• Nonprofits Acquiring For-Profits

An interview on acquisitions, asset sales, and acronyms with Gene Takagi, Principal of NEO Law Group.

Gene Takagi, NEO Law GroupGene, we have a 501(c)(3) client who may be interested in acquiring a for-profit business. What should this nonprofit consider as they explore this idea? (This is a public charity, not a private foundation.) 

Our law firm is seeing this more and more often. There are a whole host of things for a nonprofit to consider in a nonprofit – for-profit merger or acquisition. First, they need to ask themselves if they are considering the transaction to generate revenue or to advance their mission, or some combination of the two. Are the activities of the for-profit business related or unrelated to the nonprofit’s mission? Motivation matters. (Gene Takagi, pictured at right.)

That makes perfect sense, Gene. This nonprofit wants to further their mission through the acquisition of a for-profit operating in a line of work related to the nonprofit’s mission. They have a strategic reason for the acquisition in terms of serving their clients better, and they also think it would help in diversifying their funding through unrestricted income from this business. But they don’t want to jeopardize their exempt status in any way. What do they need to know before they go any further?

They need to ask themselves how this would compare to other investments they could make. Nonprofits often make investments as part of their everyday operations, such as investing funds in cash, or money market accounts, or stocks and bonds, or real estate. Board members must make sure the nonprofit’s investments are compliant with prudent investor rules, and as fiduciaries, board members must generally use the same standard of care a reasonable person would use if they were investing their own assets. Depending on all of the facts and circumstances, the nonprofit’s board of directors will also likely need to ensure that any acquisition payment it makes represents no more than the fair market value of what the nonprofit is acquiring, to ensure it does not provide any prohibited private benefit to the for-profit’s owners. Of course, if any insiders of the nonprofit have a direct or indirect interest in the transaction, that will also raise additional conflicts of interest considerations and requirements at the state and federal levels.

The nonprofit’s purchase of the for-profit or its assets, if it or they cannot be considered program-related assets, should meet its state’s version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). UPMIFA provides rules and guidance on investment decisions for nonprofit organizations. Was this investment decision made with consideration of economic conditions, tax consequences, the organization’s other resources, the needs of the organization, and the investment’s special relationship or special value to the organization’s charitable purposes? There is portfolio theory involved here, in that the acquisition of the for-profit needs to make sense within the portfolio of other investments the organization has made and be part of an overall investment strategy having risk and return objectives reasonably suited to the organization.

Great. One more acronym to remember: UPMIFA! But that sounds like something their board of directors will want to be aware of as they review this partnership opportunity. What about UBIT? 

UBIT, or unrelated business income tax, could be an issue post-acquisition if the business activities associated with the acquired for-profit are to be run by the nonprofit (or a disregarded entity like an LLC) directly, but it may not be if such activities of the for-profit would be considered a related business that contributes importantly to furthering the nonprofit’s charitable purpose, without considering how any profits are used. UBIT was set up to prevent tax-exempt organizations from having an unfair advantage relative to taxable for-profits because of their tax-exempt status when operating unrelated business activities. It might make sense to simply pay the UBIT if the unrelated business activities are not substantial relative to the nonprofit’s overall activities. But if the unrelated business activities are substantial, the acquisition might be better housed in a taxable subsidiary of the nonprofit.

Anything else they should be thinking about?

Do you know if the acquired for-profit will be wholly-owned by the nonprofit or will involve other investors or employee ownership?

I would need to find that out. Why does it matter?

If other investors are involved it can get more complicated. The nonprofit will want to be aware of any securities laws that may be triggered if they are selling interests in the venture. Also, if the nonprofit is setting up a new taxable joint venture with investors, the nonprofit would need to make sure that the joint venture’s activities further the nonprofit’s charitable purpose and that the joint venture arrangement permits the nonprofit to act exclusively in furtherance of its charitable purpose and only incidentally for the benefit of its investors. In some cases, the nonprofit may need to have sufficient control of the board (at least 50%) of the joint venture to be sure it meets these requirements. Joint ventures may also require valuations and appraisals to help determine the fair market value because the nonprofit generally cannot sell any of its assets to an investor for less than their fair market value. As mentioned before, the nonprofit will want to be especially careful if there are any insiders, like the nonprofit’s board members or officers, involved to ensure they are not compensated above fair market value by the nonprofit.

Wow. That does get complicated. I’m a fan of KISS – keep it simple, stupid! Are there any other approaches you would recommend that might help this organization achieve its objectives while minimizing some of these complexities?

Mergers and nonprofit-for-profit joint ventures can be pretty complicated. Even acquiring a business and owning all of its stock or membership interests can involve considerable planning, due diligence, and work. One way to keep things simple is to look at a straight asset sale, meaning that the nonprofit could acquire only the assets of the for-profit without also inheriting its liabilities and obligations. But if isolating the liabilities of an acquired business and shielding the nonprofit are important, or if the acquired business would create a risk to the nonprofit’s tax-exempt status, dropping the assets into a subsidiary may be a good strategy. A great resource for this topic is this article by David Levitt

Thank you Gene. This has been so helpful. I think as nonprofits and for-profits consider partnerships more frequently, we need to be well-versed in the legal frameworks in which they operate.


Tags: cross-sector, implementation, mergers, strategy, joint venture, parent subsidiary

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