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.
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 conducted 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.
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 every day. 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.
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.
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.
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.
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.
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This Post Has 22 Comments
Is it possible for the 501(c)(3) to own the land and the 501(c)(2) to own the building constructed on the land? I have a 501(c)(3) client that has purchased raw land prior to the formation of the 501(c)(2) and we are trying to determine the best course of action on the ownership of the real estate. Thanks for any guidance.
Sorry for the very late response. I would say such a scenario is possible, assuming the title can be split between the land and structure. Sometimes this is not possible, at least not easily. My concern is whether you would really have increased liability protection since the building would be sitting on land titled to the 501c3. You might need an attorney opinion on this one.
Hi Greg, should the 501(c)(2) have separate management/board of directors from the parent 501(c)(3)?
It can, but it isn’t technically necessary due to the 501(c)(2) having to be a subordinate of the parent organization. You can do what makes the most sense for you. I prefer at least an overlap of directors on the board.
I work with an organization that has a 501(c)(2) that has been in place for a few decades as the title-holding company for below-market cooperatively-managed housing. We’ve had a few times where other nonprofit organizations have wanted to donate their buildings to us for this purpose, or sell at below-market rates.
Would a 501c3 seeking to donate or sell a property below market rate be required to sell directly to our parent c3 and then have us transfer it to the c2 or is a sale to the c2 directly for all intents and purposes the same as selling to the c3?
So, so late answering this question…apologies. Give the property to the c3, then transfer title. They are legally separate entities, even though the c2 is subordinate to the c3. A c3 should never give directly to a non-subordinate c2.
Hi Greg, I really enjoyed this article about the relationship between a 501(c)(3) and (c)(2). I am the staff account for a private foundation that is an educational tax exempt 501(c)(3). We do have a 501(c)(2) setup for our real property holdings. I do have a question regarding the (c)(2) collecting income and then turning over the entire amount to the (c)(3). Because we are a private foundation (file 990-PF) and are subject to excise tax, is the income transfer from subsidiary to parent just an equity transfer? Or is it reportable on the 990-PF “Net Investment Income” that would be subject to the 1.39% excise tax?
The net rental income should be treated the same to the foundation as it would be if the foundation were renting the property directly. If the property is not debt financed, it should be considered non-taxable passive rental income. If it IS debt financed, then you have to calculate the nontaxable portion vs the unrelated business income portion based on the fraction of indebtedness. I would not consider it net investment income for the purpose of the excise tax.
Greg, thanks so much for your response. One additional question regarding your comment about treating net rental income the same as if the foundation was renting the property directly. A foundation’s assets are classified as being held for “charitable use” or “non-charitable use”. Our foundation’s endowment includes real property that is classified NCUA. Can this real property be deeded and held in the subsidiary 501(c)(2) or can only charitable use property be held in the 501(c)(2)?
It doesn’t have to be charitable use property to be titled to a 501c2.
Would like to talk with you about establishing a 501 c2 for our company. We have 4 pieces of real property that needs protection. Thank you.
Hi, Temetry…we’d love to help. Click here to go to our SureStart page. There you can fill out our contact form at the bottom of the page. Be sure to mention that you’re looking to start a 501(c)(2). We’ll have a member of our team reach out to you to discuss.
Our nonprofit runs an educational farm and just acquired the property on which the farm is located. Our legal counsel advised us to create a separate LLC as a land-holding entity, which we did, and so our nonprofit now “owns” (is the sole member of) an LLC, which itself owns the property. Does this achieve the same result as a 501(c)(2) holding the property? Our lawyer is experienced in corporate law but not nonprofit law specifically, so he may not hav known about this option.
p.s. — LOVE your site! Just stumbled across it
Hey, Tim…glad you’re liking our site! Look for a reboot of our YouTube channel coming in early 2022. We’ll be producing weekly content, so be sure and check it out.
I’m going to answer your question by saying “maybe” it does a similar service. The problem with an LLC, particularly one that is sole member, is that it doesn’t really provide much separation between the parent 501(c)(3). For tax purposes, the IRS considers sole member LLCs owned by a corporate nonprofit to be “disregarded entities”, meaning the IRS disregards the LLC entirely as if it didn’t exist. A tax standard is different from a legal liability standard, so I wouldn’t blanketly say that an LLC doesn’t provide some of the protection you’re looking for. However, I much prefer the 501(c)(2) because it is specifically designed to hold title to property owned by a parent nonprofit, but yet has its own accountability for compliance and isn’t treated as a disregarded entity. If liability protection is your primary motive, you may want to consult with your attorney as to his opinion of whether piercing the corporate veil between the entities is harder with your LLC or with a corporate 501(c)(2). I believe the answer is probably a c2, since it is also a nonprofit, nonstock corporation that is subordinate to the c3, but isn’t “owned” by anyone.
Good luck with it. If you decide to go the c2 route, give us a shout. We’d love to help.
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?
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.
Hello, I’m wanting to start my own 501(c)3 to start a street outreach for the homeless in my area. But, with the housing first approach I don’t know if I’ll have much luck in my area with landlords and the rapid re-housing program. I know legally I can’t manage their cases and be their landlords because it would be a conflict of interest. So, I was thinking of getting property as a 501(c)2 for my 501(c)3 and rehousing homeless that way, then the money made from rent after they’re self sustainable will go back into the rapid re-housing pool for the next homeless person. Does this sound doable? And could I get the houses worked on or build while the title is held by a 501(c)2?
Sorry for the delay in response, James.
It’s possible, but keep in mind that the primary purpose of a c2 is to hold title to property otherwise owned by the c3. It can’t operate a program of its own…only rental activity. My concern is that if your c3 is providing services to the renters of the property in the c2, the property and the rental activity are really integral to the program and the rent becomes active income, not passive. I don’t see much way around that.
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.
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!
We have an endowment to protect.
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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