Not So Fast! When Choosing For-Profit vs. Nonprofit, Consider Options Carefully

The Harvard Business Review recently provided some interesting insight on bad reasons to start a for-profit social enterprise. The post points out that while the for-profit form may be right for many—and that there are more such choices (e.g. benefit corporations) available than before—some entrepreneurs may be making this choice for the wrong reason by relying on the following mistaken impressions:

  1. Only for-profits use “business discipline.”
  2. Only for-profits can sell a product or service.
  3. Only for-profits can properly compensate employees.
  4. Only for-profits have a sustainable revenue model.
  5. Nonprofits are “old-fashioned” and only for-profits earn respect in their sectors.

In working with nonprofits and with entrepreneurs who are deciding which form to use, our firm deals with this issue quite often (see our previous posts on using for for-profit/nonprofit combinations and choice of form. The Harvard post is correct that the impressions listed above are mistaken. However, there are some definite pitfalls and risks of which to be aware in these areas, particularly with respect to sales of products and services, and compensation.

Sales of goods and services. It is certainly true that nonprofit, tax-exempt organizations face no blanket prohibition on this type of activity. In fact, some “classic” types of nonprofit 501(c)(3)s like schools and hospitals primary get their revenue from selling products and services.

However, some issues can crop up in other areas, including unrelated business income taxation and exemption issues.  If the sales activity is regularly carried on and not substantially related to the organization’s exempt purpose, it can result in taxable income. And if the unrelated activity is too substantial in size, it ultimately can threaten the organization’s exempt status. This means that, when deciding what form to choose, a key question is the nature of the sales activity and how well it fits within the exempt organization framework.

The IRS also can potentially push back on an activity under the commerciality doctrine, which essentially looks at whether an activity is “too similar” to for-profit, commercial activity (see our previous post on this topic here. This is a gray area with a lack of certainty, but again a key question is the nature of the activity and how it will be carried out.

Compensation of employees. Nonprofit, tax-exempt organizations can provide compensation to employees, and it is true that executive-level employees in larger nonprofits like universities and hospitals can earn a sizeable paycheck by any standards. But nonprofit exempt organizations (particularly 501(c)(3) and 501(c)(4) organizations) always need to aware of the restrictions against private inurement and excess benefit transactions, which can come into play with compensation. A nonprofit should take care in determining and structuring compensation, and take advantage of the rebuttable presumption process under IRS regulations to provide additional protection to its board.

Leaffer Law Group continues to monitor and write on social enterprise developments. For questions in this area, contact us at  kleaffer@leafferlaw.com or bseidel@leafferlaw.com.

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