Social Enterprise Part II: Business Entities and Hybrids

This is the second installment of a two-part series for nonprofit organizations looking to generate earned income from social enterprises. Here, I will offer advice for deciding what kind of entity is best suited for a particular organization’s needs.

The first part in the series covered unrelated business income tax. I recommend organizations begin here because the tax consequences are the best way for organizations to choose between starting:

  • a wholly owned subsidiary or
  • an independent for-profit entity, joint venture, or partnership.
  • Each option has its benefits and concerns, which I will discuss here.

Wholly-Owned Subsidiary

In my opinion, the easiest way to get into social enterprise—by far—is to create a single member Limited Liability Company (LLC). Choosing a single member LLC is a good choice for many organizations because they are very quick to form. In addition, it is a “disregarded entity” under the Internal Revenue Code, meaning it carries the 501(c)(3) classification of its sole member and does not require filing an exemption application.[1] Further, charitable contributions to them are deductible as if they were given to the parent member.[2] The single member LLC’s finances flow through to the nonprofit and are reported as a program activity. If the subsidiary is engaged in related business, this is not taxed. If it is engaged in unrelated business, the organization must file a Form 990-T on the taxable income it generates.

However, a single member LLC is not the only option. The for-profit subsidiary can be incorporated as a regular for-profit corporation, or even a controlled nonprofit corporation that is created solely to engage in unrelated business activities.

A controlled subsidiary is the easiest kind of entity to manage because there is no question about who calls the shots. If the parent board decides that the subsidiary is going in the wrong direction, it can exercise its reserved powers to alter course. Ultimately, if the parent board is disappointed with the results, it can abandon the project.

Independent For-profit Entities

If you decide to spin off a completely independent social enterprise, you can choose a traditional form or one of the emerging hybrid forms. The traditional forms are partnership, corporation, and LLC.

Partnership.  I strongly advise against forming a partnership; while it offers a “flow through” treatment for tax purposes, there is no liability protection for partners, as each is considered to be jointly and severely liable for any debts or liabilities.

Corporation.  The classic for-profit enterprise is a business corporation that is recognized by the Internal Revenue Service (IRS) underSubchapters C or S of the Internal Revenue Code. Every state has basic business corporation formats. You can own 100 percent of the stock; or, you can be one of several shareholders. Net profits are taxed at the corporate level, and if your organization engages “passively” (that is, it launches the business but does not run it), the profits and dividend income are not taxed.

LLC. The LLC is a hybrid. It offers the liability protection of a corporation, while retaining the flow-through tax treatment of a partnership. The social enterprise can operate as a single member LLC as a joint venture with other exempt organizations, or with for-profit partners. However, be sure to draft the operating agreement carefully so that all expectations are clearly addressed, especially if your organization is partnering with a for-profit company.

There are emerging social enterprise formats on the horizon.

B Corp. There is a lot of buzz about B Corps. However, a B Corp is not a corporation in and of itself, but a seal of approval granted to a for-profit business that is involved in social enterprise. The B Corp certification was created by the nonprofit B Lab, which seeks to encourage high standards of purpose, accountability, and transparency in the social enterprise sector.[3]

Benefit Corporation. Many states have enacted legislation that allows for the incorporation of benefit corporations, which are operated with the view to profit for a recognized purpose.[4] While there is no real difference between a benefit corporation and an ordinary for-profit in the way they are operated, by law the benefit corporation must:

  • operate for the purpose of making a positive impact on society and the environment;
  • be accountable to its employees, the community, and the environment; and
  • publish an annual benefit report that compares its overall performance against a third-party standard, such as the B Lab’s B Corp standard.

Low-Profit Limited Liability Company (L3C). The L3C, which also has been created by state statutes, is organized like a traditional LLC. However, its articles of organization indicate that:

  • its primary focus is on furthering a socially beneficial purpose;
  • no significant purpose is the production of income or the appreciation of property; and,
  • in some states, if it ever finds that its focus has shifted from social purpose to profit, it must amend its articles so that its suffix is LLC rather than L3C.

L3Cs are at an advantage in that the IRS allows private foundations to make program-related investments in L3Cs without having to obtain a private letter ruling from the IRS in advance.[5]

If your state does not offer any of these new hybrid enterprises, you may go to a state that has the enacting legislation and form one there. States will recognize and honor the entity you have formed, so long as it is legal in the state of origin.[6]

An important word of caution: If your organization intends to operate a social enterprise of any sort, be sure to consult legal and accounting professionals in your state. They can assist you in deciding which format is best for your needs, how they will be treated by the taxing authorities, whether they are required to register with charity regulators, and how to avoid unpleasant surprises. In Illinois, for example, single member L3Cs will not be granted sales tax or property tax exemptions, even if their sole member is a 501(c)(3) exempt organization.

The bottom line is this: You must arm yourself with critical information before undertaking any significant unrelated business operations.

– Kathryn M. Vanden Berk, J.D.

This article is provided for general information and should not be relied upon as legal advice for a specific situation.  If you are in need of specific advice or legal representation, please do not hesitate to contact us.

©2014 Bea & VandenBerk

[1] See “Single Member LLCs: The Flexibility of Limited Liability Companies is One Asset for Nonprofits” by Kathryn M. Vanden Berk, published in the Fall 2005 Alliance for Children & Families Magazine.

[2] See IRS Notice 2012-52.

[3] Learn more about being a certified B Corporation online.

[4] At this time, seven states have benefit corporation statutes: California, Hawaii, Maryland, New Jersey, New York, Vermont, and Virginia.

[5] The advantage of creating an L3C is that it is designed to meet the IRS requirements for qualifying as a recipient of Program Related Investments (PRI). Federal tax law generally requires private foundations to annually distribute at least five percent of their assets to social programs or designated PRI recipients in order to receive their tax benefits. Many foundations refrain from investing in for-profit ventures due to the uncertainty of whether they would qualify as PRI’s or use costly time and resources to acquire a Private Letter Ruling from the IRS to verify that the venture is a valid PRI. An L3C’s operating agreement minimizes this problem by specifically outlining its respective PRI-qualified purpose in being formed, making it easier for foundations to identify social-purpose businesses, as well as helping to ensure that their tax exemptions remain secure.

[6] The Full Faith and Credit Clause of the U.S. Constitution requires each state to respect the “public acts, records, and judicial proceedings of every other state.”