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March/April 2018

The Tax Cuts and Jobs Act Joint Ventures

403(b) Plan Investment Options

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March/April 2018Volume 29, Number 5

THE TAX CUTS AND JOBS ACT BRINGS NEW LAW FOR TAX-EXEMPT ORGANIZATIONS 3

BRUCE R. HOPKINS

TO PARTNER OR NOT TO PARTNER – 15IT’S AN EXEMPTION QUESTION

RON G. NARDINI, MENACHEM DANISHEFSKY, AND EKATERINA V. LYASHENKO

FUNDS, FEES, AND ANNUITIES – A GUIDE TO 403(b) INVESTMENT OPTIONS 23

DANIEL J. SCHWARTZ AND JEFFREY A. HERMAN

COLUMNS

CHARITABLE ASSETS 34ERIN BRADRICK

The Sale of Charitable Assets to a For-Profit to Further Exempt Purposes: The Legal Considerations

PUBLIC CHARITY 42CHRISTOPHER RAJOTTE

The Impact and Classification of Unuusal Grants on Public Charity Status

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Editors-in-Chief

Board of Advisors

Joseph E. LundySchnader Harrison Segal & Lewis

Philadelphia, PA

Sharon W. NokesThe Pew Charitable Trusts

Washington, DC

Barbara L. KirschtenWilmer, Cutler & Pickering

Washington, DC

James J. KnicelyKnicely & AssociatesWilliamsburg, VA

Michael S. KutzinGoldfarb & Abrandt

New York, NY

Stuart J. LarkHolme Roberts & Owen, LLC

Colorado Springs, CO

Deborah M. LernerWillig, Williamson & Davidson

Philadelphia, PA

Jerry J. McCoyWashington, DC

Suzanne Ross McDowellSteptoe & Johnson LLP

Washington, DC

Douglas M. MancinoSeyfarth Shaw LLPLos Angeles, CA

Patrick D. MartinNixon Peabody LLP

Rochester, NY

David S. RhineBDO SeidmanNew York, NY

Laura M. RivkinN.J. Dept. of Education

Trenton, NJ

Celia RoadyMorgan, Lewis & Bockius

Washington, DC

Stephen SchwarzHastings College of Law

San Francisco, CA

John C. StophelChambliss, Bahner & Stophel, P.C.

Chattanooga, TN

Scott TaylorUniversity of New Mexico

School of LawAlbuquerque, NM

Jeffery L. YablonPillsbury Winthrop Shaw Pittman LLP

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Ronald AucuttMcGuire Woods, LLP

McLean, VA

Wendell R. BirdBird & LoechlAtlanta, GA

Milton CernyMcGuireWoods LLPWashington, DC

Thomas E. ChomiczQuarles & Brady LLC

Chicago, IL

Gregory L. ColvinSilk, Adler & ColvinSan Francisco, CA

Dominic L. DaherUniversity of San Francisco

Harvey P. DaleNew York University School of LawCadwalader, Wickersham & Taft

New York, NY

William A. DylewskyDylewsky & Goldberg

Stamford, CT

Joseph E. GreifNeimark & NadelWashington, DC

D. Greg GollerKPMG

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Barry J. HartWinston & StrawnWashington, DC

Deborah A. HerringtonDeloitte & Touche LLP

Stamford, CT

Frances R. HillUniversity of Miami School of Law

Coral Gables, FL

Bruce R. HopkinsBruce R. Hopkins Law Firm, LLC

Kansas City, MO

Christopher M. JedreyMcDermott, Will & Emery

Boston, MA

Elizabeth J. KingsleyHarmon, Curran, Spielberg &

Eisenberg, LLPWashington, DC

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Historically, the majority of sales of substantial chari-table assets to taxable entities have occurred in the con-text of conversions of nonprofit hospitals and schoolsto for-profit entities, 1 but that trend seems to have beenchanging recently. Increasingly, there has been a blur-ring of the line between the nonprofit and for-profitsectors, with rising numbers of social enterprise ven-tures run by nonprofits, joint ventures between non-profits and for-profits, and for-profit entitiesestablishing affiliated nonprofits. For-profit entities aremore frequently seeking to differentiate themselvesand generate goodwill by self-identifying as sustainablebusinesses or social enterprises, and social entrepre-neurs are expressing sector agnosticism as they seekthe most effective and efficient way to accomplish theirgoals. With these changes, it is unsurprising that thereis also an increase in the frequency of nonprofit entitiesconsidering a sale of significant charitable assets, or allof the assets related to a certain program or set of pro-grams, to a for-profit entity.

These transactions are occasionally motivated pri-marily by financial considerations, such as when anonprofit is seeking to convert to a for-profit entity orwhen a nonprofit has developed an asset or programthat is inherently attractive to a for-profit purchaser.Sales are also sometimes motivated by a nonprofit’s de-sire to wind down its affairs where it holds assets thatmay not be particularly attractive to other nonprofits..

However, nonprofit sales of assets to for-profit en-tities that are motivated primarily by mission align-ment and accomplishment of the nonprofit’s exemptpurposes are becoming more frequent. For example,some nonprofits have come to the conclusion that theoperation of their programs within a for-profit entitywould be likely to lead to increased and scaled chari-table impact in a way the nonprofit seems unlikely tobe able to accomplish on its own. Nonprofits that havearrived at this conclusion have then gone on to inde-pendently identify for-profit entities that are mission-aligned and have sought competitive bids frominterested parties. Other nonprofits have entered intocontractual transactions with for-profit entities oper-ating in the same space, and, over time, such partner-ships have organically led to discussions of a potentialsale of the nonprofit’s assets to the for-profit entity.

The sale of charitable assets held by an organiza-tion recognized as exempt under Section 501(c)(3) toa for-profit entity raises legal issues at both the federaland state levels, and is potentially subject to oversightby the IRS and the relevant state charity regulator. Thisarticle lays out some of those potential legal consider-ations, and assesses how they may apply to such trans-actions, particularly where motivated primarily by thenonprofit’s desire to further its exempt purposes.

State nonprofit law considerationsDirectors’ fiduciary duties. In the context of thesale of a nonprofit’s assets to a for-profit entity, thefiduciary duties the directors owe the nonprofit, in-cluding the duties of care2 and loyalty,3 do not nec-essarily dictate a particular outcome or specific termsof such transaction. They do, however, mandate thateach director act in a manner that he or she reasonably

ERIN BRADRICK is Senior Counsel at NEO Law Group in San Fran-cisco, where her practice focuses on corporate, governance, charitabletrust, and tax matters solely for nonprofits and exempt organizations.In 2017, Erin was awarded the American Bar Association’s “On theRise – Top 40 Young Lawyers” by the ABA Young Lawyers Division.Prior to joining NEO Law Group, Erin was a litigation associate withSimpson Thacher & Bartlett LLP and also clerked for the HonorableDana M. Sabraw in the United States District Court for the SouthernDistrict of California. Erin is a graduate of UCLA and Yale Law School.

CHARITABLE ASSETS

THE SALE OF CHARITABLE ASSETS TO A FOR-PROFIT TOFURTHER EXEMPT PURPOSES:THE LEGAL CONSIDERATIONSERIN BRADRICK

34 taxation of exempts March/april 2018

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believes to be in the best interests of the nonprofit,and puts the interests of the nonprofit above thoseof any other entity or individual.

When negotiating the terms of a sale, directorsshould generally seek to get the greatest value in returnfor the assets being sold, consistent with their applica-ble fiduciary duties. However, this has the potential tocause tension when a director believes that the sale ofthe assets to a for-profit, and possibly a particular for-profit, is the most effective and efficient way to furtherthe nonprofit’s mission. For example, would it be in-consistent with the duty of loyalty for a director to sup-port the sale of charitable assets to the lower of twofor-profit bidders where he or she believes that suchpurchaser is more likely to use the assets in furtheranceof the nonprofit’s charitable purpose?

Charitable trust law. Nonprofits hold charitableassets in trust to be used in furtherance of the char-itable purposes for which they were raised, and gen-erally may not divert such assets for use in furtheranceof another purpose. For example, the Model Non-profit Corporation Act, Third Edition, states: “Prop-erty held in trust by an entity or otherwise dedicatedto a charitable purpose may not be diverted fromits purpose by any transaction under this [chapter]unless the entity obtains an appropriate order of[court] [the attorney general] specifying the dispositionof the property to the extent required by and pursuantto the law of this state on cy pres or otherwise dealingwith the nondiversion of charitable assets.”4

To be organized for the purposes specified in Sec-tion 501(c)(3) and satisfy the organizational test, a non-profit’s articles of incorporation or other appropriateorganizing document must also permanently dedicateits assets to be used in furtherance of the organization’sSection 501(c)(3)-consistent exempt purposes. In thecontext of a sale of charitable assets to a for-profit en-tity, this dedication requirement and the state doctrineof charitable trust typically require that the nonprofitreceive at least fair market value (FMV) in exchangefor any assets sold, and that the proceeds from the salebe used in furtherance of the charitable purposes forwhich the sold assets were held.

However, where mission alignment and probableuse of the assets by the for-profit purchaser to furtherexempt purposes are part of the motivation for the sale,it is not as clear whether accepting less than the highestoffer would be considered to be a violation of charita-ble trust. It is likely that most state charity regulatorswould view the transaction in light of all of the factsand circumstances.

For example, consider a situation in which one po-tential purchaser offers a set purchase price and is likelyto use the purchased assets in furtherance of its chari-

table purposes. Another offers slightly more moneyand is likely to use the purchased assets for an unre-lated purpose. A third offers slightly more money thanthe second, but will likely use the purchased assets todefeat the charitable purposes for which they wereraised. Would a state charity regulator view all of thefacts and circumstances and determine that acceptingthe first offer is consistent with the charitable trust ap-plicable to the assets being sold, even if the selling or-ganization could have received more for such assets?

Charity regulator review. Although the applicablerequirements vary from state to state, the sale ofcharitable assets, including by an entity subject tothe oversight of the respective state charity regulator,generally does not require prior review or approvalby such office. However, certain states have enactedlegislation requiring prior notice to be provided tothe Attorney General or another state regulatorybody before a nonprofit sells or otherwise transfersassets representing all or substantially all of the or-ganization’s current assets.

For example, the law applicable to California non-profit public benefit corporations requires such entitiesto provide notice to the Attorney General 20 days be-fore they sell, lease, convey, exchange, transfer, or oth-erwise dispose of all or substantially all of their assets“unless the transaction is in the usual and regularcourse of its activities or unless the Attorney Generalhas given the corporation a written waiver of [the ap-plicable] section as to the proposed transaction.”5

While California law does not define what consti-tutes “substantially all” in this context, the CaliforniaAttorney General has asserted that it has the full au-thority to review any transaction in which charitableassets subject to its oversight are being sold, to obtainall relevant information related to such transaction,and to take appropriate actions to remedy any breachof trust that occurs.6 In making this assertion, the At-torney General points to its broad statutory authorityto bring an action to enjoin, correct, obtain damages

chariTaBlE aSSETS 35 taxation of exemptsMarch/april 2018

Nonprofits holdcharitable assets intrust to be used infurtherance of thecharitablepurposes for whichthey were raised,and generally maynot divert suchassets for use infurtherance ofanother purpose.

1 Specifically, private foundations may be subject to the following ex-cise taxes and operating restrictions: A 2% tax on net investment in-come (Section 4940), prohibitions on self-dealing (Section 4941),minimum income distribution requirements (Section 4942), prohi-bition on excess business holdings (Section 4943), limitations onhigh-risk investment of foundation assets (Section 4944), and limi-tations on expenditures of foundation funds (Section 4945). Addi-tionally, while public charities can undertake certain insubstantiallobbying activities, private foundations cannot lobby at all. Section501(h).

2 Section 507. 3 Section 170(b)(1)(A). 4 Section 6104(b). 5 “For purposes of this title, the term ‘private foundation’ means a do-

mestic or foreign organization described in section 501(c)(3) otherthan” the organizations listed in subparagraphs (1) through (4) ofSection 509(a).

6 Section 509(b).


for, or otherwise remedy a breach of charitable trust,7

and its general authority to examine any Californianonprofit public benefit corporation at any time to “as-certain the condition of its affairs and to what extent,if at all, it fails to comply with trusts which it has as-sumed or has departed from the purposes for which itis formed.”8

If a California nonprofit corporation is required toprovide advance notice of a proposed sale to the stateAttorney General, it must submit to the Attorney Gen-eral a letter signed by an attorney for or director of thecorporation describing the details of the proposedtransaction; a copy of the resolution adopted by theboard of directors approving the transaction; currentfinancial statements; and its articles of incorporationand the formation documents for any other party tothe transaction.9 The Attorney General may also re-quest evidence of an independent appraisal or other-wise demonstrating that the sale price and terms arefair to the nonprofit.

In its Review Protocol with respect to such trans-actions, the California Attorney General lists exten-sive documents that should be obtained and reviewed,including any collateral or ancillary agreements; fi-nancial documents on which future earnings andFMV analysis may be based; relevant contracts thatmay affect value; employee contracts; information re-lating to ownership interests in the purchaser; and alldocumentation relating to the process by which theboard approved the proposed transaction.10 The Pro-tocol makes clear that the Attorney General primarilywill be reviewing the transaction to ensure no self-dealing or private inurement will occur, and that thenonprofit is receiving at least FMV in exchange forthe assets it is selling.11

In a similar document, the Michigan Department ofAttorney General states that its broad common law andstatutory authority to protect charitable assets in the stateextends to the sale of charitable assets.12 Although theMichigan Nonprofit Corporation Act does not explicitlyrequire notice to be provided to the Attorney General inadvance of the sale of a Michigan nonprofit’s assets, evenif substantially all of the assets are being sold, the AttorneyGeneral indicates on its website that the “sale or conver-sion of nonprofit entities to for-profit ones creates a riskthat charitable assets will be diverted for private benefit,”and because of “the risk to charitable assets, the Charita-ble Trust Section reviews these transactions.”13

The Review Process document issued by theMichigan Attorney General states that any party re-questing review by the Attorney General should sub-mit a lengthy list of documentation relating to theproposed transaction, including a narrative describingthe purposes and programs of the nonprofit, the cir-cumstances that led to the proposed sale, and the

process used to reach the terms of the proposed trans-action; copies of all bona fide purchase offers receivedby the nonprofit in the prior three years; copies of allnonprofit board and committee meeting minutes dis-cussing the proposed sale or the specific transaction;copies of the due diligence materials used by the boardor committee; information related to any related-partytransactions; copies of any ancillary agreements thatmay involve directors, officers, or key employees of thenonprofit; and information regarding how the pro-ceeds of the sale will be used.14

However, while both of these Attorney Generalguides emphasize the importance of ensuring that thenonprofit receives FMV in exchange for any assets itsells, neither addresses how mission furtherance may af-fect the terms of the transaction, or how the AttorneyGeneral would consider the nonprofit’s acceptance of alower offer by a potential purchaser that was more mis-sion-aligned. Rather, the California Review Protocol ex-plicitly states “[s]imply put, the charitable beneficiariesare entitled to receive maximum value for their assets.”15

Federal tax law considerationsPrivate benefit. Although Section 501(c)(3) does notdirectly mention private benefit, it does require anorganization to be organized and operated exclusivelyfor one or more purposes set forth in that Section.The associated Regulations provide that an organizationis not organized and operated exclusively for exemptpurposes within the meaning of Section 501(c)(3) ifit serves a private rather than public interest.16 Althougha 501(c)(3) exempt organization may provide benefitsto private entities or individuals, such benefits mustbe incidental, both quantitatively and qualitatively,to furthering the organization’s public purposes.17

In this context, qualitatively incidental meansthat “the private benefit is a mere byproduct of thepublic benefit.”18 Quantitatively incidental meansthat the private benefit must be insubstantial inamount when compared to the public benefit ofthe specific activity in question.19

When there is a sale of a 501(c)(3)’s assets to afor-profit entity, the 501(c)(3) will typically need toensure that it receives at least FMV in return for anyassets that it sells to avoid providing a prohibited pri-vate benefit to the purchaser. However, a finding ofprivate benefit does not necessarily require that a501(c)(3) receive less than FMV for goods or servicesthat it sells, or make payments for goods or servicesthat it purchases that are more than FMV. Rather,the question is generally whether the 501(c)(3) isproviding a substantial benefit to a private individualor entity. Any scrutiny of such a transaction wouldlook to whether it was engaged in and structured for

chariTaBlE aSSETS36 taxation of exempts March/april 2018

Certain states haveenacted legislation

requiring prior noticeto be provided to theAttorney General or

another stateregulatory body

before a nonprofitsells or otherwise

transfers all orsubstantially all ofthe organization’s

current assets.


the benefit of the 501(c)(3) and to further its exemptpurposes, or primarily for the benefit of the for-profit purchaser.

Private inurement. Section 501(c)(3) describes an or-ganization organized and operated exclusively forone or more of the purposes set forth in that Section,“no part of the net earnings of which inures to thebenefit of any private shareholder or individual.”20

The corresponding Regulations provide that an or-ganization is not operated exclusively for one or moreexempt purposes within the meaning of Section501(c)(3) if it permits its net earnings to inure to thebenefit of private shareholders or individuals.21 Inthis context, a private shareholder or individual issomeone who has a personal and private interest inthe activities of the organization, referred to as an “in-sider” of the organization.22 While there is no strictdefinition of “inure” in this context, it is generally un-derstood as providing unjust enrichment from theorganization’s net earnings or assets to an insider ofthe organization.23

In a substantial sale of a 501(c)(3)’s assets to a for-profit entity, the greatest risk of inurement exists whendirectors, officers, or other key employees of the sellingorganization have a financial interest in the purchaseror otherwise in the proposed transaction. As the IRS hasnoted,

…[t]here is no absolute prohibition against an exemptsection 501(c)(3) organization dealing with its founders,members, or officers in conducting its economicaffairs. However, any transaction between a section501(c)(3) organization and one or more individualswho control the organization, in which the individualsappear to receive a disproportionate share of thebenefits of the exchange relative to the exemptpurposes served, presents a possible case of prohibitedinurement.24

The risk of inurement may arise where a for-profit entity owned or controlled by an insider of thenonprofit or his or her family members initiates dis-cussions of a sale with the 501(c)(3). It may also arise

by virtue of the proposed terms of the transaction.For example, it may be customary in a for-profit ac-quisition of another for-profit entity for the acquir-ing entity to offer lucrative compensation packages,stock options, bonuses, or other benefits to the lead-ers of the to-be-acquired entity to incentivize thedeal. However, in the context of the purchase of a501(c)(3)’s assets, such offers may be viewed as al-lowing amounts that should have been paid to the501(c)(3) to instead improperly inure to the benefitof its insiders.

Excess benefit transactions. Even when a transactionin which insiders of the 501(c)(3) public charity havean interest does not rise to the level of private inurement,the excess benefit transaction rules may apply. UnderSection 4958, an excess benefit transaction is “anytransaction in which an economic benefit is providedby an applicable tax-exempt organization directly orindirectly to or for the use of any disqualified personif the value of the economic benefit provided exceedsthe value of the consideration (including the perform-ance of services) received for providing such benefit.”A disqualified person generally includes any personwho, at any time during the five years prior to the dateof the transaction involving the excess benefit, was ina position to exercise substantial influence over theaffairs of the organization, a family member of suchan individual, or an entity of which such a person con-trols 35% or more.25

A disqualified person who receives an excess ben-efit is subject to an initial excise tax equal to 25% of theexcess benefit.26 If the disqualified person fails to cor-rect the excess benefit transaction within the taxableperiod (the period between when the transaction oc-curs and the earlier of the date of mailing of a defi-ciency notice by the IRS with respect to the 25% taxor the date on which the 25% tax is assessed), he or shewill also generally be subject to an additional excisetax equal to 200% of the excess benefit.27 Wheneverthe initial tax is imposed on a disqualified person pur-


A 501(c)(3)organization willtypically need toensure that itreceives at least FMV in return for anyassets that it sells toavoid providing aprohibited privatebenefit to thepurchaser.

7 Section 509(a)(1). 8 Section 509(a)(2). 9 Section 509(a)(3). 10 Section 509(a)(4). 11 That is so because Sections 509(a)(3) and Section 509(a)(4) are

available only to a relatively narrow category of exempt entities. 12 Section 509(d); Reg. 1.170A-9(f)(7). 13 Exempt function income is income earned by the organization in fur-

therance of its exempt purposes, such as admission fees, sales ofmerchandise, performance of services, and furnishing of facilities.Reg. 1.513-1(d)(4)(i).

14 Reg. 1.170A-9(f)(6). 15 Reg. 1.170A-9(f)(3). 16 Included in the definition of disqualified persons are “substantial con-

tributors”—those who make contributions in excess of $5,000—iftheir contributions are greater than 2% of the organization’s overallsupport. Sections 4946(a)(1)(A), Section 507(d)(2).

17 Sections 4946(a)(2); Section 507(d)(2). 18 Sections 509(d)(1)-(6). 19 Regs. 1.170A-9(f)(4)(v); Reg. 1.509(a)-3(d)(2). 20 Reg. 1.170A-9(f)(4)(v)21 Regs. 1.170A-9(f)(4)(v)(B); Reg. 1.509(a)-3(d)(2). 22 Reg. 1.170A-9(f)(4)(vii). 23 That is the case even though the current regulations attempt to mit-

igate the effects of uncommon variations in the organization’s rev-enue stream by determining the qualification for public charity statusbased on a five-year snapshot.

24 Reg. 1.170A-9(f)(6)(ii). 25 Reg. 1.509(a)-3(c)(3). 26 Reg. 1.170A-9(f)(6)(ii). A similar analysis applies for analyzing

whether exempt entities that are initially classified as public charitiesunder Section 509(a)(2) continue to qualify as public charities aftertheir fifth year. Regs. 1.509(a)-3(c)(3)(i)-(iii).

27 Regs. 1.170A-9(f)(6)(iii); Reg. 1.509(a)-3(c)(4).


suant to Section 4958(a)(1), organizational managersof a 501(c)(3) (including any officer, director, or indi-viduals having similar powers or responsibilities) arealso subject to an excise tax of 10% of the excess ben-efit, up to a total of $20,000, if the managers willfullyand without reasonable cause approved the transac-tion knowing it was an excess benefit transaction.28

When a 501(c)(3) public charity engages in a saleof its assets to a for-profit entity in which a disqualifiedperson has a direct or indirect financial interest, it willtrigger consideration of the excess benefit transactionrules. To avoid providing an excess benefit, it will likelybe all the more important for the nonprofit to ensurethat it receives as least FMV for any assets that it sellsto a disqualified person or an entity owned or con-trolled by a disqualified person.

Specific transaction considerationsDetermining purchase price and terms of sale. Asmentioned above, to avoid providing a prohibitedprivate benefit, engaging in an excess benefit trans-action, or breaching the doctrine of charitable trust,the consideration to be provided in exchange forthe assets of a 501(c)(3) must generally reflect at leastthe FMV of such assets. Both the IRS and state At-torneys General have emphasized the importanceof obtaining an independent valuation of the assetsto be sold as a mechanism for ensuring FMV is ob-tained.29 Using external experts and processes tovalue the assets is particularly crucial where insidersof the nonprofit stand to gain from the sale in somemanner.

The IRS has noted that, where the sale is to an in-dependent third party in an arm’s-length transaction,

a presumption exists that the purchase price (arrivedat through negotiations) represents fair market value.However, where the purchaser is controlled by theseller (or there is a close relationship between thetwo) at the time of the sale, this presumption cannotbe made because the elements of an arm’s lengthtransaction are not present. In situations where thereis common control of or a close relationship betweenthe buyer and seller and both tangible and intangibleassets are being purchased, the value of the tangibleassets must first be established by independent ap-praisal.30Although stated in the context of a nonprofit’spurchase of the assets of a for-profit hospital, theprinciples also likely apply in the reverse situation.

The California Attorney General points to the def-inition of FMV set forth in the Code of Civil Procedureas instructive in the context of the sale of nonprofit as-sets to for-profits.31 That definition states that the

fair market value of the property taken is the highestprice on the date of valuation that would be agreedto by a seller, being willing to sell but under no

particular or urgent necessity for so doing, nor obligedto sell, and a buyer, being ready, willing, and able tobuy but under no particular necessity for so doing,each dealing with the other with full knowledge ofall the uses and purposes for which the property isreasonably adaptable and available.32

However, the definition also acknowledges thatcertain property may not have a widespread market bywhich FMV can readily be judged. This is often thecase where discussions of nonprofit sales of assets tofor-profits have grown organically out of prior mis-sion-furthering transactions and relationships be-tween the two entities involved. In such instances, thenonprofit’s primary assets of value are typically intan-gible assets, including developed technology, other in-tellectual property, and customer relationships. Thedefinition pointed to by the California Attorney Gen-eral goes on to state that the “fair market value of prop-erty taken for which there is no relevant, comparablemarket is its value on the date of valuation as deter-mined by any method of valuation that is just and eq-uitable.”33

A representative from a state charity regulator’s of-fice recently unofficially stated her understanding thatcertain assets will not have a readily available marketand their sale may not be the result of competing bidsfrom multiple potential purchasers. The representa-tive noted that obtaining an independent valuationfrom outside experts may not always be in the best in-terests of the selling nonprofit (for example, where thevaluation of difficult-to-value assets may be verycostly and the value of such assets is likely rather low).In either instance, the representative indicated that theoffice would expect a detailed explanation of all of therelevant factors leading to the proposed terms of thetransaction and would consider all such facts and cir-cumstances in its review.

In reviewing any sale of assets to a for-profit, theIRS or relevant state charity regulator is likely toscrutinize all of the terms and conditions of the salethat might affect its fairness and favorableness to thenonprofit, including any contingencies that mightinfluence the total purchase price, indemnificationprovisions, deferred payments, and noncompeteprovisions. Whereas installment payments, withpost-closing installments tied to future earnings,may be common in for-profit to for-profit acquisi-tions, they are likely to be viewed skeptically in thecontext of a for-profit’s purchase of a nonprofit’s as-sets, particularly if special protections are not inplace to prevent the purchaser from depressing post-closing short-term earnings or unfavorably allocat-ing costs or expenditures.34

Where the sale is not an all-cash acquisition andstock represents a significant portion of the purchase


Both the IRS andstate AttorneysGeneral have

emphasized theimportance ofobtaining anindependent

valuation of theassets to be soldas a mechanismfor ensuring FMV

is obtained.


price, additional issues affecting the stock value, in-cluding liquidity, restrictions on sale, control issues,potential future dilution, and voting rights, are alsolikely to be carefully scrutinized. Any such issues rela-tive to stock received in exchange for the sale may limitthe ability of the selling nonprofit to use the proceedsfrom the sale in furtherance of its charitable purposes.

In an instructive private letter ruling issued in 2013,which is discussed in further detail below, the IRS ex-amined the sale of all of the subject 501(c)(3)’s assetsto a related for-profit in exchange for a specified num-ber of shares of common stock in the for-profit en-tity.35 The IRS placed particular emphasis on the lackof an independent appraisal of FMV and the arbitrarydetermination of the purchase price, noting that thetransactions at issue “were not arms length, where thevalue of assets were arbitrarily determined by the boardof directors with no appraisal and those transactionsresulted in inurement.”36

However, there has not yet been any clear guid-ance about how mission alignment might affect theterms of such a transaction. If FMV is in part deter-mined based on the highest price that would beagreed to by a seller, does a nonprofit have the au-thority to accept an offer that is not the highest re-ceived from a potential purchaser who is more likelyto use the sold assets in furtherance of the nonprofit’smission, or to shop the assets only to such aligned en-tities in the first place?

While not dispositive in other instances, in a re-cent sale of substantially all of the assets of a Califor-nia nonprofit to a for-profit entity, the CaliforniaAttorney General did not object to the proposedtransaction, which included an all-cash purchaseprice within the range of a valuation of the intangibleassets to be sold by an independent, third party valu-ation firm. This was despite the fact that the sellingnonprofit had determined that the sale would bemore likely to maximize the long-term scalability andpotential impact of such assets and proceeded to self-identify potential purchasers. It evaluated them basedon each potential purchaser’s financial stability, abil-ity to scale the nonprofit’s current activities, presentinvestments targeted to achieve impact, and likeli-hood of success, and then solicited bids from threesuch identified entities.

Conflicts of interest. Where the terms of the trans-action may lead to financial benefits or arrangementswith the selling nonprofit’s directors, officers, oremployees, or their family members, particular at-tention will be paid to such potential conflicts of in-terest, especially if they may affect the overall benefitof the transaction to the nonprofit entity and/or theindividual’s objectivity in approving the transaction.

For 501(c)(3)s, such conflicts increase the risks ofprivate inurement and excess benefit transactions.

In the 2013 private letter ruling referenced above,the IRS made a final determination that the subjectorganization did not qualify for exempt status underSection 501(a) as an organization described in Section501(c)(3).37The organization at issue was formed forthe purpose of developing and delivering educationalcourses and programs to enhance the competitivenessof the automotive service workforce, and to developstandards in education and training for the automo-tive service industry. It applied for and received recog-nition of exemption under Section 501(c)(3). Itsubsequently formed a separate corporation with sim-ilar purposes, which it merged into, and continuedoperating the surviving entity with the disappearingentity’s employer identification number and tax-ex-empt status.

After several failed ventures involving contractswith for-profit entities, the organization was facing fi-nancial decline and decided to pivot its business modelto online training for automotive service technicians.However, on realizing that this would require signifi-cant capital infusion, might be unattractive to grant-making entities, and was possibly unrelated to itsexempt purposes, it formed a separate for-profit cor-poration to engage in such activities. The for-profit andthe nonprofit entered into a management servicesagreement, pursuant to which the for-profit made pay-ments to the nonprofit in the form of cash and stockin the for-profit.

Subsequently, the two entities entered into anasset purchase agreement pursuant to which the non-profit sold all of its assets, including contracts and ac-counts receivable, in exchange for a specified numberof shares of common stock in the for-profit entity. Amajority of the for-profit’s stockholders were the of-ficers and directors of the nonprofit and received acertain percentage of the shares of stock of the for-profit. The parties then entered into a stock redemp-tion agreement by which the for-profit agreed topurchase all of its shares held by the nonprofit, witha specified number of shares to be purchased each


When a 501(c)(3)public charityengages in a sale ofits assets to a for-profit entity in whicha disqualified personhas a direct orindirect financialinterest, it will triggerconsideration of theexcess benefittransaction rules.

28 Specifically, a relationship described in Sections 4946(a)(1)(C)-(G). 29 Reg. 1.509(a)-3(c)(4)(i). These factors are listed in the regulations un-

derlying the requirements for qualifying as a Section 509(a)(2) publiccharity. However, they are expressly incorporated into the analysisfor testing a Section 509(a)(1) charity. Reg. 1.170A-9(f)(6)(iii).

30 Id.31 Reg. 1.509(a)-3(c)(4)(ii). 32 Id.33 Reg. 1.509(a)-3(c)(4)(iii). 34 Reg. 1.509(a)-3(c)(4)(iv). 35 Reg. 1.509(a)-3(c)(4)(v). 36 Reg. 1.509(a)-3(c)(4)(vi). 37 Reg. 1.509(a)-3(c)(4)(vii).


month at a set price. However, when the for-profitwas later unable to meet its stock purchasing obliga-tions, the agreement was amended to cease paymentsto the nonprofit until such time as the for-profit hadsufficient cash flow to continue. When it did resumethe purchases two years later, it was at a significantlylower purchase rate per month. For five years afterthe sale of its assets, the nonprofit essentially had noactivities other than to hold the cash and stock re-ceived from the for-profit.

In the private letter ruling, the IRS determined thatthe relevant organization was not described in Section501(c)(3) because, by selling all of its assets to a for-profit entity in a transaction that resulted in private in-urement, it was not operated primarily for 501(c)(3)exempt purposes. In assessing the private benefit andprivate inurement, the IRS found that the benefits re-ceived by the for-profit were more than incidental andthe 501(c)(3) was operated as the instrument to subsi-dize the for-profit.

When applicable, state self-dealing statutes thatapply to transactions in which the nonprofit’s direc-tors or officers have a financial interest may also beimplicated where the sale of a nonprofit’s assets to afor-profit involves a potential conflict of interest. Forexample, in California, the self-dealing statute appli-cable to California nonprofit public benefit corpora-tions in part requires a transaction in which a directorof the nonprofit has a material financial interest to beapproved in advance by a good faith and informedvote of a majority of the directors then in office with-out counting the vote of any interested director, andthat the board considered and determined in advancethat the nonprofit could not have obtained a moreadvantageous arrangement with reasonable effortunder the circumstances.38 This “most advantageousarrangement possible” requirement may make itchallenging for a subject California nonprofit to ac-cept an offer from a purchaser that is not the highestoffer received where a director has a material finan-cial interest in the transaction, even if attempting toprioritize charitable impact.

Even if the transaction’s benefits are flowing to thenonprofit’s junior employees, rather than to its offi-cers, directors, or key employees, it may still raise con-cerns of prohibited private benefit. For example, if anonprofit accepts a lower offer from a purchaser whois willing to employ many or all of the nonprofit’s em-ployees, and therefore may be more likely to use suchassets to continue furthering their charitable purpose,over a higher offer from one who is not, it could raisethe question of whether such acceptance provides aprohibited private benefit to such individuals. If thecompensation and retention arrangements offered bythe potential purchaser are considered by the non-profit’s board of directors in approving the transac-tion, there may also be a question of whether suchterms affected the board’s objectivity or the carryingout of the directors’ fiduciary duties.

Use of sale proceeds. Regardless of the transaction’sfinal terms, the selling nonprofit will be requiredto use the proceeds from the sale in furtherance ofits 501(c)(3) exempt purposes and, short of a cypres action permitting otherwise, consistent withthe charitable trust restrictions on the assets thatwere sold. This may be accomplished by pivotingthe programmatic activities of the nonprofit toserve the same class of beneficiaries through a dif-ferent set of programs, or through a shift to grant-making to support consistent activities conductedby other entities. At the state level, if applicable,the Attorney General or other oversight body re-viewing the proposed transaction will expect tosee a description of how the nonprofit plans to usethe sale proceeds to continue furthering its charitablepurposes post-closing.39

To continue qualifying as exempt under Section501(c)(3), the selling nonprofit will also need to keepsatisfying the operational test and ensuring proper useof its remaining assets, including any proceeds fromthe sale. In a particularly egregious situation, the IRSrevoked the exempt status of a nonprofit under Sec-tion 501(c)(3) after it sold its assets to a for-profit en-tity and then failed to distribute the proceeds from thesale to another organization recognized as exemptunder Section 501(c)(3). Instead, it permitted the pro-ceeds to inure to the benefit of one of the nonprofit’sdirectors.40

While the prohibition of such direct inurement ofsale proceeds may be rather obvious, the IRS has alsonot looked favorably on a nonprofit merely sitting onsuch proceeds. In the 2013 private letter ruling dis-cussed above, the IRS rebuked the nonprofit’s asser-tion that its post-sale activities consisted of makinggrants to other tax-exempt organizations with similarpurposes, noting that, at the end of the five-year period


Where the terms ofthe transaction

may lead tofinancial benefitsor arrangementswith the selling

nonprofit’sdirectors, officers,

or their familymembers,particular

attention will bepaid to the

potential conflictsof interest.

38 Reg. 1.509(a)-3(c)(4)(viii). 39 Reg. 1.509(a)-3(c)(4)(ix). 40 Rev. Rul. 76-440, 1976-2 CB 58. 41 Reg. 1.509(a)-3(c)(6), Example 2. 42 Reg. 1.509(a)-3(c)(6), Example 3. 43 Reg. 1.509(a)-3(c)(6), Example 4. 44 Reg. 1.509(a)-3(c)(6), Example 5. 45 Reg. 1.509(a)-3(c)(6), Example 6. 46 Reg. 1.509(a)-3(c)(6), Example 7. 47 1976-2 CB 58. 48 In fact, due to the potential for uncertainty in determining whether a

contribution is an unusual grant, the regulations expressly authorizeprivate letter ruling requests for that purpose. Reg. 1.509(a)-3(c)(5).

49 See e.g. Ltr. Rul. 201239011; Reg. 1.509(a)-3(c)(6), Example 6 (note45, supra).


after the sale, a total of only two distributions had beenmade by the organization.41

Post-sale relationships. Ongoing relationships be-tween the 501(c)(3) and the for-profit purchaser ofits assets after the closing of the transaction can beparticularly problematic. Where such sales havegrown organically out of a prior mission-furtheringpartnership between the entities, it may be assumedthat the parties will continue in close collaborationafter the transaction. However, as mentioned above,the selling organization’s continued 501(c)(3) exemptstatus will be dependent on its continued operationin a manner that is consistent with the exemptionrequirements.

The 501(c)(3) cannot act merely as the exempt en-tity arm of or “simply the instrument to subsidize”42

the for-profit purchaser. Operating in a manner thatindicates a substantial private benefit, including bysteering business to a for-profit entity, may cause theorganization to fail to be operated primarily in further-ance of exempt purposes within the meaning of Sec-tion 501(c)(3). This is true even if any payments fromthe 501(c)(3) to the for-profit entity are reasonable inlight of what the nonprofit is receiving in return.43

Rather, as the Ninth Circuit Court of Appeals has held,in scrutinizing a contractual relationship between a501(c)(3) and a related for-profit, the central “inquiryis not whether particular contractual payments to a re-lated for-profit organization are reasonable or exces-sive, but instead whether the entire enterprise is carriedon in such a manner that the for-profit benefits sub-stantially from the operation of the” 501(c)(3).44

If the terms of the sale incorporate or assume that,post-closing, the nonprofit will be required to contractwith the for-profit purchaser for certain services or useof the sold assets, that will also be viewed suspiciouslyin any regulatory entity review. For example, the Cal-ifornia Attorney General Review Protocol states“[w]here sale proceeds are tied to the provision of serv-ices by the acquiring for-profit entity, they should becarefully scrutinized for necessity, valuation, and ver-ifiability. These provisions are always suspect.”45

The IRS has also noted the potential problems withsuch post-transaction contractual arrangements, par-ticularly where insiders of the selling entity have a fi-nancial interest in the for-profit purchaser or wherethe nonprofit does not maintain substantial ongoingexempt activities. In the 2013 private letter ruling, theIRS said that, following the sale of the nonprofit’s assetsto the for-profit, the entities also entered into an ad-ministrative services agreement pursuant to which the

nonprofit paid the for-profit a monthly fee to provideit with accounting and financial services, grant man-agement services, maintenance and security of histor-ical and official business, and other administrativeservices.46 In finding that the nonprofit was not oper-ated in a manner consistent with exemption underSection 501(c)(3), the IRS in part determined that theorganization’s post-transaction activities consisted pri-marily of making monthly payments to the purchaserfor administrative services, which resulted in a prohib-ited private benefit to the for-profit purchaser and in-direct private inurement to the common directors ofthe two entities.47 If disqualified persons of the selling501(c)(3) public charity are parties to such post-saletransactions, including if the purchasing entity is suf-ficiently controlled by disqualified persons and is itselfa disqualified person, the excess benefit transactionrules discussed above may also apply.

ConclusionSales of significant charitable assets by 501(c)(3) publiccharities to for-profit entities motivated primarily bymission alignment and accomplishment of the501(c)(3)’s exempt purposes are increasing in fre-quency. For example, 501(c)(3)s have independentlyreached the conclusion that certain charitable assets orprograms would be more likely to lead to increased andscaled charitable impact if operated by a for-profit en-tity, rather than by the 501(c)(3). Sale conversationshave also grown organically out of a prior contractualrelationship between a 501(c)(3) and a for-profit oper-ating in the same space.

As more 501(c)(3) entities engage in social enter-prises and seek to achieve impact through the develop-ment of technological or other tools, and as moreentrepreneurs seeking to have positive social influenceelect for-profit business models for doing so, it is likelythat there will be continued changes in the nature of,and motivation for, the sale of charitable assets to for-profit entities.

Such sales, regardless of motivation, raise signif-icant legal issues under both state and federal lawsand may potentially be subject to oversight or re-view by the IRS and the relevant state charity regu-lators. While many of the basic legal principlesapplicable to the sale of 501(c)(3) charitable assetsto for-profit entities are well-established, there re-main many open questions as to how and underwhat conditions such sales may be structured whena substantial or the primary motivation is to furtherthe selling 501(c)(3)’s exempt purposes. �



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