1. Introduction

An organization’s corporate structure is vitally important to its long-term maintenance and day-to-day operations, as the corporate structure establishes the rights, powers, tax consequences, and liabilities of the organization.  Whereas in the past a Church was low risk and had limited liability and thus, generally only needed one structure to protect and provide all possible benefits to its members and affiliate organizations, this has dramatically changed.  The 21st century has seen a substantial increase in lawsuits and judgments amounts and a purposeful targeting by the secular legal community of Church and non-profit organizations ass a new “deep pocket.”  Coupled with this changing legal environment, Churches have expanded and branched out into numerous other areas other than just weekly worship services (e.g.- daycare, schools, food pantry’s/clothes closets, low income or elderly housing, significant property holdings, etc).

In light of these new developments, it is more imperative then ever for Churches to consider structuring their various organizations in such a manner to separate their greatest liabilities from their major assets.  Each Church is different and should be analyzed accordingly by knowledgeable legal counsel to ensure that the proper structure is utilized to provide the most favorable tax, control, and liability arrangement for that particular Church.  This memorandum outlines various options available top churches and nonprofits to effectively manage their risks in this environment and briefly covers advantages and disadvantages of each entity and structure.

1.1     Examples and Overview of Issues

Let us start with an example typical of many moderate to large modern Churches.  Consider an incorporated Church that has opened a daycare and K-12 school in order to better serve the members of its congregation and community.  The school is advertised primarily at church services and on church bulletin boards, but it is open to non-members, who are charged the same amount as members for the school’s services.   The Church seeks to provide religious instruction and religious activities that correspond to the church’s beliefs, and general education is also provided.

Although the school is well staffed and maintains all suggested and required safety precautions, injuries are inevitable, and while the church thoroughly screens, trains, and supervises the school employees, abuse could occur.  As you can imagine, any number of tragic events could occur at the daycare or school that would expose the church to major liability.  All of the church’s assets (e.g. the building, land, etc.) would be subject to any lawsuit of the school or daycare.  Even with the best of insurance, the church’s very existence would be at risk.

The questions then are: 1) which subsidiary structure would best shield this Church from the extra liability?  2 ) how much control would the Church have to sacrifice in order to protect themselves from these liabilities?  3) what type of administrative entanglements or costs would result from creating each subsidiary organization? And what structure to be more cost effective and easiest to operate. These are just some of the questions which an organization needs to contemplate in creating a subsidiary organization, and which would need to be discussed with legal counsel.

1.2     Legal Considerations

Undoubtedly, the most tangible benefit to creating a subsidiary is the “liability shield.”  In the same way incorporating a Church or Nonprofit (NP) acts as a shield to protect Church/NP leaders and members from personal liability, creating subsidiary corporations can protect a Church/NP from any extra liability.  For example, any claims against a subsidiary can only be satisfied by that subsidiary organization’s assets, and the Church’s assets would not be subject to any judgment and vice versa in most cases.

Another consideration is that certain business activities may jeopardize a nonprofit organization’s tax exempt status.  According to IRS code § 501(c)(3), a nonprofit organization must operate exclusively for at least one of the following exempt purposes: religious, charitable, scientific, literary, education, etc.  If a nonprofit organization expands to encompass and control an unrelated, non-exempt enterprise, any income from that enterprise would be taxed as unrelated business income (UBIT), and, if such activity and income is substantial, the organization’s tax-exempt status could be at serious risk.  In such a situation, properly establishing a subsidiary organization could also preserve the nonprofit’s tax-exempt status by isolating the for-profit activity in a subsidiary.

1.3     Administrative and Practical Considerations

A parent church/NP must also consider the extra administrative requirements of creating subsidiary organizations.  The oft-quoted saying by corporate lawyers is that creating an organization is like birthing a baby.  The incorporation is just the beginning.  After its birth, the parent Church/NP will need to maintain the subsidiary.  Obviously, some organizational forms are easier and less costly to maintain.  For example, if a Church decides just to create a separate 501(c)(3) organization then that subsidiary will have to comply with the extensive and costly requirements of receiving IRS tax-exemption approval (Form 1023), an annual tax return (990) will need to be filed, the organization will need to keep its finances separate from the Church (no commingling of monies), and observe all corporate formalities of having a separate Board that conducts regular board meetings with written minutes.  In conjunction with the time that will have to be devoted to the proper record keeping, the organization will also incur accounting and legal fees.

  1. A New Section 501(c)(3) Organizations

The first and most obvious option is for a Church to create a new separate non-profit corporation for a subsidiary.  Like the parent Church/Nonprofit, to qualify for tax-exempt status as a non-profit organization the subsidiary would need to meet the following four factors established by the IRS: 1) the organization must be organized and operated exclusively for one or more charitable purposes; 2) it must not allow for private inurement/benefit[1]; 3) no political activity and insubstantial amount of legislative activity (such as grass roots and direct lobbying, etc.) may not be a substantial part of its activities; and it must report and pay taxes on any unrelated business income (UBIT).[2]

Unlike a Church which automatically qualifies for tax-exemption with the IRS, a separate subsidiary organization is required to apply to the IRS for an exemption.  To do so, the subsidiary will have to complete and submit the lengthy and complex IRS Form 1023 and pay the application cost (currently $750) and respond to various questions and requests from the IR in order to achieve its favorable tax exempt determination.  Moreover, organizations required to file Form 1023 will also be required to file an annual renewal, Form 990 (unless gross receipts are typically less than $25,000/5,000 per year).

Therefore, establishing a subsidiary organized as a separate § 501(c)(3) organization provides all the tax-exempt benefits to the subsidiary that the Church/NP would have and would provide protection from liability to both the Church and the subsidiary.  But, the creation and maintenance of the subsidiary will require extra costs and administrative upkeep.

Using the above example of the church which operates a daycare and school, the daycare and school would be structured as one or two separate § 501(c)(3)’s.  The daycare and school would be required to satisfy all the requirements of § 501(c)(3), but could do so easily based upon their educational and religious purposes.  The subsidiary organizations would be tax-exempt, non-profit corporations and would therefore need to have their own Boards and comply with all IRS requirements, but all liabilities from the subsidiaries would be clearly separate from that of the parent Church/NP.

  1. Integrated Auxiliaries

Another option is the use of what is called an “integrated auxiliary.”  Although this structure can be very effective and beneficial, it has statutory requirements that limit its availability to very specific circumstances.  An integrated auxiliary must be a tax-exempt organization according to the IRS rules (listed above), it must be created and operated exclusively to serve a church or a convention or association of churches, and it must also be internally supported.

The sticky requirement is that the subsidiary be “internally supported.”  A subsidiary will be considered internally supported unless it offers admissions, goods, services, etc. to the general public (ie- not to the Church’s members), except on an incidental basis, and normally receives more than fifty percent of its support from any combination of governmental sources, public solicitation of contributions, and receipts from sale of admissions, goods, services, etc. in activities that are not unrelated trades or businesses.  Also, the IRS allows some organizations (men’s and women’s organizations, seminaries, mission societies, and youth groups) to be considered internally supported without demonstrating they meet the above test.

As an example, the church school/daycare mentioned above would likely satisfy the requirements of § 501(c)(3) and would also likely be internally supported.  Although the daycare and school receive monies from non-members, it does not market its services to the general public, and any public participation is on an incidental basis.  Thus, even if more than fifty percent of its support comes from receipts from the performance of services, the school would still be internally supported because it does no outside soliciting. To be doubly safe, the tuition may go directly to the church and then granted back to the daycare/school on a regular basis as needed for budgetary concerns.  If structured as an integrated auxiliary, the school would be automatically tax-exempt and would not have to file yearly tax returns.  There are many other considerations and possibilities to ensure a school meets the test that should be discussed with a knowledgeable attorney.

The great benefit to an integrated auxiliary is that it is exempted from applying for tax-exempt status (Form 1023), exempted from filing annual returns (Form 990), and exempted from filing tax returns upon dissolution.  The subsidiary organization can, in essence, “piggyback” off of the church’s tax exemption.  Like churches  integrated auxiliaries may also receive the benefit of restrictions on IRS civil tax inquiries and examinations, and therefore are generally not subject to the IRS’s typical procedure for tax inquiries and audits (though the IRS is loathe to audit a church or denominational related entities of any form without a specific complaint(s) alleging some form of egregious wrongdoing).

  1. Nonprofit LLCs

Many states, including Virginia[3] and Maryland[4] have recently passed laws allowing the creation of nonprofit LLC’s.  Using this structure and to be consistent with tax exempt purposes, the subsidiary would be created as a single-member LLC (SMLLC) and the Church/NP would be the sole member.  Like an integrated auxiliary, the LLC can obtain a derivative tax exemption, making it a “disregarded entity,” based upon the Church’s tax exempt status.

To be a “disregarded entity” the LLC’s activities must be consistent with the church’s exempt purposes under § 501(c)(3).  For the Church to form or participate in a nonprofit LLC, the enterprise must further the church’s charitable purposes, the governing documents of the LLC must permit the church to act exclusively in furtherance of its exempt purpose, the church must have more than fifty percent control over the LLC, the church must maintain sufficient control over managers (e.g.- right to terminate agreement), and the LLC must not be operated more than incidentally for profit.  If the LLC engages substantially in unrelated business, it could jeopardize the exemption of the church organization and the deductibility of any donations to the church or the LLC, and it would expose the church to unrelated business income tax (UBIT).  However, some unrelated activity can be strategically made related to the organizational tax exempt purposes with a creative and knowledgeable attorney and thus, avoid the tax and problem with losing its tax exempt status.

Instead of setting the LLC up as a disregarded entity, the Church may have the nonprofit LLC seek its own tax exemption under § 501(c)(3) to further strengthen its liability shield.  Such an election would mean that the LLC would be required to follow the aforementioned procedural and administrative requirements associated with a § 501(c)(3) organization.  One uncertainty though is whether a contribution to a non-profit LLC would be deductible.  The IRS has not yet specifically held whether a donation to a SMLLC is tax-deductible, though it appears that a gift to a Church’s wholly-owned SMLLC would be deductible. However, in most cases the substantial contributions could go to the parent church/NP as a designated gift who in turn would grant it back to the NPLLC thereby avoiding the deductibility issue altogether.

An organization that is disregarded for federal tax purposes is, in this instance, considered to be part of its church/NP, unless the LLC files for its own exemption.  If the LLC is treated as a disregarded entity, it is treated like a branch of the church/NP organization.  Thus, it need not file an application for recognition of tax exemption (Form 1023), nor need it file an annual return (Form 990) as the LLC’s income is included with the Church’s.  On the other hand, a nonprofit LLC that elects to obtain separate § 501(c)(3) status will be required to file the forms necessary for obtaining and maintaining the tax exemption, and is therefore more costly.

Choosing a nonprofit LLC (disregarded or separately exempt under § 501(c)(3)) as the means by which to organize a subsidiary also allows for manipulation of control.  The church organization may retain direct management of the LLC by creating what is called a member-managed LLC, give up most direct control by creating a manager-managed LLC (i.e.- like a board of directors), or blend the two types of management.  If the LLC’s operations will be similar to those of the church, then the church, since it already has a certain expertise, might be more inclined to organize the LLC as a member-managed company, allowing the experienced directors to put their knowledge to use (note: liability concerns may prevent or alter this analysis).  If, however, the LLC will be branching out into unfamiliar territory for the church, it might be a more prudent decision if the church structures the LLC as a manager-managed company, so as to allow the church to bring in more experienced directors for the new enterprise.

One drawback to using an LLC is the lack of legal precedents regarding their use.  So far LLC’s have been treated similar to other corporations, but it is unclear if courts would differentiate, especially when dealing with non-profit LLC’s.  There is a concern that if a Church is the sole member of an LLC that if a creditor were to bankrupt the Church, then the Creditor might be able to reach the subsidiary LLC.  However, under Virginia[5] law unlike Maryland law, it appears that in such a situation the Creditor could only get revenues that the LLC pays to the Church and could not reach the assets held.  Therefore, using an LLC as a property holding company seems to be an appropriate use because a holding company would not generate much profit and the Creditor would be unable to reach the holding companies assets themselves.

  1. Statutory Property Holding Companies

The IRS specifically allows a property holding company (IRS code 501(c)(2)) that can be used to hold multiple types of property, such as real estate, capital campaigns, endowments, intellectual property, literature and investments.  To qualify, though, a number of requirements must be satisfied.  The company must exist for the exclusive purpose of acquiring, holding, and collecting income from property.  Even though the church transfers its assets to the holding company, it must maintain control over the activities of the holding company in order for the holding company and property to maintain its tax exemption.  Also, the holding company must remit its income to the church organization; however, it is permitted to retain income to cover operating expenses, depreciation, and income that is applied to indebtedness on property to which it holds title, and up to 10% of extra income. Under the tax code property holding companies are viewed as separate corporations and are accordingly required to file an application for exemption (Form 1023), and annual tax returns (990).

Clearly, the most tangible benefit to establishing a separate holding company is the clear limited liability that results from such a structure.  By creating a property holding company, a nonprofit organization can separate its main assets, its property, from its riskier activities.  If the holding company is the record owner of the nonprofit’s assets but is unlikely to be vulnerable to massive liabilities, then the assets that the church transferred to the holding company will likely be protected from claimants and creditors of the church.  With regard to tax benefits, donations to property holding companies are not typically deductible, but donors could simply make designated gifts to the Church for the benefit of the holding company. It should be noted, however, for churches it is generally better to utilize an integrated auxiliary or non-profit LLC to hold property in order to avoid the IRS filings although for investment and endowments the church/nonprofit should consider this property holding company for greater clarity and protection.

  1. For-Profit Organizations

If a nonprofit, tax-exempt organization expands to include a substantial for-profit enterprise, it will likely lose its tax-exemption unless it organizes a subsidiary.  Creating a for-profit subsidiary allows a nonprofit organization to engage in numerous activities that would have been unavailable to a tax-exempt organization.  Any type of corporate structure (corporation, LLC, etc.) would likely be effective at isolating the church’s liabilities and assets in an appropriate manner.

Although the Church and subsidiary must be legally separate entities, the church organization may still receive profit from the subsidiary.  If organized as a stock corporation or LLC, for example, a subsidiary could sell all of its stock or member interest to its church, and distribute profits annually to the church by paying a dividend, which would be considered part of the church’s income but would not be taxable to the church or deductible by the subsidiary.  Other income transfers to churches, such as rent, interest, annuities, and royalties, will generally be taxable to the church as unrelated income (UBIT).

If properly organized and maintained, a for-profit, non-exempt subsidiary can allow a church to engage indirectly in revenue-generating activities unrelated to its tax-exempt purpose, receive monies from the subsidiary, and isolate the church’s assets from third party claims while maintaining tax-exempt status.  Another option, not fully discussed herein, is creating joint venture agreements between nonprofits and for profits under specific IRS guidelines to allow for such revenue and related activity to occur.  Again, one should bear in mind that knowledgeable legal counsel is essential in determining what entity best serves the needs of an organization, and what consequences necessarily follow from any such election.

  1. Corporate Formalities Must be Strictly Observed

Regardless of the choice of corporate structure listed above, a church must properly maintain the subsidiary as a separate legal entity throughout its existence, or else a court may find that the Church is liable for the actions or debts of a subsidiary (or vice-versa).  Such a finding by a Court is called “piercing the corporate veil” (“PCV”).  Courts employ this legal device when organizations do not properly establish policies or conduct their activities in a manner that evidences they are separate entities.

Courts have not established exact tests for deciding when PCV is appropriate.  They have, however, mentioned in many cases the types of behavior that will trigger a piercing.  A Church must be careful not to commingle funds with the subsidiary.  Meaning, the different organizations should keep separate financial records, bank accounts, and one organization’s funds should not be used for the benefit of the other.

As well, organizations must observe any formalities associated with the business structures involved.  For example, both the church and the subsidiary corporation should separately elect officers, conduct board meetings, keep independent financial records, and not have identical board members or officers.  It is recommended that no board members, but definitely no more than a slim minority of board members, overlap and that officers and employees are separate to insure the strongest shield.  Moreover, the Board for the subsidiary, especially any overlapping Directors, must not appear to neglect the interests of the subsidiary in order to focus exclusively on the interests of the church.   Such directors must take care to satisfy their fiduciary duty of loyalty and duty of care.   Courts have also looked to see if a subsidiary is properly financed or whether it seems designed merely to defraud any possible creditors.  If a subsidiary is improperly undercapitalized courts will PCV.

Finally, a Church must be careful not to promote the subsidiary relying solely upon the church’s reputation or represent to the public that the Church and subsidiary are one enterprise.  Court’s will not allow an organization to deceive the public via misleading advertising practices.  To avoid such an outcome, the organizations should manage their advertising and public relations in order to accurately represent their true relationship, such as a family of ministries or closely partnering together for common purposes.

8.   Substantive Bankruptcy Consolidation

The above considerations are some ways an organization can minimize the risk of PCV.  Many of those methods also apply in considering the likelihood of bankruptcy consolidation.  With bankruptcy consolidation, courts will consider the divisibility of corporate assets and liabilities, whether there are consolidated financial statements, the profitability of consolidation at a single physical location, the unity of interests and ownership between the various corporate entities, the existence of church and inter-corporate guarantees on loans, and the transfer of assets without observance of corporate formalities.  If a court orders substantive consolidation for either a church/NP or subsidiary in a bankruptcy proceeding, the creditors of the bankrupt organization will be able to satisfy their claims against the other organization that has funds.  Thus, in order to avoid such an outcome, a Church/NP should maintain the proper corporate formalities and finances to evince that the subsidiary is legally separate from the church.

  1. Summary

As should be evident from the above, a proper organizational structure is necessary but must be chosen wisely.  The subsidiary structure best suited for any given organization depends on the purpose, priorities, potential liabilities, and number and size of assets of the church.  The first move is for a Church to ensure that its Church is properly incorporated.  Then, a Church should assess the possibility of establishing any subsidiary organizations.  The Church should analyze whether it has significant assets: property, money, investments or buildings; or potential liabilities, such as active ministries connected to the Church like a school, daycare, thrift store, seminary, etc.

Once a Church realizes it needs to explore the possibility of establishing a subsidiary, it should seek legal advice from an attorney knowledgeable in corporate, liability/risk management and tax-exempt law.  A knowledgeable attorney can assist a Church in selecting the proper structure and also ensure that the subsidiary organization and Church are properly connected to each other in a way that complies with State law and the tax code.



[1] Private Inurement/Benefit Doctrine.  Section 501(c)(3) also indicates that an organization claiming exemption under that provision must not have any part of its net earnings benefit a private shareholder or individual (whether directly or indirectly affiliated with the organization).  Treasury Regulation 1-501(c)(3)-1(d)(1)(ii) specifically says that an organization “is not organized or operated exclusively for [exempt purposes] unless it serves a public rather than a private interest.”

[2] Unrelated Business Income.  Although commercial activity is permissible provided that the activity does not fail the “operational test,” if an organization engages in activities unrelated to its charitable purpose, the income from such activities will be taxed as unrelated business income.  If such unrelated business activities compose a substantial part of the organization’s activities, it could lose its tax-exempt status.

[3] Va. Code Ann. §13.1-1008 (2006)

[4] Md. Corporations and Associations Code Ann. §4A-201 (2006)

[5] Note:  Maryland law is different and does not provide as much protection to LLC’s.