The formation of affiliate organizations in the not-for-profit world is a consideration that surfaces during the lifetime of many not-for-profit organizations as a strategy to expand operations, address tax implications of unrelated business income, shield itself from liability and expand on overall capacity to deliver more on an organization's charitable mission. Prior to forming an affiliate organization, it is imperative that an organization consider all available options ranging from affiliate structure, contractual affiliation, merger, dissolution or creation of a new entity.  It is also important to understand the legal and financial implications that such arrangements may have on the organization. For the purposes of this article, we will focus on New York State law though the laws pertaining to not-for-profit corporations in each state may vary.  We recommend consulting with an attorney and tax advisor prior to moving forward with a desired corporate structure.

Affiliate Structure

When forming an affiliate entity, the structure of the affiliate matters; there are multiple structures to choose from. The not-for-profit parent organization could form another not-for-profit corporation, a for-profit C corporation, a limited liability company (LLC) or a partnership. The characteristics of these structures vary.

Some of the structures, such as LLCs and partnerships, are referred to as “pass-through” entities because they do not pay entity level tax.[2] The activities of such affiliate entities are imputed on the tax-exempt parent as if the parent were conducting the activities directly. The activity of these pass-through entities must be related to, and in furtherance of, the tax-exempt parent's charitable purpose, otherwise any income is considered unrelated and subject to unrelated business income tax (UBIT) under Internal Revenue Code (Code) Section 511, et. seq. 

C corporations are not pass-through entities because they must pay an entity level tax. This alleviates UBIT concerns because the activities of the corporation are not attributed to shareholders. Essentially, the C corporation acts as a “blocker” from the activities it conducts. Further, any dividends are not subject to UBIT. It’s important to note, however, that there are controlled entity UBIT rules in Code Section 512(b)(13).

To understand some other differences between structure types, here is a chart comparing two common affiliate structures in New York–a not-for-profit corporation and a sole member LLC:

Other Affiliate Structure Considerations

To maintain liability protection, an affiliate entity must have sufficient control and exist on its own in all respects. The affiliated entities must observe corporate formalities, otherwise courts can pierce the corporate veil and hold the parent liable for acts of the affiliate. If the parent and affiliate have shared employees or services, there should be a written agreement in place to protect against piercing the corporate veils. Sharing employees or services can be beneficial because it allows entities to “test drive” a business relationship before agreeing to enter a merger or consolidation, but such arrangements should always be documented in a written agreement. Note that any arrangements between a tax-exempt entity and a taxable entity are especially important because the tax-exempt entity cannot use its assets to benefit private interests of the taxable entity owners.

Another consideration is the potential for excess benefits transactions. Employee compensation paid by tax-exempt organizations must be fair and reasonable. Code Section 501(c)(3) and 501(c)(4) entities are also subject to Code Section 4958, which imposes an excise tax on excess benefit transactions between a disqualified person and the applicable tax-exempt organization. The excise tax is 25% on the disqualified person and requires repayment with interest of the excess benefit amount to the tax-exempt organization.[3] The tax is a personal penalty on the individual who received the excess benefit. There is no indemnification permitted, and directors’/officers’ insurance will not cover these penalties.

For purposes of Code Section 4958, disqualified persons include directors, officers, substantial financial contributors, family members of these individuals, as well as individuals in a position to exercise “substantial influence” over the organization (e.g., chief executive officer and chief financial officer, regardless of title). Compensation to any disqualified person must be reasonable to avoid the excise tax.

New York Not-for-Profit Corporation Law (N-PCL) Section 715 allows for the assessment of similar penalties for related party transactions that are not approved as required by statute.

Contractual Affiliation

LOW                                                                                                                                                     HIGH

HIGH                                                                                                                                                         LOW

When considering an affiliation model, flexibility is important. Even if a merger or transfer of assets is the desired result, starting with a contractual affiliation or services agreement may be an important interim step in the affiliation process. Some key considerations to consider when determining where to start with an affiliation include:

(1)   Establishing a common vision. Is it possible to establish a common vision for the organizations involved?   If the mission and purposes of each organization are not easily synergized, then an affiliation model with lower integration is likely the better starting point.

(2)   Compatible cultures. How compatible are the cultures of the various organizations?  The more similar the cultures, the easier it is to successfully achieve one of the affiliation models that require a higher degree of integration and lower level of local control. Overall, culture should be considered as well as those of governance, management and operations.

(3)   Stakeholder support. Which process will be undertaken to communicate with stakeholders to ensure support for the affiliation? Is it expected that stakeholders will be reluctant or supportive of the affiliation? Transparency (as much as possible) and a willingness to address the hard questions during affiliation discussions will generally assist with alleviating stakeholder concerns. If stakeholders are reluctant, then an affiliation model with a lower degree of integration and higher level of local control may be a better starting point.

(4)   Governance structure. What is the ideal governance and management structure post-affiliation? The more similarities to the post-affiliation structure each of the individual organization has, the more likely an affiliation model with a higher level of integration may be to accomplish. Note, however, that the current board composition, management structure and leadership styles should also be considered to determine the most appropriate affiliation model and whether an interim affiliation model should be used. 

(5)   Assets. Which assets does each organization hold and what, if any, limitations on the transfer of such assets exist?  For example, if contracts require consent to be assigned to another entity or upon a merger, then an affiliation model with a lower level of integration may be better in the short term, while necessary consents are obtained.  Various sources of revenue may also not be easily transferable, including revenues received from governmental agencies or restricted donations. Therefore, it is important that these arrangements be carefully considered and, again, may support an affiliation model with lower integration such as a services agreement or contractual affiliation.

(6)   Liabilities. Which liabilities does each organization have, including the possibility of unknown liabilities?  (See comments above relating to the transfer of assets.)  Note, also, that if the operations or activities of an organization could result in a high level of unknown liabilities, then an affiliation model with a lower level of integration may be better to start with while further review is conducted. Due diligence regarding any potential or pending litigation or other liabilities should be carefully considered.

Contractual Affiliation, Shared Services or Management Services Agreement

These options are very similar because they involve the organizations entering into a contractual agreement. The starting point of this model is to identify areas where activities and personnel may be combined to allow each organization to operate more efficiently and effectively. Key elements:

• There is no transfer of assets or liabilities.
• Can be unwound by terminating the written agreement.
• Each organization maintains its governing board focused on the organization’s individual mission/purpose.
• Only areas or personnel where efficiencies identified are consolidated.
• Individual IRS, New York, audited financials are maintained.
• No regulatory consents required.

Merger/Consolidation

As more particularly articulated in Article 9 of the N-PCL, merger and consolidation are procedures required when two or more corporations (constituent corporations) become a single corporation. A merger involves the legal combination of one corporation into and with another corporation; as an example, Organization A would merge into and become part of Organization B. The legal corporate existence of Organization A would cease. Key elements of a merger:

• Ownership of all assets transferred as an operation of law and no separate transfer required.  Note that consent for the transfer of contracts may still be required.
• All liabilities transferred as an operation of law. Surviving entity assumes responsibility for all liabilities, whether known or unknown, without limitation.
• The merger cannot be easily unwound.
• Decreased costs of administration due to operation as single entity (e.g., IRS, NYS Charities Bureau, audited financials). 
• Full integration of governance, management and employees. Note that benefit and union (if applicable) integration may raise issues that need to be addressed.
• Requires New York Attorney consent under the N-PCL and court approval if the Attorney General requires.

Consolidation is also an option and involves combining Organizations A and B into a single, newly created corporation (Organization C).  The new corporation (Organization C) would then need to obtain a new EIN and apply for tax-exempt status with the IRS. It does not assume the tax-exempt status of either constituent corporation. This can result in a more lengthy process, therefore making a merger generally the preferred option. 

Article 9 of the N-PCL authorizes a merger or consolidations of two constituent corporations only upon a finding by the Attorney General (or Supreme Court) that the interests of the constituent corporations and the public interest will not be adversely affected by the merger or consolidation. [See N-PCL Section 907-a(e)-(f).]

In order to complete a merger or consolidation, the Board of Directors of each constituent corporation adopts an Agreement and Plan of Merger, which is then submitted to the members (if applicable), the Board signs the Agreement and Plan of Merger, the organizations submit a Petition to the Attorney General and (once approved) the Certificate of Merger is filed with the New York State Department of State.[4] A merger becomes effective upon the filing of the Certificate of Merger with the Department of State, or on a later date, as stated in the Certificate of Merger, which may not be more than 30 days after such filing.

Sale/Transfer of Assets

In lieu of a merger or consolidation, not-for-profit corporations may consider transferring all or substantially all of one constituent corporation's assets. (This process is subject to N-PCL Sections 510 and 511.) Attorney General and court approval (if required by the Attorney General) is required.[5] A sale or transfer of assets would allow a not-for-profit organization to select specific assets to sell to another not-for-profit organization. Assets can only be transferred from one not-for-profit corporation to another not-for-profit corporation. A few key things to keep in mind when it comes to selling all or substantially all of the assets of a not-for-profit corporation:

• Only ownership of assets specifically identified are transferred.  Consents for the transfer of contracts may be required.
• Only liabilities specifically identified are transferred and assumed by the receiving organization. In this instance, the organization may need to consider whether there is successor liability.
• The transfer cannot be easily unwound.
• Decreased costs of administration because the organization transferring substantially all of its assets dissolves once the assets are transferred.
• Requires Attorney General consent under the N-PCL and court approval if the Attorney General requires, to the extent the transfer of asset constitutes all or substantially all of the organization's assets.[6]

Before completing any affiliation, regardless of whether it is a merger, consolidation or sale of an organization's assets, it is important to consider the concept of successor liability. The most compelling reason to start fresh rather than recycling an existing not-for-profit corporation is that the existing organization may have liability associated with it.

Such liability could come in the form of employment claims, contract claims, tort claims, failure to file prior tax returns, payroll tax liability, misclassification of workers, unreported excess benefit, or private inurement; the list goes on. Unless you know exactly what potential claims may be lurking out there, the safe and prudent course is to create a new entity with a fresh clean slate with any assets being sold to the new entity for fair market value.

[6] Note that the Attorney General may be reluctant to approve a 510/511 application if there is no consideration for the transfer as N-PCL Section 511 requires that the transaction be fair and reasonable to the entity transferring its assets.  In these situations, an asset dissolution under Article 10 of the N-PCL may be used.