Section 501(c)(2) Tax-Exempt Title Holding Corporations: The Good, the Bad, and Other Options

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The Problem of Risk to Nonprofits

Lawyers often advise to “separate valuable assets from risky activities.”  It’s a legal maxim with which nonprofit directors and officers should be familiar. Keeping valuable assets away from risky activities may provide an organization with protection in the event of a lawsuit or other liability.  Exempt organizations have sometimes used  501(c)(2) title-holding corporations or other tax-exempt corporate structures to provide such protection.  Nonprofit leaders should be aware of the protections available through such risk management options.

Consider the following scenario: A terrible accident occurs on the grounds of a nonprofit preschool.  Multiple parties later sue the preschool for accident-related injuries.  The preschool has substantial and valuable real property holdings.  If the preschool is held liable for damages resulting from the accident, the outcome for the church may be catastrophic.  The organization’s insurance protection may be stretched beyond policy limits.  If the insurance coverage limits are reached or portions are outside the scope of the coverage itself, the organization is ultimately responsible.  In a worst-case scenario, a court may order liquidation of the organization’s real property to pay the judgment. 

Mitigating Risk and Other Benefits – the 501(c)(2)

Dating back to 1916, Congress has provided nonprofit entities with a means to mitigate risk.  Presently, the 501(c)(2) title-holding corporation provides such protection.  A 501(c)(2), like its section 501(c) siblings, is exempt from federal income tax.  The (c)(2), however, has a single limited purpose:  to hold title to property on behalf of another exempt entity.  A (c)(2) is generally controlled by a parent tax-exempt organization, and the (c)(2) holds title to property (which can be real, personal, or intellectual property), which may be used for the parent’s exempt purposes.  Income from the (c)(2) passes to the parent.   In theory, if the parent organization is sued, as in the above example, its liability from potential damage suits should be limited to the organization itself, and not the separate legal entity that holds title to the property held.  In reality, the limitation of liability will depend on several variables, such as proper legal structuring of the entities and the organizations’ observance of corporate formalities.  Before structuring such an arrangement, interested entities should consult with experienced legal counsel.   

Beyond the limitation of liability, the IRS has identified the following additional benefits of the 501(c)(2): 

·      enhancement of ability to borrow;

·      limitations imposed in gifts and bequests to exempt organizations that effectively require such gifts to be kept in separate entities;

·      clarity of title;

·      accounting simplification; and

·      limitations imposed by various state laws on organizations that would be recognized as exempt under the federal revenue laws.   

See 1986 EO CPE Text, C. IRC 501(c)(2) - Title-Holding Corporations at 2, “Background.” 

            A further advantage of a (c)(2) is that only its net income may be available to creditors.  Nonprofits thus may use a (c)(2) to protect certain revenue streams from access by creditors, which may be a very valuable benefit.

Narrow Focus

Organizations that consider the benefits of utilizing a 501(c)(2) should also carefully evaluate their limitations.  First, a (c)(2) may not operate a trade or business.  That’s true even if the business is conducted in the building to which the (c)(2) holds title.  According to the IRS, “Where the active operation of any business other than the rental of real estate has been involved, exemption has consistently been denied.”  Accordingly, the charter statement in the (c)(2)’s articles of incorporation should specifically restrict its corporate purposes to comply with 501(c)(2).  Qualified legal counsel should be consulted in the drafting of such articles.  Where the scope of the organization’s activities are not appropriately limited,  tax exemption may be denied.

Potential Alternatives

Though the 501(c)(2) provides risk diversification, it is not always the best vehicle for nonprofits to utilize.  Often, a nonprofit will elect to establish a supporting organization under 501(c)(3) to hold title to property for risk management purposes.  A supporting organization does not carry the same purpose and operational limitations imposed under (c)(2).  Further, the c(2) is generally not a good choice for religious worshipping bodies, like a church, mosque, or synagogue. To elaborate, the federal regulations that exempt certain controlled or closely affiliated organizations of religious institutions from also filing Form 990 do not specifically cover 501(c)(2) organizations.  For this reason, many religious institutions have strategically elected to utilize a supporting organization under (c)(3) or a limited liability company, both of which, if structured properly, can qualify as exempt from filing Form 990 and from having to file an application with the IRS for recognition of tax-exempt status. 

Nonprofit leaders, with the advice and counsel of qualified legal professionals, should carefully vet the advantages and disadvantages of various risk-management structures.  Furthermore, organization leaders must remember that establishing the proper corporate structures is only the beginning of a successful risk-diversification process.  Care must be taken through the organization’s life to ensure that proper corporate formalities are followed.  Otherwise, courts may allow creditors to “pierce the veil” and allow access to valuable corporate assets.

The adoption and use of a 501(c)(2) title-holding corporation may serve as a valuable tool for tax-exempt organizations for helping protect organizational assets. The formation of such an entity, however, requires careful evaluation of the (c)(2)’s purposes and limits.