NONPROFIT MANAGEMENT: Outlining affiliation structures in the nonprofit sector

“Coming together is a beginning, staying together is progress, and working together is a success.” — Henry Ford

One thing about the pandemic is now perfectly clear. That is, nonprofit health and human-service organizations have, for the most part, been given a reprieve from the $6 trillion-plus of federal stimulus initiatives. Just one example of this reprieve is the New York State budget receiving a gift of $25 billion from the American Rescue Plan. Without this additional revenue to New York State, Gov. Cuomo had been predicting significant cost reduction and reform initiatives for the $83 billion state Medicaid program and other forms of state contract funding to Social Determinant of Health (SDOH) providers. In addition, we now have wage hikes and other forms of inflation accelerating throughout the economy. This situation will place many tax-exempt organizations in a position of assessing their ability to maintain autonomy or the need to pursue an affiliation/acquisition in the next 12-36 months. 

The fact pattern described above, coupled with additional economic, pandemic, and demographic challenges, will prompt the need for updating and/or revising strategic plans to evaluate the likelihood of each tax-exempt organization being able to sustain financial viability. The extraordinary pressures faced by board and management of tax-exempt organizations will continue to force many nonprofits to merge or affiliate with other organizations. In a 2012 column, I coined the term of increased affiliations as representing the “WalMarting” of the nonprofit sector. 

The following lists provide the primary external and internal factors that support the inevitability of increased merger and affiliation activity. As a result of the foregoing, maintaining autonomy may not be the best alternative strategy at this point. 

External factors include the following:

• “Bigger is better and more efficient” in the eyes of government
• Fewer providers = less cost
• Aggregation / transfer of financial risk = less state administrative cost
• Government views smaller providers as “higher risk”
• Networking and consortiums may create favorable contracting leverage 

Internal factors impacting agency strategy are as follows:

• Maintaining sophistication in information technology, particularly telehealth and telemedicine
• Affordability of electronic-medical records and documentation
• Maintaining regulatory compliance requirements
• Increased regulatory enforcement scrutiny and audits• Pressure on administrative efficiency and cost-driving expectations from 15 percent to 10 percent or less

There have been many local examples of success in tax-exempt service organizations collaborating to achieve an effective fulfillment of their collective mission. I believe that every nonprofit organization should have the strategic objective of continuing to assess the impact and outcomes of program services, while effectively managing the cost of service delivery.

In fact, every nonprofit should be able to candidly evaluate and answer the following two questions:

• What strategies can we implement that will make our organization more cost effective with improved service outcomes? 

• What are the non-core competencies of our organization that could benefit from a strategic affiliation?

I have previously developed and strongly encourage many tax-exempt board and management-team members to consider the following continuum of contractual and structural alternatives between autonomy and acquisition. In between these two ends of the affiliation spectrum, we have:

• Co-optition 
• Collaboration 
• Shared-service agreement 
• Contractual affiliation 
• Network formation – independent provider associations
• Joint venture 
• Partnership/corporation 
• Merger 

At the opposite end of this continuum is as an acquisition, which is generally a four-letter word for the acquired party to the transaction. Merger is, by far, the preferred terminology.

As affiliations and mergers continue to increase in the nonprofit sector, the following information should be viewed as a primer for affiliations and the most popular structures being implemented.

I. Corporate Restructuring Utilizing a Passive or Active Parent Entity

Typically, the board and management of the nonprofit-program service provider, working with appropriate legal and financial advisors, will discuss, evaluate, and determine the most appropriate approach to forming a parent-entity structure. This structure should only be established in situations where there are clearly defined benefits that will facilitate future growth of the organization’s programs and services as well as providing for appropriate legal protections between and among the parent entity and its respective affiliates. 

In conducting the evaluation referred to above, it is beneficial for the following initiatives to be completed. 

• To identify the benefits to be derived from a corporate restructuring by conducting a needs assessment that would summarize the strengths, weaknesses, opportunities, and threats (SWOT) that may be relevant for board and management consideration.

• To identify the advantages, disadvantages, challenges, and opportunities that may be derived by a corporate restructuring process for board and management to consider regarding preferred corporate-restructuring models.

II. Passive vs. Active-Parent Entity Structures — What’s the Difference?

• Passive-parent entity — The passive parent corporate restructuring model is by far the most common approach utilized in the nonprofit sector. The passive-parent board retains “sole member” status in all the subsidiary/affiliate entities that provide charitable services under a tax-exempt 501(c)(3) exemption. For-profit subsidiaries/affiliates of a passive parent, depending upon the structure of the taxable entity, will have the passive parent as its sole member or 100 percent shareholder.

• Active-Parent Entity — The passive-parent entity model may or may not evolve to an active-parent entity model. The decision to move to an active-parent model can be influenced by several variables that can be characterized as either advantages or disadvantages. However, the primary difference between an active or passive-parent entity model is that active-parent entities are subject to far more regulatory reporting requirements and related policies and procedures that satisfy all the governance regulatory requirements related to the subsidiary/affiliate entities that provide programs and services. In an active-parent entity model, the senior management / executive leadership team typically become employees of the active-parent entity. 

It is possible, under either the passive or active-parent entity structure, to have the management / executive leadership team personnel continue to be employed by the primary program service entity or through the establishment of a separate and distinct management / administrative / shared-service organization. 

III. Common Alternative Corporate Entities in a Parent Model

The following corporate entities are the most common structures established by tax-exempt organizations providing health and human services in New York state. 

1) Management-Services Organization (MSO) — As described above, the MSO entity structure can be used as a transition model for purposes of evaluating future affiliate entities for the parent. 

2) Existing and Newly Established Program Service Entities under a Common Parent Entity (Passive Parent) — This is the most common affiliation structure used over the past 15 years as the hospital industry has gone through its own consolidation / affiliation process. This model typically allows for the local governing board of each entity to remain intact, with the combination of board members from each entity on the parent entity’s board. This model provides the parent entity with usually five or six reserve powers that represent what is commonly referred to as “sole member” status. 

3) Passive-Parent Entity Structure with Limited Decision-Making Control by the Parent Board — In this model, current, and future affiliated entities would be under the auspices of a parent entity similar to Alternative #2. However, the reserve powers in this model provide for greater autonomy to the board and management of current and future affiliated entities. 

4) For-Profit Entities — If it is determined that the activity is a for-profit business activity, it could be substantial enough to jeopardize the tax-exempt status of the parent entity or its affiliates, one or more for-profit taxable corporate entities may be formed. The for-profit entities established are also considered to be subsidiaries of the parent entity. 

5) Full-Merger Alternative — In this model, the programs and services of the current operating entities are determined to be most effectively provided in a single merged entity with separate lines of business established based on the different programs and services provided. In this model, board and management would ultimately determine that neither the passive nor active-parent model is in the best interest of the future growth prospects of the organization. This single-entity structure would result in full control by a single governing board and a single management team. 

Please be advised that any future substantial asset transfer from one 501(c)(3) public charity to another falls under the potential need for regulatory review and approval by the New York State Attorney General’s Office and its Charities Bureau.

Remember to keep your eyes focused on the mission of your organization. Do not allow the issues of who gets what job or who gets what number of votes to dictate your ultimate decisions.                     

Gerald J. Archibald, CPA, is a partner in charge of the management advisory services at The Bonadio Group. Contact him at garchibald@bonadio.com