Current tax law allows a tax exempt organization to conduct unrelated business activities through a for-profit taxable subsidiary. The reasons for forming such a business structure are not always tax-related, but are used to adopt compensation arrangements, employ different management structures for its various activities, to avoid disclosure of sensitive financial information or protect the exempt organization from the liabilities of the business activity.
Tax considerations may also play a role in the decision, because dropping the taxable activity into a for-profit subsidiary may protect the exempt organization from challenges to its exempt status. As long as the two entities are kept separate, the identities of the exempt and the controlled subsidiary are almost always respected by the Internal Revenue Service. The activities and income of separate controlled entities generally are not taken into account when determining whether an organization’s “primary purpose” is a tax exempt purpose, at least if the parent does not exert day-to-day operational control over the subsidiary’s activities.
Taxable subsidiaries are sometimes used to serve as the general partner when an exempt organization engages in a joint business venture with for-profit entrepreneurs and investors. Joint ventures between nonprofit and for-profit entities provide an alternative for the nonprofit to advance their mission while eliminating total reliance on more traditional sources of funding. They also allow the nonprofit to benefit from the managerial expertise of their for-profit partners.
The Arts is one of the principal areas in which joint ventures have been employed, and Broadway plays often use the limited and general partner structure. More recently, limited liability companies have been the vehicle of choice, though some of these structures attract attention from the I.R.S.
The test of charitability and private benefit, where the participation of the nonprofit furthers its exempt purpose and permits the charity to operate exclusively for exempt purpose and not for an impermissible private benefit, was developed from the case of Plumstead Theatre Society, Inc. v. Commissioner.
As one of a variety of planned activities to promote the arts, a nonprofit theater company served as a general partner in a limited partnership to co-produce a play. The theater company contributed a portion of its intellectual property rights in the play in exchange for a 36.5% profit and loss interest in the partnership. The limited partners contributed $100,000 cash for the remaining 63.5%.
The Tax Court held that the purpose of the joint venture was to raise capital to further the theater’s exempt purposes, and it did not cause Plumstead to be operated for a private rather than a public purpose. The court set out three factors that controlled its decision: 1) the theater as the general partner controlled the venture; 2) it was only one of many different activities engaged in by the theater, and 3) none of the limited partners of the joint venture was an officer or a director of the theater society.
Some joint ventures are conducted through less formal contractual arrangements such as joint operating and licensing agreements. These forms are less protective of the nonprofit organization, but may suit its purposes as long as the transactions are at arm’s length and do not serve private interests. The same test for charitability set out above controls in these situations.
So if the ministry in question uses a separate for-profit subsidiary to conduct its for-profit YouTube advertising business, it may retain its tax exempt status and avoid liability from the business activities. If it forms a joint venture with a for-profit company, as long as it controls the venture and it is only one of the various activities it is engaged in and the venture furthers its exempt purpose, it should not jeopardize its tax exempt status.
The tougher requirement in this case may be the fact that the for-profit company may contain persons who are an officer or director of the ministry, giving the impression of a conflict between the service of the charitable purpose and the private interests.
Any business transacted by a nonprofit, whether in a joint venture with a for-profit business, or as an unrelated business of its own, will most likely require payment of taxes on that income, so the benefits and burdens of each structure must be researched and seriously considered before the activity is conducted. A caveat to this analysis is that it was reached through the study of Internal Revenue Code and Treasury Regulation sections, pertinent federal cases, and the writings of legislators and experts in the field.
It is wise to seek the advice of a tax professional before deciding on a business structure that involves the utilization of a §501(c)(3) nonprofit organization’s tax exempt status as part of the funding of a film or other artistic creation, even if the film directly “exploits” the same function as the nonprofit. I have tried to give filmmakers an overview including actual case examples of this type of funding, so they can consider its benefits and drawbacks in their decisions.
Mary Ellen Tomazic is an attorney in Cleveland specializing in entertainment issue
such as copyright, trademarks, contracts and licenses for musical groups and filmmakers.