Nonprofits are organizations that exist for a charitable or social cause, rather than for the purpose of making a profit. However, some nonprofits may find themselves in a position where starting a for-profit company could help them achieve their mission more effectively. While this may seem like a contradiction, it is possible for nonprofits to spawn for-profit companies, under certain conditions.
In general, nonprofits are allowed to create for-profit subsidiaries or spin-offs, as long as the for-profit entity is legally separate from the nonprofit and operates in compliance with all applicable laws and regulations. However, this is a complex area and there are several factors that need to be considered before a nonprofit can decide whether or not to create a for-profit company.
One of the main reasons a nonprofit might consider creating a for-profit subsidiary is to generate revenue that can be used to support its charitable activities. For example, a nonprofit that provides job training services might decide to create a for-profit staffing agency that helps place graduates of its training programs into jobs. The revenue generated by the staffing agency could be used to fund the nonprofit’s other programs and services.
Another reason a nonprofit might create a for-profit subsidiary is to take advantage of certain business opportunities that are not available to nonprofits. For example, a nonprofit that operates a restaurant might decide to create a for-profit catering company that can compete for contracts with private companies and government agencies. The catering company would be able to make a profit, while the nonprofit restaurant would continue to operate as a charitable organization.
However, there are some important considerations that nonprofits need to take into account when creating for-profit subsidiaries. One of the key issues is ensuring that the for-profit entity does not undermine the nonprofit’s charitable mission. This can be a difficult balance to strike, especially if the for-profit company is operating in a different sector or industry than the nonprofit.
Another important consideration is ensuring that the for-profit entity is not engaging in activities that could jeopardize the nonprofit’s tax-exempt status. Nonprofits are subject to strict rules regarding their activities, and if they engage in certain types of commercial activities, they could risk losing their tax-exempt status.
Nonprofits that are considering creating for-profit subsidiaries should seek professional advice from attorneys and accountants who specialize in this area. They should also be prepared to invest significant time and resources into setting up and managing the for-profit entity, including developing a business plan, raising capital, and hiring staff.
In conclusion, while it is possible for nonprofits to spawn for-profit companies, it is important for them to carefully consider the potential risks and benefits before doing so. Nonprofits should ensure that the for-profit entity is legally separate from the nonprofit and operates in compliance with all applicable laws and regulations. They should also ensure that the for-profit entity is not undermining the nonprofit’s charitable mission or risking its tax-exempt status. With careful planning and management, however, nonprofits can create for-profit subsidiaries that help them achieve their mission more effectively.
Video Transcript
In this video, you get answers to these questions:
- What’s the Difference Between a Nonprofit and a For-Profit Company?
- What Does the Law Say About Starting a For-Profit Business from a Nonprofit Organization?
- What is Unrelated Business Income Tax (UBIT)?
- Why Does the IRS Allow Nonprofits to Own For-Profit Companies?
- How Complicated Is It to Start a For-Profit Company from a Nonprofit?
- How Would Somebody Know If a Nonprofit Owns a For-Profit Business?
- What “Resources” Might a Nonprofit Use to Start a For-Profit Company?
- Can a Nonprofit Use Its Resources to Help an Unrelated Business?
- Did ChatGPT Have Any Validity in Saying That Creating a For-Profit from a Nonprofit is “Unethical and Illegal”?
- ChatGPT Said That Using Nonprofit Resources for a For-Profit Would Be a “Clear Violation of the Nonprofit’s Tax-Exempt Status.” How Do Nonprofits Get Around This?
- ChatGPT Said That Starting a For-Profit Company “Under the Guise of Nonprofit Organization” Is a “Violation of the Law.” Why Is That Inaccurate? What Are the Key Differences in the Governance Structures of For-Profit Companies Versus Nonprofits?
- How Does a Nonprofit Communicate Starting a Business to Stakeholders Like Donors, Volunteers, and Employees?
- How Do You Retain the Core Values and Culture of the Nonprofit Organization in a Business it Owns?
- Can a Nonprofit Co-own a Business with Private Individuals?
- Can We Consider ChatGPT to Be a Legitimate Source of Legal Knowledge?
- Can You Create a For-Profit Company from a Nonprofit?
Can nonprofits create for-profit companies? Recently in the news, Elon Musk was discussing a response from ChatGPT. Elon had asked ChatGPT the following question, “Can you create a nonprofit and then spawn a for-profit company under it using resources from the nonprofit?” And ChatGPT essentially said, “No. Nonprofits are not permitted to use their resources to create for-profit companies.” That’s not necessarily correct, and I love ChatGPT. I use it a lot. In my experience, the vast majority of the time, ChatGPT provides the right answer, and I understand it is getting better and better, but unfortunately, it is not always right because it is based on information on the internet. And as we all know, information on the internet isn’t always right. So let’s talk about whether a nonprofit can create a for-profit company. And the answer is quite simple. It can.
I am Aaron Hall. I am a business attorney. I also deal with nonprofit organizations. There is a lot of overlap there, and I represent entrepreneurial companies. I put together these educational videos to help you, as business owners and organization leaders understand how to avoid legal problems and how to educate yourself to empower yourself as a leader.
If you don’t yet have my cheat sheet, Seven Common Legal Mistakes Made by New Businesses, you can get that at aaronhall.com/free. Not only do you get the mistakes as examples, but I will provide you with how to avoid those mistakes. And I send out regular videos that provide educational information for CEOs, business owners, and entrepreneurs to try to avoid legal pitfalls in their own companies.
Let’s get into the heart of the issue that made headlines recently. So setting aside that Elon Musk was trying to use ChatGPT’s answer to raise questions about OpenAI, the founders of ChatGPT, let’s just simply talk about, generically speaking, can a nonprofit, which OpenAI was one at one point, or is partially one, but can a nonprofit create a business like an LLC or corporation? And the answer is quite simply yes.
What’s the Difference Between a Nonprofit and a For-Profit Company?
Well, a nonprofit is created for the benefit of the public. Any profits that are generated in the company or in the nonprofit organization must be used for the purposes of the nonprofit. You cannot have any profit distributions to shareholders because a nonprofit has no shareholders. A nonprofit doesn’t have owners. An LLC has owners or members, and so a profit distribution or dividends would be paid out to the owners of an LLC or corporation. A nonprofit doesn’t have that. A nonprofit has a board of directors who have fiduciary duties to administer the organization and oversee the organization for the benefit of the public, as stated in the nonprofit’s articles of incorporation.
What Does the Law Say About Starting a For-Profit Business from a Nonprofit Organization?
The law says nonprofits can start a for-profit business, but there are some restrictions, and some taxes probably too.
What is Unrelated Business Income Tax (UBIT)?
Let’s talk about that tax. It is called Unrelated Business Income Tax or UBIT. What is UBIT or unrelated business income tax? It is income tax for certain activities within a nonprofit. What activities are we talking about, or what income? It is income from a trade or business regularly carried on that is not substantially related to the charitable, educational, or another purpose for which the nonprofit obtained tax-exempt status.
So let’s talk about each one of those elements. In other words, a nonprofit will have to pay tax on income that meets these three elements. First, income from a trade or business. So if a nonprofit either starts as an LLC or a corporation or has some other business enterprise, like, let’s say, it is a carwash that the church youth group does once a year to raise money for the activities of the church. Is that activity subject to unrelated business income tax? Well, let’s talk about it. Is it income from a trade or business? When we look at that, we don’t look at how the money is spent. Because, of course, it is spent for the nonprofit. We look at how the money is generated. Is a car wash income from a trader business? Yes. Even though it is done by the youth group kids, it is income from a trader business. Is it regularly carried on? Well, in this situation, if they do it once a year or even a couple of times a year, the answer is no. It is not regularly carried on. So because a car wash does not fulfill that element, the revenue from the carwash would not be subject to UBIT. In other words, the church would not have to pay unrelated business income tax.
And then finally, the question is, is the income from the trader business substantially related to the charitable, educational, or other purposes? And again, we look at how it is generated. How that income is generated, and the answer here is no. It is not generated from church activities. It is generated from something that’s traditionally a trader business—a carwash.
Now you might say, “Well, what about a coffee shop in a church on Sunday?” Well, a coffee shop is clearly income from a trader business. They are selling coffee. It is regularly carried on because every Sunday they have it. Now you might argue, “Well, it is not every day; it is only every Sunday.” And that is an argument. But finally, then, we have, “Is it substantially related to the charitable, educational, or other purposes?” You could make a good argument that having coffee available prior to a church service enhances the experience in the church service. People are more alert, they are more awake, they feel better, it makes for a more pleasant experience; likewise, if they have some donuts or rolls available for purchase ahead of time, people are less hungry during the church service. They are more likely to come to the church service because of the refreshments that are available. Now, I don’t know if there is actually been an IRS ruling on this. The IRS often takes a position contrary to taxpayers. In other words, the IRS says, “Hey, tax is due.” But these, at least, are the issues that are addressed when determining whether income is subject to tax in a 501(c)(3) nonprofit organization.
Why Does the IRS Allow Nonprofits to Own For-Profit Companies?
All right, some other questions. Why does the IRS allow nonprofits to own for-profit companies? Well, many times, it is going to generate revenue for the organization. There was a time in the law when it wasn’t real clear, but the law is very clear now that nonprofits can own LLCs and corporations.
How Complicated Is It to Start a For-Profit Company from a Nonprofit?
It is not hard. You just need an attorney who can help you navigate some of the legal issues here.
How Would Somebody Know If a Nonprofit Owns a For-Profit Business?
Often you can look up some sort of public filings, like a 990, which is an annual filing provided by nonprofits to the IRS that is public information. There might be other public filings or public listings. It is not always public, though.
What “Resources” Might a Nonprofit Use to Start a For-Profit Company?
A nonprofit can use its own resources to start a for-profit company as long as the proceeds from that company are also used for the nonprofit in the furtherance of its purpose or mission.
Can a Nonprofit Use Its Resources to Help an Unrelated Business?
No. So let’s say a nonprofit wants to use its resources to help an LLC or a corporation owned by somebody else. Can it do so? No. Nonprofit funds need to be used for the furtherance of the mission of the organization. Now, of course, a nonprofit could pay a printing company to provide printing services. We assume that those services are provided at a fair market value. A nonprofit can buy office supplies from an office supply company at a fair market value. A nonprofit can pay rent to a landlord or a management company for use of space at a fair market value. So there is nothing wrong with using nonprofit resources to pay fair market rates for services and goods, but a nonprofit cannot donate the resources to a business or cannot use those resources to create advertising or some other gift in kind or benefit in kind, kind of a non-monetary benefit for a private individual or a company owned by private individuals.
Did ChatGPT Have Any Validity in Saying That Creating a For-Profit from a Nonprofit is “Unethical and Illegal”?
I think there is some validity there because there is probably a lot of information on the internet about the important distinction between nonprofit and for-profit organizations. And so, it is very important to keep a distinction there. But as far as technically, can a nonprofit own a for-profit company? The answer is yes.
ChatGPT Said That Using Nonprofit Resources for a For-Profit Would Be a “Clear Violation of the Nonprofit’s Tax-Exempt Status.” How Do Nonprofits Get Around This?
Well, nonprofits don’t have to technically get around it. It is not a violation of a nonprofit’s tax-exempt status to have a for-profit company. Nonprofits can create LLCs and corporations. They just have to keep in mind that they may owe taxes. That is the UBIT (Unrelated Business Income Tax), and there are rules and laws, and regulations governing doing this properly.
ChatGPT Said That Starting a For-Profit Company “Under the Guise of Nonprofit Organization” Is a “Violation of the Law.” Why Is That Inaccurate? What Are the Key Differences in the Governance Structures of For-Profit Companies Versus Nonprofits?
What are the key differences in governance structures for for-profit companies versus nonprofits? The big issue here is a for-profit company is owned by shareholders or members of an LLC. So it is private individuals, and it is operated for the profit and benefit of those individuals. A nonprofit is not owned by anybody, and it is operated for a public benefit governed by a board of directors. So very different in governance, structure, and ownership.
How Does a Nonprofit Communicate Starting a Business to Stakeholders Like Donors, Volunteers, and Employees?
Usually, a nonprofit will first work with an attorney for the rollout and incorporation of an LLC or corporation. Technically, setting up an LLC is called an organization, but regardless, an attorney will help with the legal aspects. And then PR people, whether employed by the nonprofit or outside, will help work with the attorney to communicate that the nonprofit has started an LLC or corporation to further the nonprofit’s purposes and mission and explain that there is no person personally benefiting from the profits of the company. Instead, that company is used to benefit the organization so that it has more resources to further its mission.
How Do You Retain the Core Values and Culture of the Nonprofit Organization in a Business it Owns?
I haven’t seen this as a huge problem because usually, when the nonprofit starts a business, the core values and the purpose permeate that business and the hiring of the people. And it is very clear in the messaging that the business exists for the benefit of a nonprofit. But ultimately it is constant communication of the purpose in the business.
Can a Nonprofit Co-own a Business with Private Individuals?
Technically, the answer is yes. But it needs to be done very carefully. For example, if a nonprofit buys shares in a publicly held company to invest some of its money, technically, that nonprofit co-owns the public corporation. So yes, it is permissible, but it is very risky if there is a private company. In other words, it is not on a public stock exchange, but it is owned by an individual. It is even riskier if the company that is co-owned is partially owned by the nonprofit and partially owned by somebody related to the nonprofit, like the president or a board member. It is possible to do it right. But there are a lot of rules and regulations about how that needs to be done so that it is approved by disinterested board members who are part of the nonprofit. And very likely that transaction is going to be scrutinized by the IRS or the Attorney General and perhaps even by the courts. And so doing that properly often involves hiring an attorney who is very experienced with that sort of transaction.
Can We Consider ChatGPT to Be a Legitimate Source of Legal Knowledge?
I find ChatGPT is usually accurate, but not always. And I think the difficulty right now is the information is presented in a way that can lead people to rely on it without understanding that there may be errors. It is probably going to get better and better as artificial intelligence improves. But at this point, I find it helpful, but I don’t rely on ChatGPT if the stakes are high.
Conclusion
So to conclude, can you create a for-profit company inside a nonprofit? The answer is yes. You absolutely can. You just have to do it the right way.
I am Aaron Hall, an attorney for business owners. If you like educational videos like this, you are welcome to subscribe. If you don’t like it, click the thumbs-down. And also, if it is helpful, you can click the thumbs up. If you have questions, you are welcome to ask them in the comment section below. I will do my best to use those questions to generate topics for future videos. And again, if you don’t yet have the free resource I provide, Seven Common Legal Mistakes Made by New Businesses, go to aaronhall.com/free and sign up for that. You will also get some exclusive videos that are educational to help you avoid common problems in your business. That is the best way to get the highest quality content that I put out because I put it out for my subscribers so that we can stay in touch and you can improve your business and avoid unnecessary legal mistakes as you grow your company.