Nonprofit organizations that want to become for-profit, even if only as a public benefit corporation, must manage a singular tax requirement. The nonprofit must sell its assets for fair market value, which must be determined via arm's-length bargaining. When nonprofit fiduciaries are both seller and buyer, the transaction must be managed to negate conflicts of interest.
A conversion, unlike a merger or contraction, happens when business owners change a business's legal structure usually without altering ownership. Charitable nonprofits may merge or contract, but they can never convert to something other than a charity. This is because once a corporation is established under state nonprofit law, or is determined tax-exempt under federal tax law, it must forever exist as such -- or not at all.
What is sometimes nevertheless labeled a "nonprofit conversion" is different. A nonprofit conversion, such as what OpenAI is attempting, imprecisely refers to a contraction or termination that alters beneficial ownership.
This can only happen by selling some or all assets held in trust by a nonprofit fiduciary, followed by redeployment of those assets in the buyer's profit-making business. But even when a nonprofit sells, the proceeds inherit the charitable immortality previously attached to the sold assets.
Here, the word "trust" is important. It means the nonprofit "owners" have legal duties but no beneficial rights to nonprofit assets -- they may never exploit the assets for their own profit but must manage those assets for the beneficial owners.
The beneficial owners of nonprofit assets are taxpayers, who subsidized the acquisition of assets via tax exemption and charitable contribution deductions. Taxpayers are the beneficial or real owners on whose behalf the trustees must act in accordance with fiduciary duties first imposed by state law but most often enforced by federal tax law.
Trustees may decide for business or regulatory reasons that their work might be better accomplished under a different legal statute through which successors acquire both legal and beneficial ownership. To carry out that sort of conversion, the successors must purchase the nonprofit's assets.
But in their private roles, trustees are naturally motivated to pay the least amount possible for the assets. Clearly, the public can't be sanguine if the buyers are also the sellers' agent. The conflict is clear -- yet it would be bad policy to entirely prohibit such transactions, so the law imposes guardrails.
Both process and price for a nonprofit conversion -- a sale of all or some of the assets -- must fairly protect the real owners' financial interest. State and federal tax laws determine what is fair. To be substantively fair, the sale price must at least be equal to fair market value, a concept easily articulated but difficult to determine.
To be procedurally fair, the negotiation process must negate the impact of the trustees' irredeemable conflict. Fair price and process are generally, though not invariably, symbiotic. A sale price will typically be considered fair, with no other required proof, if the process is fair.
A process will be considered fair if the resulting price is within a provable range of comparable prices, but the latter correlation may vary. In Smith v. Van Gorkum, for example, the beneficial owners sold stock for a premium, and yet the Delaware Supreme Court found that directors violated their fiduciary duties because of an unfair process.
When trustees are both buyers and sellers, the transaction must be negotiated by substitute trustees free of financial conflict who comply with the same fiduciary duties applicable to the conflicted trustees. The practical and legal requirements are codified in Reg. 53.4958-6.
That regulation should be followed as closely as possible, especially by nonprofits such as OpenAI that sell valuable intangible assets. Schedule N, Form 990 is the IRS's primary method of policing nonprofit conversions particularly when trustees are the successors. Schedule N provides a practical question and answer checklist for nonprofit conversions.
The required answers underscore the need to ensure a fair process and price. Understanding that the trustees must eventually explain the methodology used to determine fair market value, and disclose whether they succeeded to beneficial ownership, should be enough to stimulate very careful planning.
The consequences of failure can be significant. Section 4958 of the tax code imposes substantial but avoidable excises taxes on trustees and even on the successor entity if trustees hold sufficient interest in the successor, as might be expected.
High-value cases such as OpenAI's help demonstrate the points, even if specific details are still unknown. We do know, for example, that the majority of OpenAI's board members are outsiders and will have no financial interest in OpenAI's buyer. They won't have to engage substitute trustees, though it might be a good idea anyway given the level of scrutiny expected.
At least one board member, Sam Altman, will reportedly take equity in the buyer. That only means he and any other interested fiduciary or successor shouldn't be allowed to participate in the transaction other than as buyer. We also know that the trustees have engaged valuation experts.
As complicated as the transaction may eventually prove, those two basic steps greatly increase the likelihood that the OpenAI conversion will succeed without undue federal tax or state law challenges.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Darryll K. Jones is a law professor at Florida A&M University College of Law.