By Erin Bradrick, senior counsel, NEO Law Group
The twelfth in our series of blog posts written by BLF 2013 speakers, presenters, and sponsors.
The movement towards social enterprises that we’ve seen in the last decade is beginning to reshape both the nonprofit and for-profit sectors — with many nonprofit charitable organizations looking more and more like for-profit entities and vice versa, the rise of joint ventures between nonprofits and for-profits, and increasing numbers of for-profit entities creating and controlling affiliated charities. Nonprofit boards of directors are moving their organizations towards social enterprise structures in an effort to increase revenues as they face simultaneous challenges of diminishing governmental funding, uncertain philanthropic funding, and increased competition for limited resources. For-profit entities are similarly operating in an increasingly competitive market and are seeking to differentiate themselves and generate goodwill by self-identifying as social enterprises, sustainable businesses, and/or certified B corporations. And social entrepreneurs are moving towards sector agnosticism as opposed to limiting pursuit of their charitable goals to traditional nonprofit structures.
As the differences in the activities of nonprofit and for-profit organizations continue to blur with the increasing commercialization of charities and the growth of socially purposed taxable entities, the nonprofit sector will see stronger pushback from regulators and critics. The IRS will place greater scrutiny on unrelated business taxable income; nonprofits will respond with increased use of taxable subsidiaries; and critics of the “hybrid” entities will become increasingly vocal, warning legislators of the risks of charity-washing and encouraging attorney general oversight. As a result of this shifting regulatory environment, boards of nonprofit organizations seeking to launch social enterprise ventures must ensure thorough compliance with the applicable laws and regulations and should give careful consideration to the legal structure best suited to the goals and needs of the organization.
Before kicking off a social enterprise venture, the initial threshold questions a nonprofit organization’s leaders should ask are whether the idea is viable and whether the organization has the capacity to make the venture successful. In evaluating its capacity, the organization should look not only at its financial resources, but also its human, systems, technology, time, administrative, and space resources, and should consider what resources in each of these categories it currently has available, what resources it will need in order to successfully operate the social enterprise venture, and what modifications to its operations it may need to make in order to adjust its available capacity. The nonprofit should also conduct significant research regarding the relevant market, as well as develop a thoughtful business plan and financial projections. The organization’s board of directors will also want to take certain steps to ensure that each director has satisfied her or his duties to the organization, including by conducting a reasonable investigation of the contemplated venture, identifying and managing potential conflicts of interest that may arise, and ensuring ongoing legal compliance.
Once an organization’s board has decided to pursue a social enterprise venture, it must determine whether to conduct such activities in-house or through a separate entity. If the business is related to the organization’s exempt purpose (which is often a complex determination requiring legal advice), or will constitute a small part of its overall activities, it may be easiest to keep it in-house. However, if the earned income is generated by a trade or business that is regularly carried on and not substantially related to the organization’s exempt purpose, it may generate unrelated business taxable income subject to the unrelated business income tax (UBIT). Moreover, and more fundamentally, under the commerciality doctrine, an exempt organization cannot engage in more than an insubstantial amount (which is not clearly defined) of unrelated business activity without risking the loss of its 501(c)(3) tax-exempt status. If the board is concerned about the possibility that the venture’s activities are unrelated and substantial, structuring the social enterprise in a subsidiary or affiliate organization may be an attractive option and may also provide the existing organization with greater protection from a venture with a higher risk profile and better preservation of the existing organizational culture of the nonprofit.
If, after reasonable investigation, the board determines it is in the organization’s best interest to create a for-profit subsidiary, it again has multiple options as to the legal structure of the entity. It may choose from among traditional business forms like a corporation or a limited liability company (LLC), which offers fewer formalities than a corporation, but is typically set up as a pass-through tax entity and therefore may not be an appropriate vehicle in which to house a substantial unrelated income-generating business. Either a corporation or an LLC may also seek to become a Certified B Corporation — a certification provided by the nonprofit B Lab to entities meeting certain social and environmental criteria.
Alternatively, the subsidiary may be structured in one of the newer “hybrid” forms, which currently include the low-profit limited liability company (L3C), the benefit corporation, the flexible purpose corporation, and the social purpose corporation. The L3C is a form of LLC, but is governed by statutory limitations that are harmonized with the program-related investments (PRIs) regulations and therefore may be more attractive to some private foundation funders, though that has yet to be evidenced on a widespread scale. Nineteen states and the District of Columbia currently permit corporate entities to be formed as benefit corporations, which must pursue the general public benefit in their corporate activities and whose boards must consider the impact of their business decisions on their employees, their suppliers, the environment, and the community at large. A social purpose corporation must similarly be organized to promote positive effects (or minimize negative effects) on the corporation’s employees, suppliers, or customers; the broader community; or the environment and is permitted, but not required, to state a specific social purpose for which it is organized. In contrast, the flexible purpose corporation requires the entity to pursue a stated specific public benefit. In making a determination regarding the legal form of an entity, the most important thing to bear in mind is that form should always follow function.
We have started to see, and will continue to see, shifts in the landscapes of the nonprofit and for-profit sectors due to the increased momentum of the social enterprise movement. As nonprofit organizations navigate the social enterprise space and as the regulatory environment continues to change, it is particularly important that organizations carefully ensure compliance with applicable laws and statutes and that their boards of directors make informed decisions throughout the process.
Are you considering a social enterprise venture?
Gene Takagi, managing attorney of the NEO Law Group, will be presenting a session on social enterprises at BLF 2013.