May 18th, 2018
One of the basic principles of tax-exempt law is that charitable and educational organizations (so-called “501(c)(3)” groups after the corresponding section of the tax code) must be formed for public purposes, not for private benefit. For most purposes, this means that compensation and expenses must be reasonable, and that the directors have to put the best interest of the organization and its mission ahead of anyone’s individual or collective personal interest. Providing an improper or excess private benefit – one that isn’t reasonable or which serves the interest of the individual rather than the nonprofit – exposes the organization to fines and penalties, up to loss of exemption.
By contrast, the very purpose of a for-profit company is to further private interests and benefit individuals individually and collectively. Even where the company’s charter includes public benefit purposes, the board still has an obligation to see that the shareholders’ interests are being served. In most jurisdictions, that means their economic interest, not their spiritual or philanthropic interests.
Nonprofit/For-Profit Tandem Structures
In the world of nonprofit/for-profit tandem structures, this juggling of public interest and private interest can be a challenge. Every arrangement and transaction between the two entities has to satisfy competing and somewhat inconsistent requirements.
Are there any rules? Sure. In general, if the for-profit company is providing a concession to the non-profit, such as offering goods or services for free, or at below-market cost, there is no financial benefit to the for-profit, or its owners, and thus no private benefit. However, if the nonprofit is paying the for-profit company for goods or services or something else of value, the price has to be at or below market to avoid any private benefit: overpaying is a classic indicator of private benefit. Indirect and incidental benefits, especially non-financial benefits such as enhanced reputation, morale, or customer loyalty are treated as incidental and don’t usually pose a problem.
In tandem structures, the private benefit issue arises most commonly when the arrangements are first being agreed to, and later whenever the two entities do business with each other.
When setting up a tandem structure, where the potential for benefitting private interest is especially acute, it is best to make sure that both entities have independent boards, so that anyone who might benefit from the arrangement or has a conflicting duty (such as a director who sits on both boards) can disclose their interest or conflict and recuse themselves from the decision. This “disclose and recuse” tactic is the best way to deal with conflicts and potential conflicts because it clears the taint of personal interest from the process. Also, the arrangement should be negotiated at arm’s length to ensure that the charity has the opportunity to protect its own interests and refuse an arrangement that is to its disadvantage. If the boards then approve the arrangement, they are presumed to be acting in good faith. Having independent boards also helps to ensure that each entity is free to pursue its own interests, and reduces the likelihood that one will take advantage of the other.
Four Important Things to Remember
When the nonprofit and for-profit entities do business together, for example when one provides goods, services, or financing to the other, management services, space-sharing arrangements, lending or sharing employees, or other situation where something of value is exchanged between the two, four things are important:
1. Be Careful and Reasonable
The terms of arrangement must be reasonable and provide structural safeguards to prevent private benefit. Structural safeguards include independent boards, separate management, third-party validation of pricing, strict conflict of interest policies, shares service agreements, and escape clauses for the charity if it concludes that anything about the arrangement is unfair, improper, unethical or might jeopardize its tax-exempt status.
2. Negotiate Terms at Arms-length
Each side should have separate counsel if possible, and the board should review and approve all major decisions after conducting appropriate due diligence.
3. Put it in Writing
There should be something in writing that sets out the terms of the agreement between the two entities. It should include the role and obligations of each party. It should require frequent consultation. It should contain standard provisions on confidentiality, intellectual property, indemnities, and the like. This kind of agreement can be called a memorandum of understanding, a letter of intent, a cooperation agreement, a shared service agreement, or anything else that the parties want. The agreement needs to be approved (and signed) by both parties.
4. Sharing is Caring
When resources are going to be shared, a shared services agreement is good to have. Such an agreement sets out the parties’ obligations to each other, articulates a framework for allocating costs between them to ensure that the nonprofit is never subsidizing the for-profit or overpaying for goods and services, and that costs that properly belong to the for-profit are paid by the for-profit, and costs that properly belong to the nonprofit are paid by the nonprofit. This is especially important if a relatively small number of people co-founded both entities or have effective control, as the IRS considers those kinds of arrangements to be the most easily abused.
Any time a nonprofit and a for-profit do business together, including tandem structures where cooperation and coordination are ongoing, the issue of private benefit is going to be a concern. Too much private benefit and the nonprofit can lose its tax-exempt status; too little private benefit and it doesn’t make sense for the for-profit to participate, especially if it has investors who expect a return. This is an inherent conflict that comes from blending two different entities into a force for good. Careful planning can minimize or eliminate some of the risks, but not all.
Someday we will devise a better model that allows for blending financial return and social good at all levels, with appropriate rules of the road and established norms. Such a structure could accept invested and donated capital, and engage in profitmaking activities while simultaneously accomplishing a charitable mission, with incentives aligned and internal processes designed to accomplish both simultaneously. Until that day arrives, the tandem structure is the best we can do. Tandem structures are becoming more widely used and widely accepted, and we need to make them work.
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