Trade associations may have good opportunities to increase revenue by creating affiliated entities or converting to a different tax-exempt status, but the tax rules are complex. Here’s an overview of key issues to consider.
Section 501(c)(6) associations seeking potential new sources of revenue could consider adding a 501(c)(3) organization, taxable subsidiary, or limited liability company (LLC) to the corporate mix. Although adding a new entity will involve additional administrative time and expense—additional tax filings, state compliance, bank and investment accounts, multiple board meetings, sharing agreements, time sheets, and separate website addresses, for example—it may be worth the effort if the new entity would invite government or private grants for research or other programs or if there is a potential revenue-generating activity.
Each type of entity involves its own set of advantages and disadvantages for leaders to consider carefully before making such a move.
Section 501(c)(3) Considerations
Section 501(c)(3) organizations can receive tax-deductible contributions and are eligible for a wide array of government and private grants. Also, state sales tax exemptions on purchases and lower postal rates benefit these types of organizations. But the 501(c)(3) tax status comes with some significant restrictions: These organizations cannot engage in substantial lobbying and are prohibited from engaging in political activity.
Because of these restrictions, when adding a new corporation to the group, care must be taken to ensure that each entity respects corporate formalities. Otherwise, the lobbying or political activities of the trade association could be attributed to the 501(c)(3) entity, potentially jeopardizing its exempt status.
Taxable Subsidiary Considerations
Unrelated business activities can also be revenue generators. If an association intends to carry on an unrelated activity on a large scale, it may jeopardize its exemption unless it puts the activity into a taxable corporation.
The tax on unrelated business income (UBI) and the corporate tax are the same, currently a flat 21 percent. However, taxable corporations have an advantage when calculating taxable income: All of the corporation’s expenses can be used to offset all of its income before tax is imposed on its net income. For tax-exempt organizations, on the other hand, the expenses of a particular unrelated business can only be used to offset the UBI of that particular unrelated business, before the tax is calculated on that UBI. So if an association has a huge loss from one UBI activity and a huge amount of net income from another UBI activity, the full net UBI income will be subject to tax without the benefit of offsetting the loss from the other UBI activity.
If an association intends to carry on an unrelated business activity on a large scale, it may jeopardize its exemption unless it puts the activity into a taxable corporation.
If an opportunity arises to partner or form a joint venture with another entity, and if the activity is related to the association’s exempt purpose, putting the venture in a limited liability company can have a good result.
Establishing an LLC limits the association’s liability to its investment in the venture, and the income is not taxed in the LLC but is passed through to the partners. The association partner would not be taxed on the income if the venture’s activity is related to the association’s exempt purpose. If the joint-venture activity is unrelated to the association’s exempt purpose, additional analysis should be done to determine the optimal tax structure for holding the venture interest.
Add or Convert?
A 501(c)(6) association can add a nonprofit corporation to its group and submit an application for exemption to the IRS for 501(c)(3) status. Adding a new corporation will increase the overall administrative burden, and a sharing agreement would most likely be necessary.
Sharing agreements typically cover sharing employees, space, and use of names and logos, among other things. Because 501(c)(3) assets must be used exclusively for 501(c)(3) tax-exempt purposes, it is important that related organizations not allow the assets of a 501(c)(3) to be used to support the activities of the 501(c)(6) without fair value compensation. The converse is permitted, however: A (c)(6) association can, for example, donate the services of its staff to support (c)(3) activities or provide discounts to the (c)(3) organization in the sharing agreement.
However, if the association does not engage in substantial lobbying and does not have a PAC or certain certification programs, the association could consider converting to a 501(c)(3). This requires amending the organization’s articles of incorporation to limit its activities to charitable, educational, and scientific activities and dedicating its assets in perpetuity to 501(c)(3) purposes. The organization would then apply to the IRS for 501(c)(3) tax-exempt status.
However, once an association converts to a 501(c)(3) organization, it can never convert back to a 501(c)(6), since its assets must be used for 501(c)(3) purposes forever. Therefore, if the organization converts and then adds a new 501(c)(6), the (c)(3) cannot then fund the (c)(6) operations. So in this case, activities for the (c)(6) would have to be carved out so that it could generate revenue, and members would be members of both organizations.
Whether a new organization is added or the association amends its articles to become a 501(c)(3), the organization will also have to establish whether it is a public charity or a private foundation.
Foundation or Public Charity?
Whether a new organization is added or the association amends its articles to become a 501(c)(3), the organization will also have to establish whether it is a public charity or a private foundation. Private foundations are 501(c)(3) entities that have few sources of support and therefore are subject to a myriad of rules and taxes. Public charities are funded by many more supporters and benefit from more favorable tax rules and regulations. There are three ways to be considered a public charity:
- For a new 501(c)(3) organization, the likely choice is Section 509(a)(1), where at least one-third of total support is from gifts, grants, and contributions, or at least 10 percent of total support is from these sources and the organization shows other facts and circumstances to demonstrate its active fundraising program. Generally, contributions from U.S. public charities and governments are counted in full in the numerator, but contributions from private sources such as individuals, private foundations, and other organizations are capped at 2 percent of the organization’s total support. So if a new 501(c)(3) will receive contributions from the numerous members of the association or a large government grant, there is a good chance that it could meet this public support test.
- For a 501(c)(6) organization that converts to a 501(c)(3), Section 509(a)(2) may be the answer. This would require the organization to show that at least one-third of total support is from gifts, grants, contributions, and exempt-function income such as membership dues, while no more than one-third is derived from unrelated business income. There are limitations on what can be counted in the support categories.
An organization has five years to show that it will meet one of these two numerical public-charity status tests. If it fails to do so during that period, it automatically becomes a private foundation. To avoid this consequence, it is recommended that an organization establish that it also meets the supporting organization option for public charity status:
- A new affiliate’s organizing documents may establish that the new 501(c)(3) is a Section 509(a)(3) “supporting organization” of the trade association (assuming that the trade association could be considered a public charity if it were a 501(c)(3) organization by meeting one of the tests above). In general, a supporting organization must be supervised or controlled by the organization it supports. The control can be as a parent/subsidiary, where the parent has the ability to appoint or dismiss the subsidiary’s board of directors. Or the control can be through a sibling relationship where a majority of the supporting organization’s board consists of members of the association’s board.
Finally, whether a 501(c)(6) organization adds a 501(c)(3) organization, a taxable subsidiary, or a joint venture, these entities will most likely be considered related entities for tax purposes, and the relationship would be reported on each entity’s Form 990 and several schedules, including Schedules J and R. This could involve reporting compensation of individuals who have roles with both entities. Other tax rules would apply when there are payments for rent, royalties, or interest between the entities.