Social Enterprise by Non-Profits and Hybrid Organizations (Portfolio 489)

Tax Management Portfolio, Social Enterprise by Non-Profits and Hybrid Organizations, No. 489-1st, analyzes the unique federal income tax and state law issues affecting the relationships between social entrepreneurship and tax-exempt organizations, whether carried on directly by the tax-exempt organization or encouraged by investments in or grants to socially- or charitably-minded for-profit businesses. The Portfolio further examines the emergence of hybrid organizations designed to apply commercial strategies to maximize a social or charitable purpose. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Description

Tax Management Portfolio, Social Enterprise by Non-Profits and Hybrid Organizations, No. 489-1st, analyzes the unique federal income tax and state law issues affecting the relationships between social entrepreneurship and tax-exempt organizations, whether carried on directly by the tax-exempt organization or encouraged by investments in or grants to socially- or charitably-minded for-profit businesses. The Portfolio further examines the emergence of hybrid organizations designed to apply commercial strategies to maximize a social or charitable purpose.

This Portfolio begins with a look at traditional social entrepreneurship by tax-exempt organizations. It considers the overall tests for tax-exemption and then focuses on specific operational activities, including job training, microfinance, low-income housing, technical assistance, the sale of products to the poor, and publishing, to evaluate when those activities can be conducted within a tax-exempt organization. The Portfolio reviews other key issues that affect tax-exempt social enterprises, including the unrelated business income tax rules, the joint venture rules, and the use of for-profit subsidiaries of exempt organizations.

This Portfolio then examines the federal income tax and state law issues affecting investments in, or grants to, for-profit entities by tax-exempt organizations. Types of investments discussed include socially responsible investments (SRIs), mission-related investments (MRIs), and program related investments (PRIs). This Portfolio also examines expenditure responsibility grants to for-profit entities.

Finally, this Portfolio looks at the emergence of hybrid organizations in the United States, which are single for-profit legal entities that simultaneously serve a traditional business purpose and a social or charitable purpose. Specifically, within the past five years, twenty-five states and the District of Columbia have enacted statutes authorizing distinct types of legal entities that cater to social enterprise. The two primary types of such hybrid organizations are the benefit corporation and the low-profit limited liability company (“L3C”). Both types of such hybrid organizations, as well as certain other variants, are discussed in detail in the final portion of this Portfolio.

This Portfolio may be cited as Brewer, Minnigh & Wexler, 489 T.M., Social Enterprise by Non-Profits and Hybrid Organizations.

Authors

Cassady V. Brewer, Esq.

Cassady (“Cass”) V. Brewer, B.S., Vanderbilt University (1983); J.D., University of Arkansas (with highest honors, 1986); LL.M. (Taxation), New York University (1987); admitted to practice in Georgia; Past Chair, Partnership and LLC Committee, Business Law Section, State Bar of Georgia; Past Member, Executive Committee, Business Law Section, State Bar of Georgia; frequent speaker and writer on social enterprise, business law, and nonprofit tax issues.

Elizabeth Carrott Minnigh, Esq.

Elizabeth Carrott Minnigh, B.A., Kenyon College (cum laude and with highest honors, 1997); J.D., University of Pennsylvania (2001); LL.M. (Taxation), New York University (2007); admitted to practice in New York and the District of Columbia; co-chair of communications and co-editor of newsletter, Washington Estate Planning Council; frequent speaker and writer on social enterprise, estate planning, and nonprofit tax issues.

Robert A. Wexler, Esq.

Robert A. Wexler, A.B., Brown University (magna cum laude, 1982); J.D., Columbia University (1985); admitted to practice in California; Chair, American Bar Association, Tax Section, Exempt Organization Committee; Lecturer in Law, Stanford Law School, frequent speaker and writer on social enterprise and nonprofit tax issues.

Table of Contents

Detailed Analysis
I. General Considerations — Introduction
A. Scope of This Portfolio
B. Definitions
1. Social Enterprise
2. Hybrid Organizations
3. B Corporation
C. History of Social Enterprises
II. Tax-Exempt Social Enterprises
Introductory Material
A. Tax Exemption Under §501(c)(3)
1. Organizational Test and Purposes
a. Charitable
b. Educational
c. Scientific
2. Operational Test
a. Exclusivity
b. Public Interest and Private Benefit
3. Private Inurement
4. Prohibition on Electioneering
5. Prohibition on Substantial Lobbying
6. Private Foundation Versus Public Charity Status
B. Specific Social Enterprise Activities
1. Job Training
2. Microfinance
3. Housing
a. Safe Harbor for Low-Income Housing Projects
b. Other Legal Theories
4. Consulting and Technical Assistance
5. Developing and Selling Products to Improve Health and/or Help the Poor
6. Publishing
C. Tax Exemption Under §501(c)(4)
D. Unrelated Business Income Tax
1. Three Requirements
a. Trade or Business
b. Regularly Carried On
c. Substantially Related
2. Common Exceptions or Modifications to UBIT
3. Exceptions to the Exceptions
E. Social Enterprise Through For-Profit Subsidiaries
F. Joint Ventures Operating Social Enterprises
III. Investments in and Grants to For-Profits by Nonprofits
A. Overview
B. Socially Responsible Investments and Mission Related Investments
1. Socially Responsible Investments
a. Screening
(1) Negative Screen
(2) Positive Screen
b. Shareholder Advocacy
c. Community Investments
2. Mission Related Investments
3. State Law Considerations
a. Fiduciary Duties
(1) Duty of Loyalty
(2) Duty of Care
b. Prudent Investor Restrictions
4. Organizational Investment Policy
5. Donor Restrictions
6. Federal Tax Treatment
a. Taxation of Private Foundation Investors
(1) Net Investment Income
(2) Self-Dealing
(3) Qualifying Distributions
(4) Excess Business Holdings
(5) Jeopardizing Investments
(6) Taxable Expenditures and Expenditure Responsibility
(7) Unrelated Business Taxable Income
(8) Excess Executive Compensation
(9) Reporting Requirements
b. Taxation of Public Charity Investors
(1) Passive Investment
(2) Application of Joint Venture Rules
(3) Unrelated Business Taxable Income
(4) Excess Executive Compensation
(5) Reporting Requirements
c. Taxation of Donor Advised Fund Investors
(1) Taxable Expenditures
(2) Excess Business Holdings
(3) Reporting Requirements
C. Program Related Investments
1. Definition
a. Primary Purpose Is Accomplishment of One or More Exempt Purposes
b. Production of Income or Appreciation of Property Is Not a Significant Purpose
c. Influencing Legislation or Taking Part in Political Campaigns on Behalf of Candidates Is Not a Purpose
2. Types of PRIs
a. Loans
b. Loan Guarantees
c. Linked Deposits
d. Equity Investments
3. Federal Tax Treatment
a. Net Investment Income
b. Self-Dealing
c. Qualifying Distributions
d. Taxable Expenditures and Expenditure Responsibility
4. Reporting Requirements
D. Expenditure Responsibility Grants
1. Pre-Grant Inquiry
2. Written Agreement
3. Reports from Grantee
4. Reporting by Grantor
5. Recordkeeping
6. Violations of Expenditure Responsibility Requirements
IV. Hybrid Organizations
A. Overview
B. Low-Profit Limited Liability Companies (L3Cs) and Benefit LLCs
1. L3Cs: Brief History and Fundamentals
2. Basic Characteristics of LLCs
a. Contract-Like Flexibility in Organization and Operation
b. Liability Protection
c. Malleable Tax Treatment
3. L3Cs: State Law Fundamentals
a. L3Cs: Common Statutory Requirements
b. Subtle Differences Among States with L3C Laws
c. Fiduciary Duty Differences Among States with L3C Laws
d. The L3C as a PRI Facilitator
4. Criticisms of the L3C as a PRI Facilitator
5. “Tranched” Investing and PRIs
a. Example of a “Tranched” Investment PRI
b. Example of Tiered or “Tranched” Returns
c. Caveats with Respect to “Tranched” Investing in LLCs/L3Cs
(1) Flexibility Creates Complexity and Cost
(2) “But-For” Test Must Be Met to Qualify as a PRI
(3) Exercise Extreme Caution to Avoid Self-Dealing
(4) Section 4940 Net Investment Income Tax Still Applies
(5) Joint Venture Rules Could Come Into Play
(6) Unrelated Business Income Tax Considerations
6. Other, Non-PRI-Related Uses of the L3C
7. Benefit Limited Liability Companies
8. Drafting Considerations with Respect to LLC/L3Cs and PRIs
a. In General
b. Expenditure Responsibility
c. Free Transferability
d. Unilateral Right to Withdraw/Exit Strategy
C. Hybrid Corporations
1. Legal Background for Hybrid Corporations
a. Ben & Jerry's Problem
b. Dodge v. Ford and eBay v. Newmark
c. The Countervailing View and the Business Judgment Rule
d. Constituency Statutes
e. Conclusion: Hybrid Versus Traditional Forms
2. Hybrid Corporations in General
3. Benefit Corporations
a. Adopting States and Introduction
b. Benefit Corporation Legislation in General
c. Principal Attributes of Benefit Corporations Under the Model Act
(1) Unique Purpose and Required Statement in Articles
(2) Conversion to Benefit Corporation Status
(3) Termination of Benefit Corporation Status
(4) Unique Rules for Directors and Board
(5) Third-Party Standard and Annual Report
d. Principal Attributes of the Delaware Act
(1) A “Light” Form of the Model Act?
(2) Some “Tougher” Aspects of the Delaware Act
e. Unique State-by-State Features
f. Criticisms/Concerns Regarding Benefit Corporations
4. Flexible Purpose Corporations
a. Permissible Purposes
b. Conversion to or from a Flexible Purpose Corporation
c. Fiduciary Duties of Directors
d. Annual Reports
5. Social Purpose Corporations
a. Permissible Purposes of Washington Social Benefit Corporations
b. Conversion to or from a Washington Social Purpose Corporation
c. Fiduciary Duties of Directors of a Washington Social Benefit Corporation
d. Annual Reports of Washington Social Benefit Corporations
e. Texas Social Benefit Corporations
6. Weighing Use of Nonprofit Corporation Versus Hybrid Corporation

Working Papers

Table of Worksheets
Worksheet 1 Sample Nonprofit Investment Policy
Worksheet 2 Comparison of Considerations for Investment Types
Worksheet 3 Sample Written Record Documenting Pre-Grant Inquiry
Worksheet 4 Comparison of Expenditure Responsibility Requirements for Written Agreement Governing Program-Related Investments versus Expenditure Responsibility Grants
Worksheet 5 Sample Expenditure Responsibility Agreement for Expenditure Responsibility Grant
Worksheet 6 Social Enterprise Comparison Chart as of August 1, 2017
Worksheet 7 Hybrid Corporations Principal Features Comparison Chart
Worksheet 8 Sample NY Benefit Newco Certificate of Incorporation
Worksheet 9 Sample NY Benefit Newco Bylaws
Worksheet 10 Sample NY Benefit Newco Incorporator's Consent
Worksheet 11 Sample NY Benefit Newco Consent of Board
Worksheet 12 Sample NY Benefit Newco Shareholder's Agreement
Worksheet 13 Sample NY Benefit Newco Stock Restriction Agreement
Worksheet 14 Sample NY Benefit Newco Subscription Agreement
Worksheet 15 Sample L3C Articles of Organization
Worksheet 16 Sample Vermont L3C Operating Agreement