RUNNING A SOCIAL ENTERPRISE: LEGAL STRUCTURE AND TAX CONSIDERATIONS

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1 RUNNING A SOCIAL ENTERPRISE: LEGAL STRUCTURE AND TAX CONSIDERATIONS Mission Edge: San Diego Accelerator + Impact Lab (SAIL) September 25,

2 Questions for audience What are you hoping to learn? Is anyone affiliated with a social enterprise? 1

3 Some considerations for choosing best structure What is your idea or objective? Solely philanthropic? Social improvement with some profit potential? Is a new entity necessary? Should you join forces with an existing entity serving a similar purpose? What are your funding sources, and are they dependent on tax-exempt status? Are qualified and interested directors available and willing to make the commitment necessary for a successful enterprise? Do you anticipate engaging in transactions with related parties that may violate applicable federal tax rules? Is exemption from property taxes important? 2

4 Basic forms of nonprofit enterprises Unincorporated associations Unincorporated group of two or more persons joined by mutual consent for a common purpose Can be organized for profit, or for a purpose other than to operate a business for profit Created through memorandum of association Recognized as separate legal entity that may contract and hold title to real estate Members generally not liable for association s contractual obligations Advantages Ease of formation and informality with which association may act Disadvantages Some remaining uncertainties concerning the law governing the association and its members Uncertainty concerning liability in SLAPP suits (influencing governmental action) 3

5 Basic forms of nonprofit enterprises, cont d Nonprofit corporations (c.f., donor-advised fund) Public benefit corporation, mutual benefit corporation, and religious corporation Formed by filing Articles of Incorporation with Secretary of State and paying modest fee Bylaws adopted for internal governance and control Must have board of directors, and may also have members (voting and non-voting) No shareholders (equity owners) as with for profit corporations Advantages Clear and well defined statutory norms for such important areas as permitted activities, internal governance, director standards of conduct, director and member liability and indemnification of agents Protection from liability, particularly for uncompensated directors and officers Disadvantages Ongoing governmental filing requirements and need to observe corporate formalities Burden imposed on directors by statutory standards of conduct 4

6 Basic forms of nonprofit enterprises, cont d Public Benefit Corporation May be formed for public or charitable purpose and may qualify for income tax exemption under 501(c) (e.g., 501(c)(3) charitable organization or 501(c)(4) social welfare organization) May not make any distribution of corporate assets to members or provide private benefit Subject to extensive governmental regulation and supervision Mutual Benefit Corporation May be formed for any lawful purpose and may qualify for income tax exemption under 501(c) (e.g., 501(c)(4) social welfare organization or 501(c)(6) business league or trade association) May make distributions of corporate assets to members on dissolution Subject to less stringent governmental regulation and supervision Religious Corporation May be formed primarily or exclusively for religious purposes and may qualify for tax exemption under 501(c)(3) May make distributions of corporate assets to members at any time Subject to less stringent governmental regulation and supervision 5

7 Newer forms of social enterprises Benefit Corporation and Social Purpose Corporation Not nonprofit and cannot qualify for income tax exemption May be right choice if: Objective is to pursue charitable or public purpose and to attract investors, or Will provide some public benefit, but not exclusive public benefit, so will not be able to qualify for income tax exemption Formed by filing Articles of Incorporation with Secretary of State with special provisions 6

8 Newer forms of social enterprises, cont d Benefit Corporation Articles required to state corporation is a benefit corporation, and purpose must be to create general public benefit in addition to business activity Activities must create a material positive impact on society and the environment, which may limit the corporation from engaging in certain business activities Examples: providing low-income housing; promoting economic opportunity to individuals; preserving the environment; improving human health; promoting arts, sciences or advancement of knowledge; and increasing flow of capital to entities with public benefit purpose Directors and officers owe duties to benefit corporation and its purpose, but must also consider impact to shareholders and others 7

9 Newer forms of social enterprises, cont d Benefit Corporation, cont d Public benefit is measured by a third-party standard that defines and assesses the overall corporate social and environmental performance Must assess impact on employees and workforce of benefit corporation and its subsidiaries and suppliers; customers; and community and society Must prepare and deliver to shareholders an annual benefit assessment report and make report publicly available Benefit enforcement proceeding may be brought 8

10 Newer forms of social enterprises, cont d Social Purpose Corporation Articles must provide that in addition to business activity, corporation s purpose is to engage in special purposes Special purposes include one or more charitable or public purposes; and promoting positive short-term or long-term effects of, or minimizing adverse short-term or long-term effects of, the corporation s activities on (i) the corporation s employees, suppliers, customers, and creditors, or (ii) the community and society, or (iii) the environment More flexibility than a benefit corporation in pursuing special purposes Must prepare annual report on special purposes but no third-party standard 9

11 Newer forms of social enterprises, cont d Low-Profit Limited Liability Company (L3C) Legislation has not been enacted in California Must be organized primarily for furthering a charitable purpose and may not significantly pursue financial return Purpose may not be to accomplish one or more political or legislative purposes 10

12 Tax Considerations Benefit Corporations, Social Purpose Corporations, and L3Cs do not qualify for income tax or property tax exemption Taxed as C corporations, and shareholders taxed on dividend distributions Only Public Benefit Corporation may qualify for income tax exemption under 501(c)(3) and property tax exemption Must be organized and operated exclusively for public or charitable purpose Must not provide private benefit (e.g., excessive salary, or above-market contracts) May influence legislation if insubstantial part of overall activities, but prohibited from supporting or opposing candidate for political office Donations are deductible; and governments, private foundations and donor-advised funds may make grants To qualify for property tax exemption, property must be owned by charity and used exclusively for charitable purposes; issues often arise where charity allows other organizations to use property 11

13 Tax Considerations, cont d Unrelated business taxable income (UBTI) Tax-exempt organizations may engage in business activity unrelated to their exempt purpose to an insubstantial degree (no bright-line test of how much is o.k. but >20% is likely a problem) To be taxable, business activity must be (i) unrelated to exempt purpose (even if proceeds used for exempt purpose), and (ii) regularly carried on 12

14 Tax Considerations, cont d Unrelated business income tax, cont d Exceptions include: Services performed by volunteers Sales of donated merchandise Income from investment transactions such as rents (where no services are performed), dividends, interest, annuities, royalties and capital gains 13

15 Tax Considerations, cont d Unrelated business income tax, cont d If property producing investment income is debt-financed, the income will be UBTI E.g., rents from property that has mortgage 14

16 Tax Considerations, cont d Unrelated business income tax, cont d May avoid UBTI by conducting business activity through for profit corporate subsidiary Also provides liability protection May also be used to attract investors, engage in joint venture or provided equity compensation to employees Should maintain separateness and not have identical boards and officers Interest, rent, and royalties received from controlled (>50%) subsidiary still UBTI, but not dividends 15

17 Tax Considerations, cont d Sales and use tax Generally applies to all social enterprises Exemption for sales for resale, occasional sales, and sales to U.S. government or instrumentalities Narrow exemptions available for charitable organizations E.g., donated property; sales of children s clothing for distribution by charity; meals served to patients of health facilities and schools; art work for display; auctions to raise funds to shelter homeless; thrift store sales where > 75% of net proceeds used for charity 16

18 Tax Considerations, cont d Employment taxes All social enterprises may hire employees and pay reasonable compensation Must withhold and remit payroll taxes (income, FICA, FUTA) 17

19 Thank you! Questions? Please feel free to contact me any time for guidance. Jon P. Schimmer Partner