Our last post discussed social enterprise in the context of hybrid entities, where both for-profit and nonprofit elements are contained within a single entity. However, a social enterprise may also be accomplished using a combination of for-profit and nonprofit entities. Often, a mission or idea doesn’t fit neatly in one box, and utilizing different entities for different purposes can yield the best total result. Here are some combinations that can be used:
- Parent/subsidiary: A for-profit can form a charitable subsidiary, or the nonprofit may be the parent and form a for-profit subsidiary.
- Brother-sister: The for-profit and nonprofit may be linked by overlapping directors and management, licensing agreements, resource sharing agreements or other agreements.
- Joint venture: The for-profit and nonprofit may enter into a joint venture like a partnership or multi-member LLC, where there is a sharing of net profits.
For example, a for-profit company that has been donating some of its products to charities that then redistribute them to needy individuals may elect to form its own charitable subsidiary to carry out this program, which can increase efficiencies and allow more of a connection with its other corporate philanthropy efforts. A nonprofit organization may choose to collaborate and work closely with a for-profit that offers a product that is key to the organization’s charitable programming. Or an individual who has an idea for a social enterprise may decide at the onset to form related for-profit and nonprofit to carry out different aspects of the enterprise.
Important Issues To Consider
A first step in deciding structure is to consider what the funding sources will be. Will funding come primarily from individuals looking to take a charitable deduction, or from entities like private foundations may require a 501(c)(3) recipient? Or will funding come from investors looking to have a “piece of the pie,” perhaps with an equity share or share of the profits? A combination structure can allow funding from a variety of sources, if there is a 501(c)(3) entity and a for-profit entity that will be carrying out the mission. However, it is important to remember that these arrangements can implicate some hot-button issues for the IRS:
- Private benefit and inurement: 501(c)(3) organizations cannot unduly benefit private interests, particularly those of insiders like directors and officers. If the nonprofit and for-profit will be engaging in transactions, it is important to have in place independent directors, a conflict of interest policy, and adhere whenever possible to the IRS process for a rebuttable presumption of reasonableness. Note that private foundations will generally be a no-go because of the stricter self-dealing rules. In addition, investment of a 501(c)(3)’s capital in a for-profit company will raise these same concerns, as well as concerns about its ability to carry out its charitable mission.
- Commerciality: an organization will not be considered charitable if it operates too similarly to a commercial for-profit enterprise. If a 501(c)(3) entity is in the mix, it is important to try to distinguish its activities from for-profit activities, such as by offering reduced or sliding scale fees for low-income individuals or demonstrating a reliance on donative support (as opposed to purely operating off program revenues).
- Charitable mission: not all social/environmental missions will necessarily be considered charitable under section 501(c)(3), so it is important to evaluate whether the nonprofit’s purpose qualifies.
- Separate identities: the two organizations will need to establish and maintain their separate and independent identities on an ongoing basis, or the IRS could disregard their separate status and treat them as one and the same. Avoiding 100 percent overlap of directors and officers, observing corporate formalities and interacting at arm’s length can help avoid this result.
These are just a few of the issues to keep in mind before deciding on a combination structure; others include charitable solicitations considerations, public filings required for nonprofit entities that will include certain related-party information, and potential application of federal and state securities laws. However, if structured properly, a combination could be a very effective way to accomplish a given mission.
We recently gave a presentation on this topic and have posted the presentation here for additional information.
Which of the issues/considerations discussed above seems to present the most difficulty in this area?
Does an entity combination look like a workable solution for organizations, or is a hybrid entity ultimately more appealing?