The nonprofit sector has seen a dramatic rise in the number of mergers and reorganizations. The constant need to reduce costs, especially in the health care sector, seems to be the driving force behind the movement.
When selecting a merger or reorganization structure, what considerations should be reviewed to ensure the structure is right for the participating nonprofits?
In general, there are six merger/reorganization structures commonly used by nonprofits, each with its own advantages and disadvantages.
Statutory Merger
A statutory merger is what most people probably think of when they think of a merger. Statutory mergers are set forth by statute (hence the name) and provide a streamlined merger process. During a statutory merger, the target nonprofit dissolves “into” the surviving nonprofit.
The target nonprofit’s assets, including most, if not all, of the target nonprofit’s contracts and licenses, are automatically transferred to the surviving nonprofit by operation of law. The surviving nonprofit also assumes the target nonprofit’s liabilities.
The advantage of a statutory merger is that it is simple. The transfers occur automatically by operation of law upon filing a certificate of merger. Once the certificate of merger is filed, the target nonprofit ceases to exist.
The disadvantage of a statutory merger is that the surviving nonprofit assumes all of the target nonprofit’s liabilities, both known and unknown. Unknown liabilities can be a great cause of concern for the surviving nonprofit, especially if the target nonprofit engaged in high-risk activities such as child care, elder care or health care. Therefore, it is important that the surviving nonprofit has sufficient insurance coverage.
Transfer of Assets
One alternative the surviving nonprofit can use to protect itself from the target nonprofit’s known and unknown liabilities is to structure the reorganization as a transfer of assets.
Under this alternative, the target nonprofit (or transferor nonprofit) uses its assets to pay its known liabilities. The transferor nonprofit then transfers its remaining assets to the “surviving” nonprofit, or in this case, the transferee nonprofit. The transferor nonprofit then remains in existence.
The main advantage of this structure is that the transferee nonprofit should have no liability for the transferor’s unknown liabilities unless the fraudulent transfer or transferee liability rules apply, in which case, the transferee nonprofit’s liability should at least be limited to the fair market value of the assets transferred to it.
Another advantage to this structure is that the transferor nonprofit can continue to receive known and unknown gifts. If the transferor nonprofit dissolved after transferring its assets to the transferee nonprofit, any gifts left to the transferor nonprofit via a will or trust will not automatically transfer to the transferee nonprofit as a successor organization.
For example, assume your will leaves $50,000 to the transferor nonprofit to be used to feed the homeless in Philadelphia. Further, assume that the transferee nonprofit feeds the homeless in New York City. While both nonprofits exist to help the homeless, their purposes are geographically distinct. Therefore, if the transferor nonprofit no longer exists, a court may direct that the $50,000 be given to a third nonprofit that assists the homeless in Philadelphia even though the transferee nonprofit is the transferor nonprofit’s successor.
Based on this example, there are clear advantages to retaining the transferor nonprofit post-asset transfer.
What are the disadvantages of this structure? Because a transfer of assets is distinct from a statutory merger, the transferor nonprofit’s assets do not automatically transfer to the transferee nonprofit. Thus, it may be time consuming and costly to transfer all of the transferor nonprofit’s assets, especially if the target entity holds real property (i.e., realty transfer tax issues and real property tax exemption issues).
It may also be time consuming and costly if the transferor nonprofit has to transfer licenses and contracts to the transferee nonprofit.
Additionally, because the transferor nonprofit continues to exist, there will likely be duplicative costs of running two organizations (e.g., insurance premiums, accounting fees).
A creditor of the transferor nonprofit is more likely to commence a legal action against the transferor nonprofit if the transferor nonprofit remains in existence.
Both nonprofits will also need to give thought to who will serve as officers and directors of each entity after the reorganization. Will there be overlapping directors and officers? Will the transferee nonprofit have the ability to appoint and remove the transferor nonprofit’s directors and officers? These considerations are important because overlap and/or control could increase the risk that a creditor of the transferor nonprofit will commence a legal action against the transferee nonprofit.
Liquidating Transfer of Assets
A liquidating transfer of assets is very similar to a transfer of assets. It occurs when the target nonprofit uses its assets to pay its known liabilities and transfers its remaining assets to the surviving nonprofit – just like a transfer of assets – but dissolves after transferring its assets.
The main advantage of a liquidating transfer of assets compared to a transfer of assets is avoidance of the duplicative fees that would be incurred if the target nonprofit remained in existence.
The disadvantage of a liquidating transfer of assets compared to a transfer of assets is that the target nonprofit no longer exists to accept known and unknown gifts and then transfer them to the surviving nonprofit.
As a result, the surviving nonprofit would need to petition the court to have the gifts redirected to the surviving entity, opening the possibility that a court could redirect any known and unknown testamentary gifts left to the target nonprofit to a third party and not to the surviving entity.
Consolidation
Under the consolidation option, the two nonprofit organizations that wish to affiliate with one another both merge into a newly formed, third entity. As a result of the mergers, both target entities dissolve into the new company.
All of target entities’ assets, including their contracts and licenses, automatically transfer to the new company. The new organization also assumes all of the target entities’ liabilities.
The main advantage of consolidation is that, like a statutory merger, it is simple. All assets and liabilities automatically transfer to the new company by operation of law upon filing the combined certificate of merger for both target entities. Once the combined certificate of merger is filed, the target nonprofits ceases to exist.
The main disadvantage of consolidation is that the new organization assumes all of the target entities’ liabilities, including lawsuits, employment contracts and any unknown liabilities (e.g., environmental, payroll taxes).
Another disadvantage of a consolidation is that the target nonprofits no longer exist to accept known and unknown gifts and then transfer them to the new company.
There will also likely be increased transaction costs to effectuate the consolidation. For instance, the plan of merger and the combined certificate of merger will be more complex because there are three parties, not just two. There will also be additional costs to form the new company and apply for tax-exempt status on behalf of it.
Despite the disadvantages associated with consolidation, it is frequently used to affiliate two nonprofit entities that cannot agree on which nonprofit entity will survive (e.g., who will control, whose name will be used).
With a consolidation, both target entities receive a fresh start and can be placed on even footing, equally incentivized to ensure the new organization is successful.
Conversion to a Sole Member Corporation
Another merger/reorganization option is to make the surviving nonprofit the sole member of the target nonprofit.
Most nonprofit entities, however, are nonmember, nonprofit corporations governed solely by a self-perpetuating board of directors. Therefore, the nonmember, nonprofit target corporation must first be converted into a member, nonprofit corporation.
The surviving nonprofit corporation would then become the sole member of the member nonprofit target corporation. The result is a parent/subsidiary relationship between the surviving nonprofit (as the parent or sole member) and the target nonprofit (as the subsidiary).
A member is akin to a shareholder and therefore has the ability to control the target nonprofit corporation. Under state law, members are given certain voting rights over the corporation, such as the power to appoint directors and approve fundamental transactions (e.g., merger, dissolution, sale of assets).
The advantage of this structure is that the nonprofit entities remain separate, which results in limited liability for both entities. Additionally, no assets or liabilities need to be transferred and the target nonprofit remains in existence to accept any unknown gifts.
The main disadvantage of this option is cost. There will be transaction costs to covert the target corporation into a membership corporation and issue a membership interest to the surviving entity. Post-reorganization, there will be duplicative costs of operating and maintaining two separate legal entities (e.g., payroll costs, accounting costs, insurance premiums).
Additional considerations with this reorganization option include control, attribution and branding issues.
In terms of control, the nonprofit entities will need to negotiate whether the target nonprofit will have representation on the surviving nonprofit’s board and whether the surviving nonprofit is limited to removing the target nonprofit’s directors only for cause.
The two nonprofit entities should avoid having fully overlapping boards because that could cause piercing the corporate veil issues or attribution issues (e.g., one entity’s lobbying or unrelated business activities could be attributed to the other and adversely affect both entities’ tax-exempt status).
The nonprofit entities should also give thought to post-reorganization branding/name issues so that donors can easily understand the new organizational structure.
Creation of a Mutual Parent Entity
Under this merger/reorganization structure, the two nonprofit entities wishing to affiliate with one another both convert into member, nonprofit corporations and create a new nonprofit corporation to serve as their sole member/parent.
The new company, as the target nonprofits’ sole member, will have the power to appoint and remove each target entity’s directors and to approve any fundamental transactions the target entities desire to effectuate.
The new organization will act as the target nonprofits’ parent organization and the target entities will act as brother/sister organizations to one another.
The advantage of this structure is that the target entities and new company remain separate legal entities, which results in limited liability for all entities. Additionally, no assets or liabilities need to be transferred and the target nonprofits remain in existence to accept any unknown gifts.
This structure also lays the groundwork for future affiliations because, once formed, the new company can easily form or acquire additional subsidiaries.
The main disadvantage of this option is cost. There will be costs involved with forming the new company and applying for tax-exempt status on behalf of it. There will also be transaction costs to covert the target entities into membership corporations and to issue membership interests to the new company. Post-reorganization, there will be triplicate costs of operating and maintaining three separate legal entities (e.g., payroll costs, tax preparation fees, accounting costs, insurance premiums).
Additional considerations with this reorganization option include control, attribution and branding issues.
In terms of control, the target entities will need to negotiate their representation on the new company’s board and whether the new organization is limited to removing the target nonprofits’ directors for cause only.
Additionally, the three nonprofit entities should avoid having fully overlapping boards because that could cause piercing the corporate veil issues or attribution issues (e.g., one entity’s lobbying or unrelated business activities could be attributed to the other entities and adversely affect each entity’s tax-exempt status).
The nonprofit entities should also give thought to post-reorganization branding/name issues so that donors can easily understand the new organizational structure.
In sum, there are numerous options for nonprofit entities seeking to merge/reorganize. The correct structure will likely be determined by the assets and liabilities at play, the existing relationship between the nonprofit entities, the transaction costs involved and post-transaction control and operational issues.
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