Five Common Nonprofit Deals with Complex Tax Consequences
Where there is a business transaction, such as a merger or acquisition, there is almost always a tax impact. But things can get particularly complicated when one or more parties in a transaction is tax exempt—meaning due diligence and careful planning are an absolute necessity.
Here are five common types of nonprofit transactions and the complex tax implications they can raise.
1. Merging Two Nonprofits
Generally, in a merger of two nonprofit organizations, the two will combine via state law statutes, and one entity will be the survivor while the other entity will no longer exist. Various business and political factors will dictate which entity will be the survivor. The new entity may change its name, have a combined board, etc. But just because both entities are tax exempt does not mean there are no tax issues. The big concern here is whether the organizations had any outstanding tax liabilities before the merger. These liabilities will not go away and could be transferred to the new (surviving) entity. Therefore, each entity must perform due diligence to make sure its tax house is in order before there is any merger.
Also, each organization must accurately report the transaction on their respective Forms 990. The organization that dissolves must file a final Form 990 five months and 15 days after it is terminated. As such, one thing that you should consider is the timing of the merger, so the organization does not have to file two tax returns—one for its year end and one due after the termination.
2. Tax-Exempt Conversion to Taxable For-Profit
There may be instances when a nonprofit organization wishes to convert to a for-profit entity and then merge with another for-profit entity. The first place to look in a situation such as this is to discern what the articles of incorporation require regarding where residual assets are to go upon dissolution. For a section 501(c)(3) organization, assets must be dedicated, in perpetuity, to charitable purposes. Therefore, if the organization is going to give up its 501(c)(3) status, it must make a plan to give the residual assets to another 501(c)(3). In some states, giving up 501(c)(3) status will require oversight and approval of the attorney general of the state, the protector of charities.
3. Taxable Corporation Converts to Tax-Exempt
If a taxable corporation chooses to convert to a tax-exempt entity, it must pay a toll before it is allowed to convert. This would typically be the case when an organization was organized as a nonprofit, is a subsidiary of a tax-exempt entity and never got exemption from tax. The parent may want to liquidate the sub and obtain an asset of the sub. The rule here, however, is that the taxable corporation will have to pay tax on the appreciation of its assets before it disappears or is liquidated, unless the property will be used in an unrelated business. (See IRC 337(d)). This is because once the taxable entity converts, the IRS will never get its money unless the assets are used in an unrelated trade or business.
4. Acquisition of a Nonprofit
When a for-profit or a nonprofit company is acquiring the assets of a nonprofit, the issue that arises, especially if the seller is a section 501(c)(3) organization, is what will happen to the sales proceeds. The seller may take the money, pay off its debts, give the residual assets to another 501(c)(3) organization and call it a day. But if the seller is a public charity that now has a hunk of cash and no program, will the seller become a private foundation? And what will the seller now do with its cash? In such situations as this, proper structuring can allow the nonprofit to support another public charity and keep its own public charity status, thus avoiding having to pay an excise tax on its investment income.
5. Joint Ventures
Many tax-exempt organizations will consider a joint venture with either another nonprofit or a for-profit entity. In many cases, this may be a precursor to a merger or acquisition. Joint ventures such as partnerships or limited liability companies taxed as partnerships are considered “pass-through” entities, since the partnership itself is not taxed, but the income and the characteristics of the activity of the partnership are passed through to the partners, who are taxed as if they earned the income directly. For a tax-exempt organization, this means that, if the activity would have been considered unrelated if the organization had conducted it directly, the income generated from that activity is unrelated income (see IRC 512(c)).
These arrangements are generally very complex and involve the provision of services, rental and sale of property, and other contracts. It is very important that the partners receive a quid pro quo interest, i.e., what they get as a return is commensurate with what they contributed and transactions are at fair market value.
In the case of a nonprofit entering into a joint venture with a for-profit, procedures must be put into place to safeguard the tax-exempt status of the nonprofit, or the nonprofit’s status could be in jeopardy (Form 990 asks if such policies are in place). For example, we often see joint ventures between a nonprofit hospital and a for-profit company to operate a department of the hospital such as a laboratory, a pharmacy or a dialysis department. But those hospitals must take precautions so that their tax-exempt status remains intact.
Mergers, sales, joint ventures and other business transactions all have their own unique, significant tax consequences. Take tax into consideration as part of the planning process to ensure the deal is seen and remembered as a successful one. And, of course, for mergers, aqusitions and joint ventures issues may be different for GAAP than tax, so please consult your auditors.