Nonprofit attorneys are advising clients to consider a strategy that would let them use losses to offset taxable income across their organizations, after the IRS proposed changing reporting rules.
In April, the IRS proposed rules that require individual businesses controlled by nonprofits to report the income separately. That practice, known as “siloing,” changes the ability for a nonprofit to use net operating losses (NOLs) in one business to another to decrease the nonprofits’ overall tax liability.
As a result, some tax lawyers are suggesting that their nonprofit clients create C corporations within their organizations to combine those unrelated business lines and avoid the siloing requirement. The idea comes as nonprofits like trade associations, colleges, universities, and hospitals are scrambling for cash from every available source as the coronavirus pandemic wreaks havoc on the U.S. and global economies.
Under a C corporation, nonprofits could merge different business lines and report the income they generate in a single report, avoiding the siloing rules and more importantly, taking advantage of tax breaks for the NOLs currently piling up.
The IRS is allowing nonprofits to aggregate NOLs across silos generated prior to 2018. But the agency is directing them to separate NOLs according to each business silo arising in taxable years after 2018, according to FAQs released in early June.
“If they are generating losses now, those are going to stay siloed unless they’re being generated in a C corp. that isn’t subject to those silo rules,” Ofer Lion, a partner at Seyfarth Shaw LLP said.
Establishing a C corporation, however, comes with its own potential regulatory pitfalls. It must have a board of directors and bylaws, as well as plans for overhead costs and limitations on deductions that may make the option unattractive to smaller nonprofits with fewer dollars on hand.
But for large nonprofits that already have a C corporation under their wings, adding unrelated businesses to that entity to capture tax benefits may make sense.
Lion said some universities that already have a corporate subsidiary in place are mulling the option to shift unrelated businesses into that organization.
Under a C corporation, the merged businesses would have to share accounting costs that would be “inevitable,” Lion said.
“You talk to the CFO or treasurer, and they will quickly remind you that there is much more cost and work involved,” Lion said. “You set the thing up, that takes you a couple days, and then I have to deal with this thing for the rest of my life—that’s their take on it.”
Christopher Moran, an associate at Venable LLP, said his team has been proposing the C corporation structure to clients since the proposed rules were released.
His advice to clients: Carefully consider the option because there is a risk of losing tax-exempt status on many activities, which could yield more problems than benefits.
The idea has generated interest from some clients, he said, but most have declined to pull the lever because the rule is still in the proposed stage and the provisions may change. He also said it’s likely nonprofits will wait a few years to apply the silo rules to see if they need to change tax strategies.
“Maybe in a couple years, when they’ve done a couple more tax returns applying the silo rules, they might think of ways to simplify the return filing process,” Moran said. “But it probably hasn’t been top of mind for a lot of clients.”