The Dangers With a For-profit and Nonprofit Hybrid Structure

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Every so often, a group of us sit down with folks from the IRS Exempt Orgs Section and chat. Talk about upcoming developments, things the IRS sees and for us to watch out for. In June, there was a lengthy discussion on structuring for-profit/nonprofit hybrid structures that stuck out to me.  One, it’s interesting the IRS is seeing so much growth here that it warranted a long shout-out. Two, the top question I get is whether someone should organize their  mission-focused business as a for-profit or a non-profit. Me being team, “why choose, do both”, it was really good to hear the big bosses’ thoughts.

Their takeaway? Prepare to eye-roll…it depends on the facts. BUT, there were key facts I noticed in the examples that will be important for you if you have or are considering a hybrid structure. I’ll talk about these and give some examples below. 

What to Watch in Hybrid Structures

So we’re on the same page, when I say “hybrid structure,” I’m talking about a situation where there that is a for-profit entity that has a nonprofit entity operating under it, or vice-versa. You often see this with for-profit businesses who really want to focus on education of, or a systemic social justice problem in, their business. The example everyone tends to think of is Amazon Smiles, under the Amazon parent.

On the other side of the token, some nonprofits spin off a money making venture that might throw their contribution percentages off, or jeopardize their exemption status. Kaboom Playgrounds did this, spinning off a for-profit consulting business under the well-known nonprofit.

When you have a hybrid arrangement, there are a few things to think about. Like:

  • Resource sharing between the two entities.  This isn’t bad, but watch for situations where it looks like a for-profit parent is capitalizing off of its nonprofit sub (cool lingo for “subsidiary”). Where a nonprofit sub is reimbursing for resources its used, at most, it should pay cost.  I noted the IRS seemed to look more favorably where nonprofits paid under cost or free.
  • How much control the parent has over the subsidiary.  Intrinsically, there will be some control over strategy and big picture operations. But, for example, in the case of a for-profit parent and a nonprofit sub the more involved the parent is in the day-to-day of the sub the more the sub starts to look like a shelter for the for-profit parent. Or in the converse situation,  as if the nonprofit is using the for-profit subsidiary to shelter activities the nonprofit shouldn’t be into. The problem with this?  Where there isn’t enough separation, the activities of the sub will be attributed to the parent for tax and liability purposes.
    • On the same token, don’t move money back and forth between the two entities. Have separate accounts, record-keeping etc.
  • Governance setup. My opinion? There should absolutely be two separate boards and executives. But this is a point where there’s debate. Some think a little overlap isn’t a problem. Others don’t see an issue where the head of the parent is also a head of the sub.  I’ll just say this, in many of the cases I’ve read sharing board and executives was used against the organizations. And even where it isn’t salacious, it seems to tip the scales toward “not ok” quite a bit.

 

The Dangers With Getting Hybrids Wrong

If a nonprofit and for-profit  hybrid isn’t set-up, or operated, correctly a few issues can come up. Of paramount concern, the board and officers of the nonprofit could be hit with penalties for self-dealing. Other claims the IRS could slap the nonprofit with are:

  • Excise Holding
  • Jeopardizing Investments
  • Excise benefit Transactions
  • Political Expenditures, etc.


In other words, what (metaphorically) starts out as a small leak can quickly turn into a typhoon. I’ll also mention, the IRS pointed out several times that there is no reasonable law defense for self-dealing. What does this mean? Even if you thought you were doing something good, that won’t be enough to get you out of trouble.

 

Example Where a Hybrid Structure Got the All Clear


(*waves hand* Here’s my little attorney disclaimer. Remember, this example is only meant to be instructive.  But hearing the facts was helpful for me and hopefully will be helpful for you.)

A for-profit created a nonprofit to provide subsidized job-training services to the community. The job-training program was in the same industry as the for-profit, which is normally a red flag. But, the nonprofit was savvy.  Its job-training participants had to be chosen by the community and community stakeholders, not the for-profit. Moreover, when the for-profit provided goods and services to the nonprofit they were free of charge; money didn’t go back and forth.  Most important, the company wasn’t allowed to benefit from the nonprofit by cherry-picking hires from those the nonprofit trained. In fact, the for-profit couldn’t hire any employees or trainees from the nonprofit.

 

Example Where A Hybrid Got the Smack Down


A family foundation issued grants to organizations servicing the community. Keep up with me here, the granddaughter of the foundations founder won one of the grants. The IRS made it a point to say, the granddaughter winning a grant from her grandfather’s foundation wasn’t in and of itself an issue (I’m skeptical).  The granddaughter ran a nonprofit that planned to use the grant to purchase recycling containers for underserved communities. Pretty fair, right? Well, the nonprofit was owned by a for-profit LLC that the granddaughter also ran. Where did the train go off of the rails? The LLC would take the recyclables collected by the nonprofit and sell them, with the profit going to the for-profit. The IRS determined this was indirect self-dealing, in that the foundation’s assets (in a roundabout way) went toward the LLC. This wasn’t helped by the fact that the granddaughter controlled both the nonprofit and for-profit.

I’m working on the PLR numbers for these two examples, for those nerds out there who want to look up the IRS’s letters and better understand the IRS’ rationale.

 

 

Other Pages You Might Like


Why You May Be Donating Wrong and My Brush With Effective Altruism

For-Profit v. Non-Profit is the Wrong Question

Doing Good Through Business Presentation (Download)

Structuring Social Impact