When Should a Nonprofit Become a For-Profit

February 15, 2013

As a nonprofit organization, you hold coveted IRS tax-exempt status, can accept grants and donations, and enjoy the public perception of benefiting the community. Why would you give that up and become a for-profit business?

Some nonprofits are finding that their particular field and constituents are better served by a for-profit status. Reasons may be that additional revenue is needed to support the mission and the best opportunities are in for-profit pursuits.

Others find that changing status frees them but doesn’t affect their revenue sources at all. Some are seeking further investment to grow, and nonprofits can’t accept equity capital with ownership strings.

One common sector where this is happening is health care. In recent years, numerous hospitals and other types of health services are giving up nonprofit status and privatizing.

These new companies are perceived to operate more leanly and efficiently, like a business. Since healthcare organizations are funded by Medicare, Medicaid, insurance reimbursements and individuals, switching status doesn’t affect their revenue streams.

Private health care has readily found investors, both individuals and businesses, who believe that treating the sick can and should generate a profit. Because their constituents need them, these organizations thrive despite public unease about bottom-line concerns affecting patient care decisions.

Many nonprofits are struggling, especially during this prolonged recession and the corresponding decrease in charitable giving. Grants are scarcer and more competitive. Adding a reliable revenue stream can be a viable option.

The key issue is whether the net income is determined to be related to your primary purpose. If not, it is called unrelated income, and it will trigger tax issues and, worse, can jeopardize tax-exempt status.

Questions to Ask

1. How will changing status affect our revenue streams?

2. What will be the impact on mission delivery and public perception?

3. Do you have an opportunity to generate revenue? If so, is the income related or unrelated to your primary purpose?

4. If you convert, what is your asset disposition plan?

Some nonprofits generate income by incorporating services into a business activity. An example is a workforce development organization operating a restaurant serving as a job training center. You might be able to create that type of mini-business under your umbrella.

If not, many nonprofits form for-profit entities that feed profits back to the original nonprofit. These are called wholly owned for-profit subsidiaries. Many groups and organizations set up these subsidiaries to offer a form of their existing services or products to a paying audience. This way existing expertise can be leveraged.

Examples include a feeding program creating retail meals; a vehicle donation nonprofit operating a used car lot; and a special education organization offering paid tutoring services.

These programs are related to the primary organization’s mission, so they qualify as related income and are not subject to taxes.

Changing your tax-exempt status or adding a subsidiary requires qualified legal and accounting advice. All possible legal, tax and economic ramifications must be examined so that you make sound decisions and carry them out properly.

Thorough financial projections forecasting the effects of the change need to be prepared for your board of directors, who will then vote. Besides any changes in revenue sources, a key issue is disposition of assets. Some nonprofits are required to donate their assets upon dissolution. Otherwise you will need to purchase them at fair-market value.

State law affects how you value assets and what happens to the cash generated when they are sold to the for-profit. For instance, Maine requires independent appraisals, public access to the conversion plan, and a distribution of asset proceeds to a foundation or public benefit for organizations with assets of more than $50,000. Those with assets under $50,000 must file with the attorney general and provide a plan to dispose those assets at fair market value to another charity.

The state regulates how you convert – whether you just need to amend articles of incorporation or dissolve and start over. Your state attorney general has the authority to approve your conversion request. If it is not approved, you will need to get court approval. In cases involving health insurance, some states have refused to allow conversions because of concerns about enrichment of individuals in the succeeding business and the impact on sick or poor policyholders, many of whom were going to be denied coverage.

If your conversion is approved, the IRS will need to be notified via a statement of nonprofit conversion that includes your plan and asset value and disposition. Tax returns will also need to be filed. IRS Publication 4779 provides guidance on the steps and forms required.