Incorporating a Social Enterprise: a Simple Legal Guide

Choosing a legal form (or structure) for your new U.S.-based social enterprise seems like it would be a piece of cake: (1) call lawyer; (2) tell lawyer what you want to do; (3) lawyer takes care of everything. Actually, it’s not so simple – especially when every lawyer you speak to says that you can’t do what you want to do or each one offers a different solution. Admittedly, what we wanted to do with our social enterprise and how we envisaged it to be structured legally was complicated. We had several goals to meet that went beyond the typical social enterprise setup. Given that many other social enterprises’ goals might overlap with ours, we have decided to share the lessons we learned after a lot of research over several months. In this blog post, we’ll outline and discuss the various legal forms we considered for our social enterprise and explain – in plain English – the pros and cons of each one. Before we do that, we’ll describe our organization and its needs so you have the lens through which we analyzed the various legal forms that we considered. Again, as each social enterprise is different, our considerations and conclusions may be different from yours. Two quick notes: 1) our legal research and analysis mainly focused on legal forms in the United States. 2) Although this post is long, it is far from complete; we came across so much information in our research, and while we try to distill it here, we could have written a book on this stuff. Post your questions below and we’ll try to help you. Disclaimer: Nothing in this blog post constitutes legal advice; it’s for informational purposes only.

Background

engageSPARK is the first product being developed by our umbrella organization, Opportunity Labs, whose mission is to eradicate poverty by creating products that are pro-poor in social and economic impact, either through the products themselves or by creating jobs at scale . Opportunity Labs is a not-for-profit social enterprise with zero personal profit motive: what we mean by this is that while we intend to bring in meaningful profits, all profits will go back into our organization to expand our impact, not to enrich a few individuals. Put another way, we are a business in practice but a nonprofit in spirit. engageSPARK is a Twilio alternative that will enable NGOs, governments, and businesses to quickly launch Voice Call and SMS programs (announcements, surveys, curriculums and decision trees) without technical help to dramatically extend their reach to the poor in 200+ countries (you can read more about the problems engageSPARK is solving here.) It will also be an attractive SaaS (Software as a Service) platform for businesses to use for customer interactions, research, marketing, and employee communications. In addition, mobile technology is helping to empower women in many developing countries, which has been recognized as one of the key catalysts for social change. Many of these applications are based on virtual phone numbers in specific geographic locations. In line with our principle of no personal profits, all profits that we earn go into increase our impact at engageSPARK and Opportunity Labs. To be able to achieve Opportunity Labs’ primary mission, we recognize that we need a strong team, great ideas, excellence in execution, and significant capital. But, without a shareholder profit motive, we can’t raise funds from venture capital firms or other profit-focused investors. While we are open to raising capital in the form of grants or zero percent interest loans, we prefer to get engageSPARK off the ground by ourselves and/or through small donations so that we could become self-sufficient and have the flexibility to run and grow our social enterprise in the best way to meet our objectives.

Our Key Goals/Desires

We had three key desires for our social enterprise: 1) Be able to sell our products to everyone – both to entities focused on helping the poor and to businesses focused on non-poor populations – without negatively affecting our legal structure / status. 2) Minimize taxes on profits to focus our earnings on our mission of building social businesses to help alleviate poverty. 3) Be a U.S.-based nonprofit organization for two main reasons: 1) to potentially tap into the large U.S. donor market, which generally wants to donate to U.S. 501(c)(3) organizations to get tax deductions, and 2) to be able to access the many free and discounted services offered to U.S. non-profits, such as the $120,000 in free Google Adwords each year.

The Legal Forms that We Considered for Our Social Enterprise

With all of that in mind, let’s jump into the three different categories of legal structures that we considered: 1) Standalone Not-for-Profit Organization

a. 501(c)(3) – Public Charity (or a Private Foundation) b. 501(c)(4) – Social Welfare Organization

2) Social Enterprise Legal Form

a. L3C b. Benefit Corporation c. Flexible Purpose Corporation

3) Multiple Entity Hybrid Social Enterprise

a. Not-for-profit entity with a for-profit subsidiary b. Not-for-profit entity with a related (or sister) for-profit entity

While we concluded that none of them met all of our goals (more on this later), some of them might meet all of yours, so let’s walk through them.

Option 1: Standalone Not-for-Profit Organization – The Best Choice, If You Can Meet All the Rules

Upsides: can accept tax-deductible donations from U.S. donors; no taxes on income from charitable activities; free/discounted services

Downsides: taxes on income earned from non-charitable activities; possibility of losing tax-exempt status

Option 1a. 501(c)(3) – Great, if almost all of your activities are charitable in nature and if you can satisfy the requirements to be a public charity (you don’t want to be a private foundation)

501(c)(3)s have three huge benefits:

1) Tax Deductible Donations: 501(c)(3)s can accept tax-deductible donations in the U.S., meaning that when someone donates money to the 501(c)(3), they can deduct the amount of the donation from their income, thus reducing the donor’s tax liability at federal, state and local levels.

2) Tax-Exempt: 501(c)(3)s don’t pay taxes on income that they earn from their charitable activities.

3) Free/Discounted Services: Many businesses offer free or discounted services to 501(c)(3)s; as we mentioned above, an example is $120,000 in free Google Adwords each year. Microsoft also heavily discounts all software for 501(c)(3)s.

Downside #1: UBTI (unrelated business taxable income) – the income you don’t want to have

501(c)(3)s, despite their many benefits, must pay taxes on unrelated business taxable income (UBTI). In your research, you’ll come across this term “UBTI” a lot. (You’ll also come across “UBIT,” which stands for “unrelated business income tax” – that’s the tax you pay on your UBTI. People tend to use these terms – UBIT and UBTI – interchangeably.) UBTI is an issue because 501(c)(3)s have to pay taxes on it. For income to be UBTI, it needs to meet all three of these requirements:

1. The income is from a trade or business;

2. The trade or business is regularly carried on; and

3. The trade or business is not substantially related to furthering the exempt purpose of the organization.

Now what does all of this mean in plain English? In short, it means that any income you earn from a business you’re regularly running that isn’t charitable at its core is UBTI (here’s the IRS’s non-plain English discussion of UBIT). A helpful example discussed and analyzed by Robert Wexler of Adler Colvin is a nonprofit focused on job training (we have no relationship with Mr. Wexler or his firm, but we’ve found many of his articles, including this one and this one, to be informative). Let’s say the nonprofit wants to train homeless people how to be waiters so that they can get jobs. The nonprofit opens a restaurant and hires homeless people to be the waiters, teaching them how to do that job well. This nonprofit is carrying on a regular business and it’s earning income from that business (meeting the first two requirements we listed above), but the business is substantially related to furthering the entity’s exempt, or charitable, purpose, i.e., job training for homeless people. So, that income isn’t UBTI and thus won’t be taxed.

But, now let’s say that the nonprofit wants to open a separate, regular restaurant staffed by professional waiters. The income from that new restaurant won’t be used to enrich any individuals (i.e., no shareholders); its purpose is fundraising, to help the nonprofit raise more money so it can train more homeless people in its first “training” restaurant. No good. This second restaurant is not substantially related to the nonprofit’s exempt purpose of training homeless people. Or, put another way, running a restaurant is simply not a charitable activity at its core; it’s a business. So, income from this restaurant would be UBTI and thus would be taxed. (The “training” restaurant is also a business, but because it exists for the charitable purpose of training homeless people, its income is not taxed.)

Our social enterprise is similar to this restaurant example. We plan to sell engageSPARK services to nonprofits to help the poor (a charitable activity), but we’ll also sell our services to businesses to generate funds that we can use for pro-poor activities. Our services are not charitable at their core and so sales to customers that are not focused on helping the poor would likely be considered UBTI, and we would have to pay taxes on profits from those sales.

Downside #2: Losing your Tax-Exempt Status – too much non-charitable activity and you could lose your tax-exempt status – the worst of all possible worlds

If your organization is spending too much of its resources on UBTI activities, you could lose your tax-exempt status. The IRS might say that your resources are more dedicated to operating a business than running a charity, and so you don’t deserve the benefits of being one. The IRS may then strip your organization of its tax-exempt nature, meaning you’ll have to pay taxes on all of your profits. Not only will you have to pay taxes on your UBTI, but too much UBTI might lead to you also having to pay taxes on income from charitable activities and losing all of the other benefits of being a 501(c)(3) – a disastrous outcome.

Losing your tax-exempt status is the worst possible outcome because the IRS will still treat you as a nonprofit, meaning that you’ll still need to satisfy all of the requirements of a 501(c)(3); you’ll just lose many of the benefits. Even though you are no longer tax-exempt and treated like a regular company for tax purposes, you’re still a nonprofit, so you won’t suddenly be able to start extracting income in the form of dividends to any individuals (remember, a nonprofit’s income can’t financially benefit any individuals). So, if you go down this path, be careful about how much time and resources you spend on non-charitable activities.

Downside #3: To get the most benefits, you need to qualify as a public charity – not easy, but important

One final issue is that there are two kinds of 501(c)(3)s: the Public Charity (ideal) and the Private Foundation (not so ideal). By default, 501(c)(3)s are private foundations; you need to meet certain requirements to qualify as a public charity. And you very much want to be a public charity because private foundations have more onerous reporting requirements, operating restrictions, and certain extra types of taxes that they have to pay.

How do you qualify as a public charity? At least one-third of your income must come from the public or the government. And, if more than 2% of your 501(c)(3)’s funds comes from an individual donor, then that donor does not count as being part of the “public” and his/her funds therefore don’t count towards the one-third requirement. (Note: donations from other public charities count as money from the public. Also, if only 10% of your income comes from the public, you can still qualify if you meet certain factual tests.)

In other words, to qualify as a public charity, your 501(c)(3) must have “broad” public support and not be funded by just a few people or families. So, if you do not intend to focus some of your resources on getting donations from the general public, then a public charity is not for you. A 501(c)(3) Private Foundation still can be the right choice for you, as it still has many of the benefits described above, but recognize that you will have to deal with many additional burdensome regulations.

Option 1b. 501(c)(4) Social welfare organization – don’t even think about it

If you’re considering a 501(c)(4) Social Welfare Organization – a tax-exempt entity promoting social good that cannot accept tax-deductible donations – don’t. We did, hoping that maybe because the 501(c)(4) can’t accept tax-deductible donations, the IRS would be more lenient about UBTI. But, we were wrong. All tax-exempt organizations must pay taxes on UBTI. We quickly saw that the 501(c)(4) had no advantages when it came to our goals over the 501(c)(3), and discarded it is an option. For some of you – specifically those of you who plan to do a lot of lobbying or don’t want to disclose your donors – a 501(c)(4) may be an option, but that’s beyond the scope of this article.

The UBTI issue and the fear of potentially losing our tax-exempt status from too many sales to commercial enterprises led us to conclude that as much as we wanted to be a 501(c)(3), it simply wouldn’t work for our business model. So, we moved on to evaluating other legal forms.

Option 2: Social Enterprise Legal Form: L3Cs, Benefit Corporations, Certified B Corps, and Flexible Purpose Corporations – Not as Great as Everyone Makes Them Out to Be

Upsides: prioritizing social mission over profits is allowed

Downsides: taxes on all profits; balancing dual missions of social impact and earning profits

There’s much talk in the social enterprise space about L3Cs, Benefit Corporations, Certified B Corporations (B Corps), and Flexible Purpose Corporations (currently only available in California). While many commentators seem to laud them, we found none of them to be particularly useful. We plan to write another blog post analyzing in detail the various Social Enterprise Legal Forms, but we’ll provide a quick summary of that analysis here. In short, the one real benefit that all of these social enterprise legal forms offer (except for the B-Corp – we’ll discuss the B-Corp in detail in our future post) is that their managers may legally prioritize their social mission over maximizing profits. Managers of regular for-profit companies must maximize profits or they can be sued by shareholders for breaching their responsibilities. So if you don’t want the pressure of the law saying that your number one priority must be to maximize profits, then these types of organizations might be appropriate for your social enterprise. However, while you won’t feel pressure from the law, you likely will from your investors. With these social enterprise legal forms, you’ll be able to work towards two missions: social impact and profits. But with those dual missions comes a cost: balancing the two will be tough, especially when your investors are pressuring you to give them higher and higher returns. You very well may find yourself sacrificing your mission – the reason you started the enterprise – to please your investors. Finally, there are no tax advantages to being any of these entities. The IRS treats them as for-profit companies, and they therefore must pay taxes on all income. These social enterprise legal forms didn’t work for us for the above reasons. In particular, the tax consequences were simply too high for us. One of our main goals was to minimize taxes on our profits, and none of these legal forms helps with that. With these forms, 100% of your profits will be taxed.

Option 3: Multiple Entity Hybrid Social Enterprise – Best Option, If Many of Your Activities Are Not Charitable in Nature

Upsides: same as a non-profit – can accept tax-deductible donations; no taxes on income from charitable activities; free services

Downsides: for-profit entity pays taxes on all income (but see the Tip for Option 3b); operational inefficiencies; conflict of interest issues

We looked at two main types of hybrid structures: 1) a nonprofit parent entity with a for-profit subsidiary and 2) a nonprofit entity with a related sister for-profit company.

Option 3a. Nonprofit with a for-profit subsidiary

Yes, a 501(c)(3) can own another legal entity – partially or wholly. For many organizations, this is an attractive legal structure and a very common one. The nonprofit gets all of the benefits of being a 501(c)(3) and avoids some of the pitfalls, like potentially losing its tax-exempt status. You’d set this up by having the nonprofit engage only in charitable activities and the for-profit subsidiary engaging in normal business activities.

The non-profit could accept tax-deductible donations, it is unlikely to lose its tax-exempt status (since all – or most – of its activities would be charitable), and it wouldn’t have to pay any taxes on income flowing from its charitable activities. The for-profit’s income would then flow to its nonprofit parent as a dividend. (Note: there are other tax-optimized ways of moving some of the for-profit’s income to the nonprofit – like royalties, licensing fees, etc. – but we won’t get into all the nitty gritty details here.)

There are, however, a series of problems with this structure.

Downside #1: Taxes – But, at least not all of your income will be taxed (like with a social enterprise legal form)

First, the for-profit subsidiary will have to pay taxes on all of its income before any funds are distributed to the nonprofit parent as a dividend. So, you’ll end up losing a lot of your income to taxes that could have otherwise gone towards helping the poor.

Downside #2: Conflict of Interest – Do you have enough staff to handle these issues?

Second, the two entities will need to be independent of each other. They’ll either need to have some different directors or some different manager/officers. They’ll need to make separate decisions, especially when conducting business transactions between the two. Otherwise, the entities will have serious conflict of interest issues. The IRS may then determine that the two entities are actually one and the same and will strip the 501(c)(3) of its tax-exempt status. You’ll then lose all the benefits of being a nonprofit.

Downside #3: Operational Inefficiencies – Do you want to slow down your business’s operations and growth?

Third, and related to the independence issue, you’ll face all sorts of operational inefficiencies. If you’re a small organization with few employees, you’re going to have to deal with managing each employee’s time very carefully. You’ll have to make sure that you properly monitor and separate employee hours, advertising/marketing costs, and a whole host of other issues between the two entities, being very clear about how much of every expense and income source is related to the nonprofit and how much to the for-profit.

As you grow and become a much larger organization, this should be easier as you’ll be able to assign some employees just to the nonprofit and others only to the for-profit subsidiary, so that there is a real separation between the two entities. But for small, startup social enterprises, managing all of this will be difficult and will make you less efficient.

For organizations like engageSPARK, which will be a web-based service, separating marketing and sales between the two entities will be especially difficult. Would we need to have two websites, one for NGO customers and another for business customers so that there isn’t too much overlap between the nonprofit parent and the for-profit subsidiary? How will that affect our marketing strategies? Our sales strategies? Etc. etc. etc. – a real headache for any social enterprise.

(We also analyzed a 501(c)(3) having a for-profit subsidiary in a foreign country but decided not to go down that route for a number of reasons. We’ll discuss our analysis of that structure in a future blog post.)

Option 3b. Nonprofit with a sister for-profit company – Cool way to limit your tax liability, but the sister for-profit’s shareholders will really need to trust each other

The non-profit with a sister for-profit entity is another interesting option. It has many of the same downsides as the nonprofit with a for-profit subsidiary – namely, the for-profit still needs to pay taxes and you still need to worry about independence and operational efficiency issues, but it has one huge potential benefit. You can set up the for-profit as an S-Corporation, which is a pass-through entity for tax purposes, meaning that rather than the S-Corp paying its own corporate taxes (which a C-Corporation, the standard type of corporation, would have to do), all of the S-Corp’s profits are treated as the owners’ individual profits, and so the shareholders pay personal income taxes on the company’s profits.

Let’s walk through why this is so beneficial. When calculating taxes, individuals can deduct donations to (most) 501(c)(3)s up to 50% of their income. So, let’s say you and a friend each own 50% of the S-Corporation, and the S-Corporation brings in $1 million in profits. Each of you will need to individually report $500,000 in profits on your personal income taxes (half of the S-Corp’s profits) because the S-Corp is a pass-through entity, but you’ll each be able to donate those profits to the non-profit. You’ll be able to deduct $250,000 (50%) from your personal income, leaving you with about $250,000 in income. So, doing a bit of rough math, you’d each pay about 30% of that $250,000 in taxes, or $150,000 in total taxes on $1 million of income. If the for-profit were a C-Corp, then the C-Corp would have to pay 40% of the $1 million in profits or $400,000. With this structure, the nonprofit would get an extra $250,000 in tax-free income.

(Note: The above example isn’t exactly accurate, but we presented it that way to make it easier to understand. The problem is that each shareholder can’t actually donate the full $500,000 to the nonprofit; otherwise, each shareholder will end up paying taxes from their own money on the $250,000 that they can’t deduct from their income. Presumably, the shareholders won’t want that personal tax hit, so what will end up happening is that they’ll donate $410,000 of the $500,000 to the non-profit, deduct half of the $410,000 donation from their income, leaving them with a tax bill on the remaining $295,000 (the $205,000 not deducted plus the $90,000 not donated), and pay the tax bill with the $90,000 of the $500,000 that they didn’t donate to the nonprofit. So, at the end of the day, the nonprofit gets a total of $820,000 after taxes on the S-Corp’s $1,000,000 in profits – still much better than getting $600,000 in after-tax income if the structure were a nonprofit with a for-profit C-Corp subsidiary.)

Downside #1: Dedicated shareholders – All of your shareholders will need to be willing to play along

The only way this S-Corp plan will work is if all shareholders are willing to play along. It’s definitely possible that down the road (i.e., once you’re bringing in big money), one or more shareholders will decide not to donate their share of the S-Corp’s income to the nonprofit. And if that happens, the benefit of this strategy will fall apart. The only way to try to limit this risk is by putting together an airtight shareholder’s agreement that requires each shareholder to donate their share of the income to the nonprofit and preventing them from selling their shares to outsiders who don’t agree with the plan. The problem, though, is that an agreement like that will likely be struck down by most state courts, which don’t like overly restrictive shareholder agreements. So, you’ll need to make sure that you can trust all of the shareholders to play along now and in the foreseeable future.

Downsides #2 & #3: Conflict of Interest and Operational Inefficiencies

The same sorts of conflict of interest and operational inefficiency issues that exist for Option 3a above also exist here, except that with this structure, you need to be even more careful because here the owners of the for-profit entity are individuals, not a 501(c)(3). If it looks like any actions by the nonprofit are benefiting the S-Corp, the IRS may interpret that to mean that the individual owners of the S-Corp are getting a financial benefit from the nonprofit – a big no-no! So, if you go down this path, be extra careful. Make sure that any business dealings between the S-Corp and the nonprofit are done at super arm’s length by very independent managers and directors.

A Tip: the more shareholders you have, the lower your social enterprise’s tax liability can be!

This structure is a nice one and can really help your social enterprise reduce its tax liability. And here’s the kicker: you could even use the S-Corp structure to reduce your social enterprise’s tax liability to zero or almost to zero. But you’ll need to have more shareholders to do it and that takes you back to downside #1 – the more shareholders you have, the higher the risk that one of them will disregard your pact and refuse to donate their share of the S-Corp’s profits to the nonprofit. But assuming everyone plays along, you really can significantly reduce your social enterprise’s tax liability.

Imagine you have 10 equal shareholders, each getting $100,000 in pass-through income of the S-Corp’s $1,000,000 in profits. Each shareholder donates $95,000 of the $100,000 to the nonprofit. The shareholders can deduct up to 50% of their total income in donations, so they can each deduct $50,000 from their income of $100,000, leaving them with $50,000 of personal income to pay taxes on. At about a 10% rate, that’s $5,000 in tax that they have to pay (which they retained from the $100,000 they received from the S-Corp so that they could pay the tax).

With this structure, the nonprofit ends up getting $950,000 after taxes of the S-Corp’s $1,000,000 in profits, much better than the example above where the nonprofit got $820,000 after taxes. This is because each shareholder is bringing home less personal income than in the previous example ($100,000 instead of $500,000) and so is in a lower tax bracket. Thus, the more shareholders the S-Corp has, the more of the S-Corp’s profits the nonprofit can get after the shareholders use some of the pass-through income to pay taxes.

(Note: in a perfect scenario – where each shareholder has separate, additional personal income that is equal to or greater than the pass-through income they receive from the S-Corp – the nonprofit can get 100% of the S-Corp’s profits tax free. In that situation, each shareholder would donate and deduct all of their S-Corp pass-through income from their total income, leaving them with income (to pay taxes on) that is equal to the separate, additional personal income they had; their S-Corp pass through income would thus have no effect on their personal income tax.)

By creating an S-Corp that is a sister entity of the nonprofit and donating the income as we describe, the nonprofit loses a lot less money in taxes that can go directly towards its charitable mission. But, you’ll need to be really careful in operating these two entities, making sure any transactions between the two are sanctioned by independent board members and managers. Again, tons of conflict of interest and operational inefficiency issues, which are really tough for small startup social enterprises to manage.

And finally, the nonprofit will need to do something. If it’s getting all of this money tax free but isn’t doing anything with that money, the whole purpose of the structure is defeated. So, you’ll need to figure out what the nonprofit is doing – is it donating those funds to other nonprofits? Is it investing via Program Related Investments in other social enterprises? Is it providing low cost or free products and services to the poor? Don’t forget – the nonprofit must perform charitable activities.

Conclusion

We analyzed many different legal forms for our social enterprise – ranging from a standalone 501(c)(3) to social enterprise legal forms like the L3C, Benefit Corporation, and Flexible Purpose Corporation, and two nonprofit/for-profit hybrid structures (the parent subsidiary and the sister structure). Unfortunately, none of these legal forms worked for us. We ultimately concluded that there simply is no real solution for a not-for-profit social enterprise under U.S. law. If the product or service that you are offering is not charitable at its core, then sales of that product or service without a direct social benefit (e.g., to businesses) is simply not a charitable activity and will be taxed under U.S. law. Trying to limit your taxes so that more funds can go towards charitable purposes is really tough and ends up leading to conflict-of-interest and operational nightmares. If you’re starting a new social enterprise that will have a dual motive of shareholder profits and social impact, then many of the above options should work just fine for you. But if, like us, you’re starting a not-for-profit social enterprise – especially one that needs to earn and maintain profits to be able to start new social enterprises (rather than to enrich investors), then you’re going to have a tough time finding the right legal structure in the U.S. – or you’ll just lose a lot of money to taxes that could have gone to social programs. So what did we end up doing? We opened a private company in Hong Kong. Why?

We’re global in nature. We don’t have any operations in the US. We’ll be doing a lot of business in the poorest countries in Asia. We may end up operating from an Asian country. Hong Kong is the financial capital of Asia.

So, Hong Kong made sense for us. (It also didn’t hurt that Hong Kong’s corporate income tax rates are low.) Being a private company, though, has risks. While our team is very dedicated to our mission of being a not-for-profit social enterprise, where no individuals financially benefit from the company’s profits, we recognize that if we start bringing in large profits, things might change. Money – big money – has a way of getting in the way of someone’s pure motives. So, to protect against the risk of a shareholder trying to take some of the company’s profits for their personal benefit, we’re putting together a very strict contract between the shareholders that severely punishes any shareholder that tries to sell their shares, and we’re forbidding dividends in our bylaws (or their equivalent under Hong Kong law). Our outcome may not be helpful for those of you operating mainly in the U.S., but we hope the rest of this post is helpful. Have you looked into these issues as well? Do you have different takeaways? Is there something in here that you disagree with or think is incorrect from a legal standpoint? Please comment below. What about those of you outside the U.S. – have you faced similar issues in forming a social enterprise? Please share your experiences and thoughts below. Also, make sure to check out our other detailed blog post analyzing the different types of social enterprise legal forms in the United States and the new legal form of social enterprise that we propose.