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Colorado Public Benefit Corporations Part IV: Focusing on 501(c)(3) Benefits and Whether They Apply

Today’s post is the last in a four-part series providing a perspective of Colorado’s new public benefit corporation law through a nonprofit lens. Its focus is on alleviating potential confusion about public benefit corporations’ eligibility for some of the benefits associated with traditional 501(c)(3) organizations, including their eligibility for funding from private foundations.

By way of recap, beginning April 1, 2014, Colorado will allow for the creation of a new “hybrid” entity—the “public benefit corporation.” These will be for-profit corporations (with private shareholders), which serve a dual purpose of pursuing profits (for the benefit of the shareholders) and promoting one or more public benefits identified in the entity’s articles of incorporation. Colorado’s new hybrid entities are similar in concept to the hybrid entities authorized in other states, known as “benefit corporations.”

Because the new law has been viewed primarily through a for-profit lens by other commentators, we chose to write a series of posts to highlight the ways these new dual-purpose entities will intersect with the nonprofit sector, and areas of potential confusion or uncertainty in the laws that apply to the nonprofit sector:

  1. Our first post provided a brief history of the new law and explained how use of the term “public benefit corporation” could cause confusion within the nonprofit sector.
  2. Our second post described how public benefit corporations will be organized and operated in Colorado, starting April 1, 2014.
  3. Our third post discussed the extent to which these new entities could become subject to Colorado’s charitable solicitations laws and whether they will be on a level playing field with the nonprofit sector when it comes to charitable solicitations and sales promotions.
  4. As mentioned, this fourth post will explain why these new entities are not eligible for the same tax benefits as tax-exempt, 501(c)(3) organizations, and the restrictions and limitations that will test their ability to gain funding from charitable foundations.

Will Colorado public benefit corporations be eligible for tax-exempt, 501(c)(3) status? No. Over the past couple years, we have fielded numerous phone calls from well-meaning social entrepreneurs operating under the false understanding that organizing as a benefit corporation will allow them to enjoy the best of both the nonprofit and for-profit worlds: to operate a privately owned, mission-minded business, while raising grants and donations from foundations and the public.

However, as for-profit corporations with private shareholders, benefit corporations will not be eligible for 501(c)(3) status. Section 501(c)(3) of the Internal Revenue Code, which bestows tax-exempt status on certain charitable entities, and the ability to receive tax-deductible donations, has a strict prohibition against private inurement (i.e., the distribution of earnings or assets to “insiders” standing in the position of private shareholders). Except in rare circumstances, the private inurement doctrine prohibits 501(c)(3) entities from having private shareholders.

Incidentally, 501(c)(4) social welfare/civic organizations, 501(c)(5) horticultural and agricultural organizations and 501(c)(6) chambers of commerce and business or trade associations are also subject to a private inurement prohibition. Therefore, benefit corporations would not be eligible for tax-exempt status under one of those sections either.

Can Colorado public benefit corporations receive tax-deductible charitable donations? No. Section 170(c)(2) of the Internal Revenue Code only allows an income tax deduction for charitable donations made to entities that are organized and operated exclusively for charitable purposes and that do not allow for private inurement (essentially, the same requirements that apply for 501(c)(3) status).

Interestingly, while Section 6113 of the Code requires other tax-exempt organizations (e.g., 501(c)(4)s, 501(c)(5)s and 501(c)(6)s) to disclose in certain circumstances that donations made to them are not tax-deductible, this does not apply to non-exempt, for-profits. Nonetheless, public benefit corporations that solicit donations will need take very seriously the need to avoid confusion and misrepresentation in this area. To the extent paid solicitors are used, the Colorado Charitable Solicitations Act (the subject of last week’s post) requires affirmative disclosure of the fact of non-deductibility. In any case, misrepresentations about deductibility constitutes charitable fraud and/or a deceptive trade practice under the Colorado Consumer Protection Act.

If a business chooses to donate to a public benefit corporation, even if the donation is not deductible as a charitable contribution, it potentially could be eligible as a business expense deduction, if the expense otherwise meets the “ordinary” and “necessary” requirements of Section 162 of the Code.

Can Colorado public benefit corporations receive grants from private foundations? As is the case with most non-exempt entities, to the extent that benefit corporations engage in charitable activities or programs (as defined in Section 170c)2)(B) of the Internal Revenue Code), they are potentially eligible for private foundation grants. However, private foundations must exercise “expenditure responsibility” over these types of grants, and if they fail to do so, they can be subject to significant IRS penalties. Expenditure responsibility is, in effect, grant underwriting and oversight on steroids. Under these rules, the private foundation must (i) conduct pre-grant due diligence on the grantee and its leadership to satisfy itself that grant funds will be expended for charitable purposes as contemplated; (ii) enter into a formal, written grant agreement that contains very specific terms and conditions relative to use of the grant funds and repayment of any misused grant funds; (iii) require periodic reports from the grantee, maintain specific records as to the grant, and investigate and recover any potential misuse or diversion of the grant funds; (iv) report the grants in a special way to the IRS on their annual Form 990-PF; and (v) require grant funds to be maintained in a separate bank account. Because of these stringent requirements, and the potential penalty if there is a misstep, many private foundations, as a matter of internal policy, will not make expenditure responsibility grants, especially to non-exempt entities.

Can charitable foundations invest in a Colorado public benefit corporation? One reason social entrepreneurs cite for wanting to use a benefit corporation (or other type of hybrid entity) is attracting program-related investments (PRIs) by charitable foundations. A PRI is an investment made primarily to further charitable purposes, no significant purpose of which is the production of income or appreciation of capital. What is important to know is that charitable foundations already have the ability to make these types of investments, whether in a benefit corporation, a for-profit corporation or a limited liability company. Organizing as a benefit corporation doesn’t make it any more likely that the enterprise will receive PRI funding—the foundation must meet the same regulatory requirements either way. The foundation must establish that the investment is being made primarily to further charitable purposes, and it cannot unduly benefit private interests. In addition, a PRI carries an additional set of expenditure responsibility rules that require a written commitment to (i) use all the funds only for purposes of the investment and to repay any portion not so used; (ii) submit full financial reports of the type ordinarily required by commercial investors under similar circumstances;  (iii)  to maintain books and records and make them reasonably available to the foundation; and (iv) not use grant funds for lobbying or political activity.

Private foundations are prohibited under Section 4944 of the Code from making jeopardizing investments, and also as charitable organizations are subject to the Uniform Prudent Management of Institutional Funds Act (“UPMIFA”)  for purposes of evaluating appropriate investments. A true PRI is exempt from the definition of jeopardizing investment and also will be considered a program-related asset that is not covered by UPMIFA. However, a mission investment that does not meet the technical requirements of a PRI—perhaps because it has a significant profit motive as well as a mission motive—should be carefully evaluated under both Section 4944 and UPMIFA before proceeding.

Is there any other way for public benefit corporations to avail themselves of the traditional 501(c)(3) benefits? As discussed in our post last fall, “Accomplishing Mission through For-Profit/Nonprofit Combinations,” it may be possible for a public benefit corporation to indirectly benefit from 501(c)(3) status through a structure involving a for-profit/nonprofit combination. However, any 501(c)(3) benefits would derive from the participation of the 501(c)(3) nonprofit entity in the combination, and the combination would need to be very carefully structured to ensure that the benefit corporation does not more than incidentally benefit from the activities of the 501(c)(3) nonprofit entity (both in a qualitative and quantitative sense), and to address a number of other 501(c)(3) tax considerations.

If public benefit corporations are not eligible for tax-exempt status, how will they be taxed? Public benefit corporations will be taxable as corporations for federal and Colorado state income tax purposes. Unless they elect to be taxed as an “S” corporation (a pass-thru entity), they will be taxed at the entity level at the regular corporate rate for “C” corporations, and will file an annual IRS Form 1120 and Colorado DOR Form 112.

We hope you have found this series on Colorado public benefit corporations. We will continue to monitor and apprise you of developments in this area.

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