by Justin Boyd
NBIA throws around the term "nonprofit incubator" a lot. But what does it mean to be a nonprofit organization? Exemption from U.S. federal income taxes, to be sure, but it's hardly as simple as that. Tax status is an integral part of a nonprofit incubator's identity, creating opportunities on the one hand, but establishing limitations on the other.
The ramifications of different types of tax status can be quite complicated, even for a stand-alone incubator. They can range from an inability to raise adequate amounts of program funding to restrictions on equity investments or royalty agreements.
But enough about stand-alone programs. How does tax status play out in the innumerable other scenarios that occur? For instance, how does a university-run incubator handle fundraising? What can a government-affiliated program do to receive charitable contributions? How can a nonprofit incubator benefit from arm's-length relationships with for-profit companies?
Following is a look at how several nonprofit business incubation programs whose activities are affected by close ties to other organizations have addressed these and other issues. Their examples provide a glimpse into just some of the tax-status issues incubator developers and managers should take into consideration when setting up a program or pursuing partnerships with other organizations.
Being a nonprofit organization requires meeting guidelines set forth by the Internal Revenue Service (IRS) and the Internal Revenue Code (IRC). The IRC describes three types of nonprofit tax status that may apply to business incubators – 501(c)(3), 501(c)(4) and 501(c)(6). Although the three designations share many characteristics – chiefly, exemption from federal income tax – they are not the same when it comes to organizational requirements, privileges and allowable activities under the code.
In pursuing 501(c)(3) status, business incubators usually rely on one or a combination of the following 501(c)(3) charitable purposes – relief of the poor, the distressed or the underprivileged; lessening the burden of government; combating community deterioration; or advancement of education or science, says Janet M. Buehler, Esq., a tax attorney in Park Ridge, N.J., who works solely with tax-exempt entities and for years was one of PricewaterhouseCoopers LLP's national nonprofit tax experts. A 501(c)(3) organization must dedicate its assets permanently to its charitable purpose, even to the point of dissolution. This means that a 501(c)(3) entity's articles of organization must include provisions that ensure its assets will be distributed to other 501(c)(3) public charities if it dissolves.
501(c)(4) incubators often have the same missions as 501(c)(3) incubators but have opted to avoid the organizational requirements of a public charity. In contrast, incubators that pursue 501(c)(6) status usually focus on a particular industry – such as biotechnology – and generally expect to receive steady funding from sources within that industry.
Because they're considered public charities, incubators that earn 501(c)(3) status enjoy important fundraising advantages over 501(c)(4) and 501(c)(6) organizations. First and foremost, 501(c)(3) organizations may receive tax-deductible charitable contributions. This is the primary reason why many incubators apply for tax exemption under this section of the code. "Bottom line is [many] people don't want to contribute – individuals, certainly – unless they can get that deduction," says Sandy Bourne, president and CEO of the Pasadena Enterprise Center, a mixed-use incubator in Pasadena, Calif.
All three types of nonprofit incubation programs (or better yet, their qualified tax attorneys or accountants) must be aware of countless IRS regulations and requirements, the violation of which may result in financial penalties or even revocation of nonprofit status. For instance, "private inurement" regulations bar nonprofit incubators from organizing or operating for the benefit of private individuals – employees, directors or other "insiders" – or private interests, such as for-profit corporations. If, for example, a nonprofit incubator were to offer its manager an excessively generous compensation package, the program could be in violation of private inurement regulations. However, nonprofit organizations are allowed to offer managers salaries, fringe benefits and incentives comparable to amounts paid at organizations of similar type and size in their geographic area. The IRS uses a relatively complicated formula – based on total compensation – to decide whether a nonprofit employee's compensation is excessive.
But we digress. It's time to get down to what all of this tax talk means in practice.
Let's face it, real life isn't as cut-and-dried as an IRS form. Tax regulations are complicated enough on paper, and they become even more so when applied to the day-to-day operations of an incubator. Add to that the complexities of minding a parent or partnering organization's tax wants or needs, and the logistics can become tedious, to say the least.
This is the case with many university- or government-affiliated incubators, which must work within the limitations of the parent organization's tax status. Tax issues aside, for university-run incubation programs, the potential advantages of this arrangement are numerous. Among them are free or nominal-cost space; high-speed Internet access; university-provided maintenance, payroll, security and other administrative necessities; availability of student interns; and access to specialized equipment and knowledgeable faculty.
The Louisiana Business & Technology Center (LBTC), a 47,000-square-foot technology incubator in Baton Rouge, La., is part of Louisiana State University's (LSU) College of Business and is a 501(c)(3) organization by virtue of the university's tax status, says Executive Director Charles D'Agostino.
LBTC's university affiliation has brought many advantages. The incubator covers its operational expenses through rent – between $250,000 and $300,000 – and the university picks up administrative and other expenses, D'Agostino says.
Also, the incubator is able to offer its staff the university's attractive compensation package, D'Agostino says. Benefits include access to sports and cultural activities, generous medical benefits, and liberal holiday and vacation schedules. Top management in LBTC's office, which runs LSU's Technology Transfer Office in addition to the incubator, command six figure salaries, D'Agostino notes.
Being affiliated with a university can have its drawbacks, however, in added layers of bureaucracy and rules, competition for funding with other parts of the school, and the possibility of loss of support from new administrators who don't value business incubation. Although nonprofit university incubators can enjoy the same tax exemptions that would apply to a similar stand-alone incubator, some things a stand-alone incubator might be able to do easily can be more difficult in a university setting.
Fundraising is one example. Many colleges and universities have active development departments. In some cases, the development department is the only entity the university will allow to solicit money in behalf of university programs. For an incubator that sees opportunities to raise its own money for its programs, this kind of obstacle can be frustrating. "I couldn't [have a capital campaign] because it would run afoul of the existing capital campaigns for the college," says P. Chris Marschner, manager of the Technical Innovation Center, a mixed-use incubator at Hagerstown Community College in Hagerstown, Md.
D'Agostino faces a similar, but more bureaucratic, challenge. Although the LBTC applies for and directly receives grants and contracts, it cannot receive private donations except through the LSU Foundation, a separately incorporated 501(c)(3) entity affiliated with the university. When a grateful graduate tried to reward LBTC for its help with a gift of stock, the incubator had to turn the gift over to the foundation, D'Agostino says. "The foundation can hold the stock, but I can't," he says. Although this arrangement adds a layer of bureaucracy to the transaction, nothing is lost to taxes when the foundation donates the money back to the incubator. "We get the full donation," says D'Agostino, who notes that the added layer of bureaucracy actually brings a perk. "[The foundation] has to deal with all the paperwork and watch my money for me. When I need something, I just draw from the account."
Incubators that depend on the university budget are also in perpetual competition with other programs for funding. For example, the Information Technology Resource Center (ITRC) saw its operational support dry up when the University of Louisville rearranged funds in the school budget and rerouted $150,000 from the incubator. "We're getting our budget trimmed back to zero on operational support from the university," says Jim Graham, executive director of the ITRC. "They're re-allocating funds to faculty salaries."
That loss is not as bad as it sounds, however, given that the ITRC doesn't have to pay employees, rent or many other expenses a stand-alone incubator would have to cover, Graham notes. Those savings amount to more than $400,000 annually, he estimates.
Incubators affiliated with city, county or state governments or government-funded economic development agencies are in much the same position as university incubators in terms of tax status: They often are programs of a larger entity and fall under that entity's tax status. These incubators often are exempt from some state and local taxes – such as property, sales and excise taxes. Some report exemptions from many of these taxes, while others pay all applicable state and local taxes. Different states and municipalities take varying courses of action regarding this issue.
Being associated with a government or government-affiliated entity can be beneficial for raising funds, incubator managers say, because some types of state and federal grant money can flow only to a governmental agency. Although any nonprofit can ultimately utilize and benefit from these types of funds, a government entity must serve as coapplicant and receive and disburse the funds. Having a close relationship with that government entity makes the process run that much smoother.
Government-run or -affiliated incubators also can benefit from the possibility of passing tax levies to support their activities. The Pitt County Development Commission runs a mixed-use incubator in Greenville, N.C., and pays for part of the incubator's $150,000 annual budget with money from a special tax the county passed to support local economic development initiatives, says commission Executive Director John Chaffee.
Sometimes a nonprofit incubator cooperates with other business-assistance organizations in its community to better serve clients, achieve its mission and reduce duplication of services. Such is the case with the Corry Industrial Incubator in Corry, Pa. The incubator is a program of the city government's Redevelopment Authority, and it works closely with two nonprofits to pursue its mission: the Corry Industrial Benefit Association (CIBA), a 501(c)(3) entity; and the Corry Area Industrial Development Corp. (CAIDC), a 501(c)(6) entity.
When the lack of a charitable-purpose entity was keeping the city's economic development leaders from accepting a large financial contribution in 1985, they put their minds to work. A company that had been in the community for more than 100 years was leaving the area and wanted to donate $100,000 to the community. "They also wanted to get some tax benefit out of their donation," says Rick Novotny, economic development specialist with the Redevelopment Authority.
The company didn't want to give the donation to the 501(c)(6) CAIDC because, even though it's a nonprofit, it's not a charitable organization. Redevelopment Authority representatives suggested that the company donate the money to the city government through the authority, but company officials weren't comfortable with law surrounding contributions made to government entities. "So, we created the Corry Industrial Benefit Corp. for those purposes – companies that want to make a contribution to the local economy for economic development." In fact, a graduate of the authority-managed incubation program also has utilized the availability of CIBA to make a donation of nearly $200,000.
Although the three entities work together on projects, they maintain separate accounts, boards of directors and management, Novotny says. "You do need to have in each agency a separate, arm's-length transaction doing whatever they do," he points out.
The story of Northwest Industries illustrates how the presence of the three different entities can benefit Corry's business incubator clients. Northwest Industries – a company that bends and fabricates metal to make office equipment – leased 2,000 square feet of space in Corry's incubator in 1997, Novotny says. The Redevelopment Authority was able to apply for and received a grant from Pennsylvania's Enterprise Zone program and loaned Northwest $170,000 of the money for equipment. The company started with seven employees and about $200,000 in annual sales, Novotny says. By the next year, Northwest had expanded into 7,000 square feet of incubator space and needed to move to a larger building to handle projected growth.
At the same time, the CAIDC had built a 33,000-square-foot building at a cost of $900,000 to offer commercial space to businesses. Of the $900,000, Novotny says, $380,000 came from a state loan; $250,000 came from a grant that the Redevelopment Authority applied for and loaned to the CAIDC; $90,000 came from the CAIDC; $75,000 came from a CIBA loan; and the remainder came from a local revolving loan fund program administered by the city Redevelopment Authority.
Northwest moved into that building and was leasing 15,000 square feet of space by the end of 1998 at market rates, Novotny says. By 2000, Northwest had more than 100 employees and about $8 million in sales. It had expanded to fill all 33,000 square feet of the building and was still growing. Northwest then decided to buy the building from CAIDC, and Corry's economic development minds again went to work to make that possible, Novotny says. In addition to money Northwest put up, the company received $250,000 from a state enterprise zone grant program that the Redevelopment Authority applied for, then loaned to the company, and $200,000 from the Redevelopment Authority's revolving loan fund.
Northwest has been so impressed with the support the Corry community has provided, Novotny says, that it made a significant donation to CIBA.
Still another arrangement some nonprofit business incubators have established in order to achieve their missions is an arm's-length relationship with separately incorporated, for-profit companies. Having affiliations with for-profit companies can simplify owning equity in incubator clients, attracting investment for graduating clients and providing performance incentives to staff. This is partly why the Kansas Technology Enterprise Corp. (KTEC) in Topeka, Kan., chose to align its 501(c)(3) organizations with for-profit entities when it formed its series of "commercialization corporations" in 1994.
Each commercialization corporation is a partnership among KTEC, a university and a local sponsor (usually the city where the commercialization corporation is located) and functions as an incubator with and/or without walls. The commercialization corporations are the flagships of a group of three separately incorporated components: a 501(c)(3) organization, which may include an incubator; a for-profit limited liability company seed fund; and a for-profit C corporation that manages, via contract, both the 501(c)(3) and the seed fund.
In forming the commercialization corporations, KTEC's intent was to spur economic development through tax-exempt, nonprofit activity and aggressive for-profit activity (venture capital investment), says former KTEC President and CEO Rich Bendis, now president & CEO of Innovation Philadelphia. This meant attracting experienced business-people to the for-profit management companies who could manage and mentor fledgling companies in the incubators, as well as function effectively in the for-profit world of venture capitalists and angel investors.
"To attract the people that you want, that have experience managing seed funds or venture capital, you have to have a very competitive compensation package," Bendis says. "You have to allow them to get a part of the equity carry that the manager gets for managing the [seed] fund." In other words, the executive receives, as part of his or her compensation, a portion of the equity that the seed fund holds.
In the KTEC model, the president and employees of the for-profit management company receive a percentage of the profits realized in the seed fund, usually after payback of capital to investors. The seed fund, in turn, can invest in and hold equity in incubator clients. Both of these activities would be tricky, if not impossible, for a nonprofit organization to pursue.
Because it is organized as a for-profit business, the seed fund also is better able than a nonprofit to attract a wide range of investors, Bendis says. "A lot of people are interested in getting into this for strictly return on investment," he says. "They're not as interested in getting into it for economic development or being good corporate citizens." The seed fund can invest in any promising Kansas start-up and is not required to invest in every incubator client, he notes.
The partners in the commercialization corporation – KTEC, the university or affiliated entity and local government sponsors – are represented on the board of directors of the various entities. "We have everything on an arm's-length, contractual basis," says Ron Sampson, president of the Mid-America Commercialization Corp. (MACC), a partnership of KTEC; Kansas State University; the City of Manhattan, Kan.; and the Manhattan Chamber of Commerce. "So even though we have management that goes across these – I'm essentially president of all (our) companies and our staff is the same – we have different boards, and we keep totally separate records. They're totally autonomous companies."
Being affiliated with a for-profit company makes it easier for KTEC to own equity in client companies. Depending on how they draft the contracts, the incubators may own equity in clients or enter into royalty agreements, Sampson says, but those determinations are made on a company-by-company basis.
Sometimes MACC's incubator receives in-kind donations of patents on technologies that an incubator client may want to commercialize. In those instances, it is appropriate for the incubator to take equity in the company in exchange for the technology license because the dispersal of technology fits with the 501(c)(3) incubator's tax-exempt mission, in this case the advancement of science, Sampson says. In cases where companies exchange equity for hands-on management and other incubation services outside the 501(c)(3)'s mission, the C corporation will hold the equity.
Ultimately, having both a 501(c)(3) charitable organization and for-profit companies gives KTEC's commercialization corporations wide fundraising flexibility because they can attract charitable donations for certain not-for-profit purposes on the one hand and for-profit investment on the other, Bendis says. "It gives options and it creates flexibility for the foundations and the not-for-profits to be able to work with the 501(c)(3) organizations, as well as other things like states or governments who are comfortable in those environments," he says. "Once you go into the corporate world or the angel world or the venture capital world, they're more comfortable in dealing in the for-profit world. You have ultimate flexibility with this structure."
Launching a successful business incubation program (or restructuring an existing one) involves many important decisions about tax status. Understanding the activities allowable under different types of nonprofit tax status will help ensure that your incubator can pursue programs and initiatives detailed in its mission. Developers and managers of nonprofit business incubation programs must prepare themselves for thoughtful discussions with partners and stakeholders about the activities and objectives they intend to pursue.
Before you make any decisions, be sure to consult a tax professional who understands the ins and outs of nonprofit tax issues, as well as the activities in which incubation programs engage. These professionals can help you make smart choices and, ultimately, structure an incubation program that will deftly accomplish its goals.
This story is adapted from the upcoming book, Incorporating Your Business Incubation Program: Tax Status and Business Entity Considerations, NBIA Publications, April 2002. Through interviews with incubator managers, tax experts and lawyers, the book will provide details on tax-exempt status and business entity as they relate to nonprofit and for-profit business incubation programs.
Part One of the book will explore the three tax-exempt statuses most relevant to nonprofit incubation programs – 501(c)(3), 501(c)(4) and 501(c)(6) – and will examine how existing incubators operate under each designation. As many applicants have discovered, the IRS scrutinizes applications for tax-exempt status. Therefore, the book also will describe the application process and suggest strategies to help incubators succeed when applying for 501(c)(3) status – the most difficult designation to receive. An appendix will provide examples of approved 501(c)(3) applications.
Keywords: 501(c)(3), legal issues, organizational structure, partnerships -- organizational/corporate, tax status
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