the general UBIT rules and Section 512(b)(13) is the key to minimizing the tax liability of the exempt organization so that the funds are available to pursue its exempt purpose.

Joint ventures 

    Another common structure involving the creation of a separate organization is the use of a joint venture. "Joint venture" has different meanings in different contexts, but for the purposes of this discussion, it refers to an arrangement that is classified as a partnership for federal tax purposes and is jointly owned by an exempt organization and an entity that is not exempt from tax (e.g., a for-profit corporation, limited liability company, or partnership). 

    Currently, a joint venture between a tax-exempt organization and a for-profit entity will be respected by the IRS and will not affect the exempt's status if it retains control over the joint venture's activities.10 In addition, the exempt organization must receive fair value for any assets contributed to, or utilized by, the joint venture. Unlike the for-profit subsidiary model, the activity conducted by the joint venture is attributed back to the exempt organization, so the activity must further exempt purposes if it is substantial in comparison to the organization's other activities. Otherwise, the venture may result in the organization losing its exempt status. If the joint venture's activities are not substantial when compared to the exempt organization's other activities, those activities will result in UBIT to the organization unless they further its exempt purposes. Therefore, an exempt organization with a pure profit-making activity will not benefit from the joint venture structure because the income from the activity will be attributed back to it as UBTI or, if large enough in scope, as a threat to its exempt status. If, however, the activity does further the organization's exempt purposes, but the organization would like to pursue it in a structure outside the strict confines of its existing structure (e.g., to tap outside investors), a joint venture may work.

Scenario—'Eradicate Global Poverty' 

    Eradicate Global Poverty (EGP) is a public charity seeking to end world poverty. It is establishing a microfinance loan structure as a means of fulfilling that exempt purpose. EGP has determined that a joint venture with a for-profit entity would help attract additional funds from investors and so increase the funds available for microfinance loans. This, in turn, would further EGP's exempt purpose. EGP will have a 50% interest in this ancillary joint venture, with the investor group retaining 50%. EGP will retain control over the joint venture's microfinance activities, but will expect the for-profit partner to attract and manage the investors and to manage their return on investment. 

    Under the authority of Rev. Rul. 2004-51, 2004-22 IRB 974, the joint venture should not threaten the exempt organization's status. The funds flowing back to the organization should be considered as coming from an activity that furthers its exempt purpose and thus would not be subject to UBIT. 

    In Rev. Rul. 2004-51, the IRS analyzed a university that entered into a joint venture with a for-profit corporation specializing in interactive video training. The joint venture, a limited liability company (LLC), was formed to offer interactive video training programs to teachers in satellite locations. Each of the members of the LLC owned a 50% interest. In the "good" scenario, the university retained control over the substantive content of the training programs, while the for-profit managed the administrative and technical aspects of the program. The IRS assumed that the joint venture activity was an insubstantial part of the university's overall program, all transactions were conducted at arm's length, and all contract and transaction prices were at fair market value. Given those assumptions and the retention of sufficient control by the university, the IRS ruled that the university's exempt status was not threatened and the university would not be subject to UBIT on its share of any profits from the LLC. The IRS emphasized that the university was required to maintain control over the substantive aspects of the venture. This has evolved into a "UBIT plus control" test, in which the standard UBIT analysis is applied to an ancillary joint venture, with an added layer of scrutiny applied to determine whether the exempt organization retained sufficient control over the relevant activities of the venture.11 

    The IRS and the courts recently have repeatedly emphasized the importance of the exempt organization's control of the activities of the joint venture, particularly with respect to the substance and daily operations of the venture. Whether the joint venture jeopardizes the tax status of the participating exempt organization, or causes its share of the income from the venture to be taxed as UBTI, will be determined by an analysis of the extent of its retention of control. 

    In addition, the controlled-entity rules of Section 512(b)(13) apply to a partnership that is more than 50% owned (directly or indirectly) by an exempt organization. Therefore, if the exempt owns more than 50% of a joint venture, the taxability of royalty income or other passive income (other than dividends) will need to be analyzed for purposes of determining whether Section 512(b)(13) will apply to tax all or (more likely) a portion of any passive income. 

    Accordingly, a joint venture is generally not the best choice for an exempt organization with a profitable business, unless that business actually furthers its charitable purpose and thus is a related activity, as in the microfinance hypothetical. There is, however, an alternative in that situation.

Sell the business 

    Another method for separating a non-exempt purpose from an exempt purpose is for the exempt organization to sell the profitable activity to a third party. Assume, for example, that a newly established corporation—Newco—buys the assets that an exempt organization—EO—used to operate the profitable business. Newco issues stock to individuals in key positions within EO in exchange for fair value consideration. The sale is based on independent valuation studies, so EO is assured of receiving fair value.12 

    There are a variety of methods for structuring the purchase price payments by Newco to EO, allowing Newco to pay over time as the business becomes profitable. This not only allows Newco to purchase the business with a minimal down payment plus a secured note, but also provides EO with a tax-free passive income stream that could be structured to stretch over many years.13 In addition, Newco should be able to take a business deduction for some of its payments to EO, thereby minimizing its tax liability, including liabilities rising from its royalties for intangible assets as discussed

    With this structure, the payments made from Newco to EO would not be subject to Section 512(b)(13) because Newco is not owned by the exempt, although EO could retain a minority ownership interest.15 Another benefit is that EO's employees, who are critical for operating the business, could resign from their positions and be hired by Newco instead. In this way, a Section 501(c)(3) or (c)(4) organization could avoid the threat of Section 4958 and excess compensation allegations because their compensation would be paid by Newco. Since the compensation would be paid directly from the for-profit Newco, the funds would never be within the purview of the exempt organization, so Section 4958 would not apply as long as all relations between Newco and EO are at arm's length. 

    However, if a disqualified person has a 35% or greater ownership interest in an entity, that entity also is a disqualified person. Therefore, if former board members or senior employees of the exempt organization (who remain disqualified persons for five years even after they leave their positions with it) own 35% or more of Newco, the transactions between Newco and EO would have to meet the intermediate sanctions requirements (i.e., be reasonable and at arm's length) to avoid excess benefit transaction treatment. If, however, one disqualified person compensates another with funds that are from the for-profit business and thus subject to tax at the for-profit corporate level, there is no potential excess benefit to any of the parties under Section 4958.
    Of course, all of these transactions have to be documented very carefully and have to be at arm's length and fair market value. All due diligence would need to be performed to ensure that none of the actions of any of the parties put the transaction back into the realm of UBIT, Section 4958, or the inurement/private benefit provisions. 16 The key is to have independent appraisals for the tangible and intangible assets transferred, and to fully document the sale of the tangible assets and the license of the intangible assets, to avoid any allegations of excess benefit/inurement. 

    For example, in Rev. Rul. 76-91, 1976-1 CB 149, the Service analyzed a situation in which a nonprofit hospital purchased assets from a for-profit hospital created by the owners of the nonprofit. Even though related parties were on both sides of the transaction, the Service found that there was no private inurement because the purchase price of the tangible assets was based on an independent appraisal. Appropriately, the value of the intangible assets was determined subsequent to the valuation of the tangible assets by utilizing the capitalization of excess earnings formula set forth in Rev. Rul. 68-609, 1968-2 CB 327. The Service found the valuations to result in a reasonable selling price for the hospital, and thus the transaction did not result in inurement to any of the insiders. 

    The Tax Court and the Fifth Circuit have also weighed in on whether the sale of a nonprofit's tangible and intangible assets to for-profit S corporations was at fair market value. The disqualified persons of the nonprofit were the shareholders of the S corporations. The IRS and Tax Court ruled that the shareholders received excess benefits subject to Section 4958 excise taxes on the sale, but the Fifth Circuit reversed and held that the sale was at fair market value.
    In Caracci, 98 AFTR 2d 2006-5264, 456 F3d 444, 2006-2 USTC 50395 (CA-5, 2006), rev'g 118 TC 379 (2002), the Fifth Circuit analyzed whether the Tax Court was correct in adopting the Service's position that the Caracci family had not paid fair consideration for its stock interests in newly formed S corporations. The S corporations purchased the tangible and intangible assets of the nonprofit Sta-Home health agencies, which the Caracci family had operated for many years. The Sta-Home agencies' assets were transferred to the S corporations. The S corporations assumed the substantial liabilities of the nonprofit agencies without providing any additional consideration on the sale/conversion. The IRS and the Tax Court imposed significant Section 4958 excise taxes on the individual Caracci family members, ultimately finding that the fair market value of the assets transferred from the exempt entities to the newly created for-profit entities exceeded the value of the liabilities and debts assumed as consideration by over $5 million, collectively owing $69.7 million in excise taxes under Sections 4958(a) and (b). 

    The Fifth Circuit reversed, and held that the valuation of the assets by the Service's expert was incomplete and fatally flawed. The Caracci family obtained two independent appraisals of the Sta-Home Health entities, both concluding that Sta-Home's liabilities and debts exceeded the value of its tangible and intangible assets. The Fifth Circuit found those appraisals to be accurate, and thus found that the transaction was in full compliance with all relevant tax laws. Thus, after extensive litigation, the Caracci family and Sta-Home health agencies were found to have structured the sale appropriately without any violation of the excess benefit rules under Section 4958.

Another benefit of selling the business is that if Newco then pays royalties to EO for use of its intangibles, there will not be a Section 512(b)(13) controlled-entity taxable event, since Newco is not controlled by EO. Presumably, Newco would not have taxable income for a very long time, given the tax deductions available for portions of the acquisition payments, plus a business expense deduction for any royalty payments. This avoids having to involve a third-party contractor, as in the AARP letter ruling, and allows the ownership of the for-profit corporation to be held by interested parties, including disqualified persons. Also, if the disqualified persons of the exempt organization continue to provide their services operating the Newco business, but are now paid by Newco with non-EO funds, Section 4958 is avoided. Since the funds compensating the individuals are never EO funds, and the individuals are performing services for the for-profit corporation, Section 4958 would not reach this compensation. Instead the payments would be governed by Section 162, for purposes of allowing a deduction to the corporation for reasonable compensation paid to employees.


    In summary, there are a variety of structures that an exempt organization may properly use to maximize any profitable activities and minimize tax liability at the nonprofit and/or for-profit level. However, all transactions must be at fair market value and with all due diligence, including independent appraisals, if appropriate. It is also important that all transactions be well documented and structured so that the desired separation of non-exempt-purpose and exempt-purpose activities is achieved, with the exempt organization retaining control over the latter.

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.



1. Staff of the Joint Committee on Taxation, "Related Organization Structures Involving Exempt Organizations," 4/19/05. This report was part of the longer study entitled "Historical Development and Present Law of the Federal Tax Exemption for Charities and other Tax-Exempt Organizations."

2. The discussion below includes only exempt organizations that are not private foundations, since private foundations are uniquely governed by a stringent set of excise taxes that do not allow excess business holdings or certain other types of business relationships. See Sections 4940 through 4946.

3. The passive income that can become subject to tax under Section 512(b)(13) includes interest, annuities, royalties, and rents.

4. Sec. 512(b)(1). The controlled-entity rules of Section 512(b)(13) do not apply to dividends, since the profits are already subject to one level of tax at the corporate level. 

5. Moline Properties, 30 AFTR 1291, 319 US 436, 87 L Ed 1499, 43-1 USTC 9464, 1943 CB 1011 (1943).

6. Section 512(b)(13)(E).

7. "AARP is Forced by IRS to Create Taxable Subsidiary," Wall St. J., 6/29/99, page C18.

8. Ltr. Rul. 200149043.

9. See Sierra Club, Inc., 78 AFTR 2d 96-5005, 86 F3d 1526, 96-2 USTC 50326 (CA-9, 1996), aff'g TC Memo 1993-199, RIA TC Memo 93199, 65 CCH TCM 2582 Common Cause, 112 TC 332 Planned Parenthood Federation of America, Inc., TC Memo 1999-206.

10. See Rev. Rul. 98-15, 1998-2 CB 718 (examples of whole-hospital joint ventures with differing results with control by the charity as the key factor in favorable outcome); Redlands Surgical Services, 113 TC 47 (1999), aff'd 87 AFTR 2d 2001-1249, 242 F3d 904, 2001-1 USTC 50271 (CA-9, 2001) (nonprofit subsidiary of a tax-exempt hospital system failed to retain control of a joint venture ambulatory surgery center and lost its exempt status); St. David's Health Care System, No. A-01-CA-046 (DC Texas, 6/7/02), vacated by 92 AFTR 2d 2003-6865, 349 F3d 232, 2003-2 USTC 50713 (CA-5, 2003) (exempt hospital retained effective control of the joint venture and was entitled to exempt status.). Rev. Rul. 2004-51, 2004-22 IRB 974, provided examples of ancillary educational joint venture with differing results with control by the charity of substantive content of educational content as the key factor for favorable outcome for charity—i.e., no UBIT. Loss of exemption was not an issue since the venture was relatively small in scope. See Jedrey, "Joint Ventures from Plumstead to St. David's," 15 Exempts 39 (Jul/Aug 2003).

11. See Sanders, Joint Ventures Involving Tax-Exempt Organizations (John Wiley & Sons, 2007), pp. 224-233 for a complete discussion of Rev. Rul. 2004-51 and ancillary joint ventures.

12. See Anclote Psychiatric Center, Inc., TC Memo 1998-273, RIA TC Memo 98273, 76 CCH TCM 175 , aff'd 84 AFTR 2d 99-5585, 190 F3d 541, 99-2 USTC 50756 (CA-11, 1999), in which the IRS alleged that the assets of an exempt hospital sold to an entity controlled by insiders with respect to the hospital were not sold at fair value. The court noted that the independent appraisal of the assets was 18 months old by the time of the sale, and thus was dated. It found the property to be worth $7.8 million rather than the $6.6 million alleged by the parties to the transaction, and thus found that this was outside a "reasonable range" of values. The Court revoked the exempt status of the organization due to inurement. However, the years at issue in the case preceded the effective date of the intermediate sanctions excise taxes of Section 4958, so revocation was the only sanction available to the court.

13. Section 512(b)(5).

14. See Sections 162, 163, 167, and 168 for provisions relating to allowable deductions for corporate acquisitions, including interest payments and depreciation.

15. Reg. 53.4958-4(a)(2).

16. A similar transaction between a private foundation and disqualified persons would be subject to an excise tax on self-dealing under Section 4941.

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