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How a Subsidiary 501(c)(2) Could Lower Risk for Your Nonprofit

How A Subsidiary 501(c)(2) Could Lower Risk For Your Nonprofit

Risk management should be among the top strategic initiatives of every nonprofit board of directors.  Establishing effective policies and procedures will help, as will requiring separation of duties and limiting conflict of interest.  But, what if your nonprofit owns real estate.  How do you effectively reduce liability and risk factors associated with the use of your land and buildings?  Insurance is good, but can you do more?

A 501(c)(2) just might be the answer.

What is a 501(c)(2) organization? 

The official IRS description is called a Title Holding Company for Single Parent Corporations.  The label is actually a great description of what this type of entity does, but it won’t make much sense to people unfamiliar with the structure.  Some key facts:  To qualify for 501(c)(2) status, a nonprofit…

  • Must be a corporation
  • Must be wholly-controlled by another tax-exempt organization
  • Must apply for IRS status using Form 1024
  • Must hold title to real estate, personal property, and/or intellectual property, and
  • Must pass net revenue (if any) on to parent organization

These 5 attributes are the minimum necessary factors to qualify for this status.  In addition, 501(c)(2) organizations are not allowed by the IRS to have any active program conduct beyond passive rental income.  It’s important to note that it isn’t necessary to have rental activity, as many are used strictly for risk management purposes.

A Risk Scenario

Consider this situation:  Centertown Baseball is a local 501(c)(3) youth league.  It has experienced tremendous growth and now owns a multi-field baseball park of its own.  During baseball season, all of the fields are in use nearly everyday.  Occasionally there are some minor injuries among the kids, but nothing really bad has occurred in the 6 year history of the organization.  That is, until the day a fly ball sneaked through a gap in the backstop fence, seriously injuring a spectator.  Within weeks, a negligence lawsuit was filed, and, if found liable, the league fears its insurance coverage won’t be enough to settle the suit.  There is a real chance that Centertown’s facility could be at risk.

The strategic use of a 501(c)(2) could help in this situation.  Instead of holding title to the property directly, Centertown could create a separate corporate entity that it controls, seek 501(c)(2) status for it, and place the property into this new holding company.  In the same injury scenario, Centertown might still face a negligence lawsuit, but its property would be protected.

You can substitute youth baseball with any number of other scenarios:  a nonprofit daycare, a college fraternity with a frat house, a private school, a church.  Any of these organizations could use a 501(c)(2) title holding company to significantly reduce the risk exposure of the most valuable asset they own…their real estate.

Rental Activity and Unrelated Business Income

We need to say a word about rental income, since many nonprofits have real estate that they rent to others.

Revenue from the sale of goods or services not related to an organization’s charitable purpose is called unrelated business income.  And while it is OK to have such revenue, the net proceeds of such activity is taxable to a nonprofit.  Rental income generated by a nonprofit is unique.  Though most rent-generating activities are considered commercial in nature, the IRS categorizes most rental income as passive, and not the active conduct of a business.  As such, a nonprofit’s rental income is usually exempt from taxation, unless the property is mortgaged.

If the property has what the IRS deems acquisition debt, then the percentage of net income attributable to the mortgaged portion of the property’s value will be taxed as unrelated business income.  This will still be true if the property title is transferred to the 501(c)(2).  In that case, the title holding company would pay the attributable tax prior to forwarding the net proceeds to the parent organization.

Private Foundation Impact

In addition to liability protection, private foundations may have another potential use for a title holding company.  The IRS requires private foundations to distribute for charitable purposes a minimum of 5% of their assets each year.  This calculation excludes assets dedicated to the foundation’s own charitable program(s).

Often, a foundation may own an investment property that is not actively used, but is quite valuable. This can significantly increase their 5% minimum distribution.  If the foundation is property-rich, but cash-poor, this could put serious pressure on their budget.  They may even have to liquidate the property in order to fulfill their distribution requirement.

A 501(c)(2) might help here.  As a separate entity, it could hold the property on its books, lowering the asset valuation on the balance sheet of the foundation.  This, in turn, would lower their 5% distribution minimum, relieving that financial pressure.

Alternatives

A 501(c)(2) is not the perfect choice for every nonprofit that owns property.  Churches may wish to consider a separate 509(a)(3) supporting organization as an alternative.  The reason is rooted in the exemption churches have from filing Form 990.  A subordinate supporting organization does not file a Form 990 either, but a 501(c)(2) may have to, if there is unrelated business income due to acquisition debt.

Is It Right for You?

It is our opinion that the 501(c)(2) entity is a vastly under-utilized structure for property-owning tax-exempt organizations.  Strategically used, it just might be the best risk management solution to truly protect their nonprofit’s assets.

If this sounds like something you would like to explore further, reach out to us and let’s talk about it.  We’d be happy to help you put one in place for your organization.

Greg McRay, EA

Greg McRay is the founder and CEO of The Foundation Group. He is registered with the IRS as an Enrolled Agent and specializes in 501(c)(3) and other tax exemption issues.

This Post Has 6 Comments
  1. We are an IRS registered 501c3 and we are in the process of registering with the IRS to have a 1024 registered 501c2 under our 501c3.
    My question is will the wealth of the officers of the 501c2 be protected from law suits?

    1. Neither more nor less than with any other corporate entity. The degree of personal asset liability protection is limited to the separation any corporate structure provides. Piercing the corporate veil is always possible when there are gross negligence and/or criminal activity. Having good D&O insurance is an inexpensive way to beef up such protection.

  2. We are evaluating launching two 501-c3 organizations; one for our Homeless Program and one for our Organ Music Program. I’ve been tasked with researching the costs, challenges and options for both. I’ve done the www research, spoken to our attorney and want to schedule a phone visit with one of your staff members. Please email with dates/times best for a call.

    1. Hi, Chuck…thanks for reaching out. My best recommendation is to follow the link below and fill out our web inquiry form. You can leave info in the comment box as to best days/times on your end. That usually works better than calling in, and all of our team being on the phone talking to others. Thanks…we look forward to being of assistance!
      https://www.501c3.org/501c3-services/start-a-501c3-nonprofit/

    1. If your endowment is cash or securities, a 501(c)(2) wouldn’t work for you. Only real estate, personal property, and intellectual property can be held by such a structure. You should probably make sure you have great liability insurance to protect your endowment.

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