As corporations explore how best to address the current crisis—both health and economic—posed by COVID-19, many are looking to utilize their existing affiliated private foundations. Funded from corporate revenues, these foundations are able to make donations to the people and organizations that need the greatest support during the pandemic and ensuing recession. Unfortunately, foundation capital will, by definition, be more limited, given that foundation budgets usually represent an expense line on a company’s balance sheet. Therefore funding will likely be reduced, as a result of either a reduction in overall revenues or a reduction in the percentage of revenues budgeted to enable companies to focus on critical internal operations (particularly retaining its employees).

One solution that can be either neutral or accretive to a company’s balance sheet is the establishment of an affiliated public charity. The public charity can be a stand-alone 501(c)(3) tax-exempt organization (noting that the application and Internal Revenue Service (IRS) review time can be six to nine months, or longer given the current environment) or a project or non-profit corporation that is fiscally sponsored by an existing 501(c)(3) public charity.[1] As distinct from a foundation, the public charity must have a diversity of funding so that it can meet the “public support” test, which means that the majority of funding should not come from the affiliated corporation.[2] Two viable options for corporations to meet this test in the short term (avoiding months or years of fundraising) are:

• Securing philanthropic donations from a consortium of companies in an industry (e.g., retail, technology);[3] and/or
• Restructuring sales to customers and/or licenses to end-users such that a few cents on the dollar from every purchase will be donated directly to the public charity.

The public charity can accept grant funding and then engage in commerce with the affiliated corporation, effectively serving as a division of the corporation that either provides the same goods and services to the “public” sector at a lower price (or for free) or provides complimentary goods or services. This will be particularly valuable now for corporations that have oversupply and a public sector that has greater demand (with limited means to pay). The key to protecting against claims of private inurement/private benefit (IRS rules that prohibit the public charity from being established to benefit the corporation affiliate or any for-profit entities) is to ensure that (1) the two affiliated entities do not directly compete, (2) the flow of funds, IP, goods, and services between the two affiliated entities is documented by contract, (3) all payments made by the public charity for resources provided to the affiliated corporation are at cost or below market (and all payments made by the affiliated corporation to the public charity are at or above market), and (4) there are at least two disinterested board members for each of the public charity and the affiliated corporation to negotiate and approve all agreements and arrangements between the two. Before we provide a summary of the legal issues and best practices, as set forth below, a few current examples of this “hybrid” model include:

• For-profit technology company with affiliated public charity that licenses technology solutions from the affiliated corporation (paying revenue-based royalties at slightly below market) and then on-licenses to entities in the public sector (governments, schools, relief organizations) at below-market rates.
• For-profit bookseller with affiliated public charity hiring staff from bookseller to provide events and lectures, some of which are held in the bookstore.
• For-profit software company that collects and aggregates data (including climate data) with affiliated public charity that licenses the climate data and develops applications for use by NGOs in mitigating climate change.
• For-profit provider of meals with an affiliated public charity providing capital equipment to retrofit kitchens to allow them to accept delivery of the meals.

There are several legal issues and best practices related to the governance of this hybrid structure:

• Functions of Entities. The entities must maintain a clear distinction between the function of the non-profit and for-profit such that the purpose and activities of the non-profit do not primarily operate for the financial benefit of the for-profit. For example, the non-profit cannot function primarily as a product or service distribution arm of the for-profit. The mission of the non-profit entity should be clearly defined and tailored to one or more of the charitable purposes set forth in Internal Revenue Code section 501(c)(3).[4]
• Tax Exemption for Public Charity. To become a tax-exempt entity, the non-profit can enter into a fiscal sponsorship with an established tax-exempt non-profit or file a Form 1023 with the IRS to become a stand-alone tax-exempt organization. The non-profit must ensure that (1) it is not generating revenue from commercial activities that do not primarily serve its tax-exempt purpose(s), (2) it is meeting the public charity “public support” test, and (3) it is not creating impermissible private benefit or private inurement to insiders or the for-profit. If the IRS determines private inurement has occurred, the entity can be required to pay substantial excise taxes.
• Disinterested Management. While the members of the boards of both entities may overlap, each board should include at least two and preferably a majority of members who are disinterested with respect to the other entity. These disinterested directors may form special committees to approve agreements or transactions between the entities, ensuring that they are negotiating and transacting with each other at an arm’s-length distance.
• Inter-Entity Agreements. The non-profit and for-profit entities may contractually share resources, services, IP, or personnel through inter-entity agreements that must be negotiated at an arm’s-length distance and must be able to be amended easily over time. These payments can include fair market value royalties paid pursuant to license agreements. Payments should be structured so as not to generate unrelated business income tax to the non-profit. The entities must track and document the flow of funds, the flow of services and resources, and the flow of intellectual property between them. Management should be required to report on the flow of funds, services, and intellectual property to the special committee on a quarterly basis to allow for amendments as the hybrid evolves over time.
• Compensation to Non-profit. The non-profit entity must receive at least fair market value for anything it provides to the for-profit, which ensures the non-profit does not violate any private inurement or private benefit rules.
• Employee Sharing. Employees can be dually employed by both entities, but they must be compensated by each entity in accordance with the time worked for such entity. Employees can also be employed by one entity then “leased” to the other entity, although such arrangements should be structured to avoid unrelated business income tax to the non-profit. The mindful structuring of employment arrangements for employees to work for/at both entities is important to prevent the “brain drain” effect in which employees at the non-profit will gradually shift into the for-profit because of higher salaries and equity incentives, leaving high employee turnover and low morale at the non-profit entity. Compensation for employees at the non-profit would be limited to some degree by the standard IRS reasonable compensation requirements. Also, any “disqualified persons” at the non-profit who are also or later employed by the for-profit may be subject to compensation restrictions.[5]
• Executive Compensation Limits. Compensation for executives of the non-profit is limited to a reasonable level as compared to other similarly situated non-profits. Directors and executives may be subject to penalty excise taxes if they receive excessive benefits from a non-profit. It is advisable to avoid sharing executives; if they are shared, any dual employment relationship should be negotiated by disinterested individuals with the entities represented by separate legal counsel. No IRS limits apply to compensation paid to persons solely employed by the for-profit entity.
• Maintenance of the Hybrid Structure. The entities should consider engaging separate law firms, independent accountants, and different valuation experts due to the multi-stakeholder negotiations inherent in this structure. It is also good practice to hire a sophisticated chief financial officer and finance team to manage the relationship and the flow of funds, assets, services, and resources.

[1] List of potential fiscal sponsors can be found here: http://www.fiscalsponsors.org/.

[2] There are two tests for public support, either of which a public charity must meet: (A) the organization receives a substantial part of its support in the form of contributions from publicly supported organizations, governmental units, and/or the general public; or (B) the organization receives no more than one-third of its support from gross investment income and more than one-third of its support from contributions, membership fees, and gross receipts from activities related to its exempt functions.

[3] Careful attention should be paid to anti-trust considerations, which must be addressed in structuring the consortium and its funding mechanism.

[4] Options include charitable, scientific, educational, religious, literary, and public safety testing purposes. Charitable purposes include relief of the poor, the distressed, or the underprivileged, lessening the burdens of government, eliminating prejudice and discrimination, defending human and civil rights, and combating community deterioration or juvenile delinquency. See: https://www.irs.gov/charities-non-profits/charitable-organizations/exempt-purposes-internal-revenue-code-section-501c3.

[5] See: https://www.irs.gov/charities-non-profits/charitable-organizations/disqualified-person-intermediate-sanctions.

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