legal structure options for employment-focused social enterprises: redf...

Legal structure options for employment-focused social enterprises: REDF Portfolio Webinar

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Project Overview

• Better understanding of legal structures across key criteria and recommendation on trade-

offs and recommendations

• Identify relevant case studies and literature

• Interview industry experts and/or social enterprises operating within each of the identified

legal structures

• Identify additional legal questions/considerations which will need to be answered by

lawyers

• To understand which legal structure(s) are most suitable for workforce development social

enterprises

• Examine legal structures currently used by social enterprises across the key criteria

(outlined in Slide 4)

• Recommendations on legal structures best suited for workforce development social

enterprises, including tradeoffs

• Types of social enterprise legal structures to consider (including information about how to

qualify or limitations associated with each legal structure)

Project Objectives

Project Goals

Project Approach

Output


Which criteria will be used to analyze various legal structure

options?

Contracting preferences

Organizational dynamics - e.g., compensation, talent management

Access to capital

Tax implications/ tax incentives

Liability implications for parent non-profit

Cost and timeline for setting up the structure

Supports accomplishment of organization’s social mission

3


Interviews Conducted

•Practitioners

Shawna Smith – Executive Director, Taller San Jose

Lee Zimmerman – CEO, Evergreen Lodge

David DeLeonardis – President/CEO, Crossroads Diversified Services, Inc.

•Experts in the field

Robert Wexler – Principal Attorney, Adler & Colvin

Gene Takagi – Attorney, NEO Law Group

Marc J. Lane – Attorney, Marc J. Lane Wealth Group

Ted Howard – Cleveland Foundation, Evergreen Cooperatives, The Democracy Collaborative

•Other

REDF Staff

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This chart addresses the business activities of the social enterprise. Support services provided to social enterprise employees is sometimes

retained within the parent nonprofit, even if the business activities are legally separated into a subsidiary. Alternatively, some or all employee

support services are also outsourced to other organizations.

Social

Enterprise,

operated by

nonprofit

• Standard LLC

• Other LLCs (series

LLC, etc.)

Structure?

Corporation

Worker

owned

No

LLC

Separate

entity?

What are the different ways in which a social enterprise, operated by a non-

profit, can be structured?

5

Ownership

Program/

division of

nonprofit

Yes

Partially

owned

Wholly

owned Tax Status

Tax

Exempt3

Taxable

Social mission

in by-laws?

Yes

No

Corporation

• Benefit

Corporation1

• Flexible Purpose

Corporation2

Wholly or partially

owned nonprofit

subsidiary

Structure?

LLC Corporation

Standard

LLC

• Worker Cooperative

Corporation1

• Business Corporation

1Allowed in certain states (details are discussed in presentation) 2California only 3The distinction between state and federal nonprofits is discussed in the appendix

Legal structure Decision Examples (not limited to nonprofits operating a social enterprise)

Social mission

in by-laws?

No

Yes L3C1


Separate entity vs. keeping entity within parent organization

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Separate Entity Within parent nonprofit

Liability • Asset protection

• Risk

• Social enterprise is main

purpose of organization

Tax implications • If paying significant UBIT,

better protection for

parent tax-exempt status

• Activities aligned with

mission

Cost and timeline to set

up

• Depends on structure

choice and organization

• Generally, cheaper and

faster

Organizational dynamics • Cultural implications • Leveraging existing

infrastructure

Supports

accomplishment of

social mission

• Capacity

• Accomplishment of

organization’s mission

• Type of operation, type of

workforce

• Considerations of

external stakeholders

• Social enterprise integral

to mission

Other

considerations

• Effect on nonprofit’s

reputation

• Revenue diversification


Nonprofit vs. for-profit

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For-profit Non-profit

Contracting

preferences

• Certain contracting preferences/

designations only available to for-profits

• Some contracts are only awarded to nonprofits

Access to capital • Option to offer equity

• More sources of capital

• Funding is generally not restricted

• Easier to put “creative” capital together

• Easier to get credit for new entities

• Majority of funding comes from donors or grants

• Fewer sources of capital

• Certain funds might be “restricted”

• May receive more favorable loan terms from

certain entities

Tax implications • Tax credits (WOTC, Enterprise zones, etc.) • If social enterprise activities are related to

organization’s mission, income is tax-exempt

• Can possibly be exempt from sales and property

tax

Other considerations • Potential stakeholders prefer or required to

work with exempt entities

• Target population

Cost and timeline to set

up

• Depends on whether corporation or LLC

• Generally for-profit entities are faster to

set up (unless bringing in multiple

investors)

• IRS approval takes between 2 to 12 months

Supports

accomplishment of

social mission

• Social enterprise does not qualify for an

exempt purpose

• Profit is a primary goal of the enterprise

• Mission of enterprise is primarily “social”

• Mission of social enterprise aligns with parent

nonprofit’s mission or social enterprise qualifies

for an exempt purpose

Organizational

dynamics

• Ability to attract talent with higher

compensation levels


LLC vs. corporation

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LLC Corporation

Other

considerations

• Less consistent treatment if

operating in multiple states

• Can elect to become L3C (if

allowed in state)

• Can elect to become a benefit

corporation or flexible purpose

corporation (if allowed in state)

Access to capital • In some cases, members of the LLC

have to provide personal

guarantees of loans

• Banks or vendors may more readily

extend credit to corporations

Cost and timeline to

set up

• Generally simple, but depends on

how complicated Operating

Agreement between owners is

• Fewer corporate formalities than a

corporation

• Generally simple to set up unless

bringing in many outside investors

Tax implications • Tax flexibility

• Implications for self-employment

taxes

• Difficult to receive tax-exempt

status for an LLC with few

exceptions

• Pay employment taxes on salaries, not

profits

• Income is taxed at corporate and

shareholder level

Liability • Both structures provide business owners with liability protection


L3Cs, Benefit Corporations, and Flexible Purpose Corporations are all new

“hybrid” structures that share similarities

9

Currently, which states allow for which hybrid structures? • Overall benefits of hybrid corps for social

enterprises:

• Broader access to different sources

of capital

• Allows higher compensation levels

• Locks-in social mission in

organization documents

• Provides potential exit strategies

• Biggest risks:

• No national standard or reciprocity

across states

• Very new structures with unknown

risks

• Tax Implications:

• For now, these structures will be

taxed the same as for-profit

corporations, though advocates plan

to ask the Internal Revenue Service

to consider tax breaks for the

hybrids in the future

• Liability - protects directors from

liability for considering a social

purpose

A hybrid legal

entity that

blends elements

of non-profit and

for-profit entities.

It is essentially

an LLC that must

be organized and

operated for a

social purpose

and profit must

not be a

significant

purpose

L3C Benefit Corporation Flexible purpose corporation

A hybrid legal entity that blends

elements of non-profit and for-profit

corporations. Essentially a corporation

that must be organized and operated

for the purpose of “creating a general

public benefit.” It is taxed like a

corporation. It protects directors from

liability for pursuing a social objective

instead of simply profit. Benefit

Corporations are also subject to

additional reporting requirements

relating to its performance in creating

a general public benefit and its

performance against a third-party

standard.

A hybrid legal entity that blends

elements of non-profit and for-

profit corporations. It is a

corporation that must state a

specific social purpose for which it

is formed. It is taxed like a

corporation. It protects directors

from liability for any decisions that

involve balancing the corporation’s

special purpose against its

financial condition. Flexible

Purpose Corporations are also

subject to additional reporting

requirements assessing its

performance in achieving its

special purpose.


Why choose a hybrid form of entity?

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Hybrid entity Traditional entity

Supports

accomplishment

of social mission

• Allows directors and officers to

consider social mission in making

decisions

• Social mission is only a minor part of

the organization’s purpose/ culture

Liability • Liability protection to its directors

and officers to consider interests

other than profits

Organizational

Dynamics

• Stakeholders are fully aware of

mission and its impact on the

business

• Ties future “owners” to the same

mission

Contracting

Preferences

• Potential preference in contracting,

especially as these structures

become more common

Access to capital • Unclear how lenders and investors

may view these entities

• L3C may make it slightly easier to

access PRIs

• Established entity form – will likely

mean more consistent treatment from

lenders and investors

Tax implications • No tax benefits to organizations with social mission in articles/ operating

document

Cost and timeline to

set up

• L3Cs, Benefit Corps and Flexible

Purpose Corps are only allowed in

certain states

• New legal forms

• Established legal form – relatively easy

to set up


Overview of legal entity options for Social Enterprise1

Corporation LLC

Business Corporation Flexible Purpose/

Benefit Corporation

Nonprofit Corporation

501(c)(3)

LLC L3C

Availability All 50 states Flexible Purpose: CA

only

Benefit Corp: 7 states

All 50 states All 50 states 9 states, 2 tribes

Purposes For-profit only (may

consider parties other

than shareholders in

some states)

Dual purpose (profit/

social)

Charitable purposes only

(profit on exempt

activities or unrelated

business activities is

allowed but may be

required to pay UBIT)

For profit, defined by

Operating Agreement

No significant

purpose for profit or

production of

income

Equity Shares Shares None Member interests Member interests

Tax on Profit Yes, at corporate level Yes, at corporate and

shareholder levels

Tax exempt, except on

unrelated business

Yes, at member level Yes, at member level

Management

and control

Board elected by

shareholders

Board elected by

shareholders

Board of directors,

chosen by members,

designators or self-

elected

Per Operating Agreement Per Operating

Agreement

Profit

Distribution

Share repurchases,

dividends

Share repurchases,

dividends

None. All profit must be

reinvested to fulfilling

the mission

As defined by agreement of

investors; most operating

agreements provide that a

member’s distributive

share is in proportion to his

percentage interest in the

business

As defined by

agreement of

investors

Capital Sources Sell shares, debt Sell shares, debt ->

potentially more

attractive to impact

investors

Grants, donations, loans,

tax-exempt bond

financing, earned income

Sell membership interests,

debt

Sell membership

shares, debt

11 1Source: http://www.adlercolvin.com/pdf/tax_treatment/Beyond_Taxation_A_Guide_to_Social_Enterprise_Vehicles_(00302967).pdf, irs.gov

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Sources of capital/ funding

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Corporation LLC

Business

Corporation

Flexible Purpose/

Benefit Corporation

Nonprofit

Corporation

(501(c)3)

LLC L3C

Shares/ Equity Yes Yes No Membership

contributions

Membership

contributions

Government

Grants

Yes Yes Yes Yes Yes

Other grants

(foundations)

Not common (often

done through PRI)

Not common (often

done through PRI)

Yes Not common (often

done through PRI)

Not common (often

done through PRI)

PRI Yes, but more

difficult than other

entities1

Yes Yes Yes Yes1

Bank loans Yes Yes Yes (might be harder

to get loans when

starting up vs. a “for-

profit” business)

Yes (might be harder

than for a

corporation and

owners may have to

provide personal

guarantees)

Yes (same as LLC)

SBA Guaranteed

Loans and Grants

Yes (small

businesses as

determined by

criteria)

Yes (same as

business

corporation)

No Yes (same as bank

loans)

Yes (same as LLC)

1IRS policy on program-related investments - it is more difficult for a for-profit entity to qualify because production of income cannot be a significant purpose and has to further a charitable

purpose. See http://www.irs.gov/charities/foundations/article/0,,id=137793,00.html. See also http://www.irs.gov/charities/article/0,,id=256679,00.html.

http://www.irs.gov/charities/foundations/article/0,,id=137793,00.html

http://www.irs.gov/charities/article/0,,id=256679,00.html


Reasons to consider a social enterprise that is a program/ division of

nonprofit

13

Social enterprise is critical to fulfilling organization’s mission

Social enterprise activity is the majority of what the organization does

Mission of social enterprise is primarily “social”

Majority of organization’s assets and liabilities are related to the social

enterprise

Social enterprise activities are tax-exempt

Grant funding is and will remain an important revenue source for the enterprise

If the majority of the following is true:

• Lose access to certain contracting preferences only available to for-profits (SBA

loans, minority or women owned certification, local small business

certification)

• Customers may view social enterprise as a nonprofit rather than a business

which could lead to certain perceptions such an an expectation for lower

pricing

Potential downsides


Reasons to consider a social enterprise that is a wholly-owned

nonprofit subsidiary

14

Social enterprise is only part of organization’s activities

Social enterprise activities could pose liability issues for parent nonprofit

Social enterprise activities are tax-exempt

Grant funding is and will remain an important revenue source for the

enterprise


• Costs for setting up a new entity can be expensive

• Ongoing costs for a new entity can also be very expensive i.e., (sustaining

infrastructure)

• Need to ensure proper separation of two entities to truly protect assets of parent

nonprofit – otherwise, the parents assets will be more vulnerable to debts and

liabilities of the subsidiary, also known as “piercing the corporate veil”

Potential downsides


Reasons to consider a social enterprise that is a wholly owned

for-profit subsidiary/ benefit or flexible purpose corporation

15


Social enterprise activities are not tax-exempt

Social enterprise requires outside capital

Social enterprise operates in an industry that is difficult for a nonprofit to operate in – e.g.,

construction

Primary motivation of social enterprise is profit

Social enterprise can benefit from licenses, certifications and tax credits that are only

applicable to for-profit structure

Social enterprise can benefit from contracting preferences only available to for-profits


• Might be harder to access grant funding

• Potential reputation impact on parent nonprofit from stakeholders and community if they are

seen as too “business-like” or “profit motivated”

• New hybrid entities have not been tested

• Additional reporting requirements

Potential downsides


Reasons to consider a social enterprise that is a partially owned

for-profit subsidiary/ benefit or flexible purpose corporation

16


Social enterprise activities are not tax-exempt

Social enterprise operates in an industry that is difficult for a nonprofit to operate in

Social enterprise can benefit from licenses, certifications and tax credits that are only

applicable to for-profit structure

Social enterprise can benefit from contracting preferences only available to for-profits

Social enterprise wants to bring in additional sources of funding, especially in the form of

equity


• Partially owned subsidiaries can be complicated and expensive to set up, especially when

bringing in equity investors

• Having multiple stakeholders/ shareholders making decisions for the organization may

potentially lead to straying from organization’s initial mission or purpose of the social

enterprise

Potential downsides


APPENDIX

17


Tradeoffs between different ownership structures

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Wholly owned Partially owned Worker owned

Cost and timelines to

set up

• Varies based on legal

form

• Can be expensive and

complicated to set up

depending on ownership

structure

• Can be expensive to set

up effectively

Organizational

dynamics

• Parent nonprofit selects

board and has control

via this process

• Decision making can be

complex

• Worker-owned aspect

key to mission

• Decision making

structure varies

Access to capital • Capitalized by parent

nonprofit

• Attract equity

• Potential for innovation

• Depends on legal

structure of the

cooperative

Other considerations • Make decisions on how

to represent

relationship (i.e.,

consolidated financial

statements)

• Generally, cheaper and

faster

• Ongoing investment and

training to maintain

culture

• Might be suitable only

for certain target

populations

Tax implications • Depends on the legal

form of the subsidiary

• Depends on the legal

form of the subsidiary

• Worker owned

cooperatives are not tax

exempt

Supports

accomplishment of

social mission

• Supporting mission can

get complicated if

multiple parties are

involved

• Worker ownership

critical to mission

and/or theory of change


L3C: Low-Profit Limited Liability Company

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What is an L3C?

➨ An L3C is a hybrid legal entity that blends elements of non-profit and for-profit entities. It is essentially an

LLC that must be organized and operated for a social purpose and profit must not be a significant

purpose

Other

considerations

• Unlike an LLC, the L3C has an explicit primary charitable mission and only a secondary profit concern

• Unlike a charity, the L3C is free to distribute the profits, after taxes, to owners or investors

• Makes it simpler to qualify for PRIs

What makes an

L3C different than

standard LLC?

Level of support

• Relatively new legal form, only allowed in certain states

• Many practitioners and experts in the field are not a fan of this structure for the following reasons:

• In general, the L3C has more restrictions without clear benefits (for example, no tax breaks -> structure

might make more sense if there are tax breaks)

• Untested new form with not much information currently available

Sources: Interviews 1http://www.sec.state.vt.us/corps/dobiz/llc/llc_l3c.htm


Benefit Corporation

20

What is a Benefit Corporation?

• Mandates that, in addition to shareholders, the board of directors take the environment, community, employees and suppliers into account

when they make decisions; Requires environmental and social benefit (i.e. triple bottom line)

• Environmental benefit can be minor (i.e. recycled paper, no water bottles, etc.) but social benefits are not enough

• Mandates a high level of transparency and accountability - within 120 days after the end of each fiscal year, a Benefit Corporation is

required to publish a Benefit Report, which states how the Benefit Corporation performed that year on a social and environmental axis

• Mandates that directors assess the performance of the corporation in achieving its general public benefit purpose against a third-party

standard (such as B Corp)“

• Provides clarity to directors and officers that duty includes pursuing the creation of material positive impact on society and the

environment, even in liquidity scenarios

• Offers liability protection to its directors and officers to consider interests of its workforce, community, and the environment when making

decisions

• Offers a distinct point of differentiation in environmental where many organizations may claim to be socially minded

• Pending legislation in San Francisco: “provide for a downward adjustment in price or upward adjustment in rating of a proposal or bid from

a California Benefit Corporation for a competitively-solicited City contract.”4

What are the

advantages of

this structure?

• Third party independent assessment that measures social and environmental impact; most prominent is currently B Labs’ Assessment.

The Benefit Corporation has to then share this assessment of its performance publicly

• Both GRI and B Lab offer companies the use of their reporting (GRI) and assessment (B Lab) tools for free What is a Benefit

Report?

➨ A Benefit Corporation is a hybrid legal entity that blends elements of non-profit and for-profit corporations. It is

essentially a corporation that must be organized and operated for the purpose of “creating a general public benefit.” It

is taxed like a corporation. It protects directors from liability for pursuing a social objective instead of simply profit.

Benefit Corporations are also subject to additional reporting requirements relating to its performance in creating a

general public benefit and its performance against a third-party standard.

Characteristics

of a Benefit Corp/

Social Mission

Level of support • Relatively new legal form, only allowed in certain states


California Flexible Purpose Organization

21

What is a Flexible Purpose Organization?

➨ A Flexible Purpose Corporation is a hybrid legal entity that blends elements of non-profit and for-profit

corporations. It is a corporation that must state a specific social purpose for which it is formed. It is

taxed like a corporation. It protects directors from liability for any decisions that involve balancing the

corporation’s special purpose against its financial condition. Flexible Purpose Corporations are also

subject to additional reporting requirements assessing its performance in achieving its special purpose.

• Unlike a Benefit Corporation, a Flexible Purpose Corporation is not required to pursue a generalized public benefit or

measure its performance against a third-party standard. Flexible Purpose Corporation directors may give weight to a variety

of factors, including the prospects of the corporation, the interests of the corporation and its shareholders, and its “special

purpose

• Flexible Purpose Corporations are allowed to choose their own “special purpose,” as long as it fits the general description set

forth below. The FPC must clearly state its specific purpose, outline goals to achieve that purpose, and publish an annual

report disclosing how well it has achieved that purpose (no third-party standard for this report yet)

• The special purpose chosen by a FPC can be anything that generally benefits society, but can include the following:

• One or more charitable or public purpose activities that could be carried out by a California nonprofit public benefit

corporation

• The purpose of promoting positive short-term or long-term effects of the Flexible Purpose Corporation’s activities

upon stakeholders, the community and society, or the environment

• The purpose of minimizing adverse short-term or long-term effects of the corporation’s activities upon stakeholders,

the community and society, or the environment

What is considered

a “special

purpose”?

What are the

advantages of

this structure?

Characteristics

of a Flexible

Purpose

Organization

• Similar to Benefit Corporation (previous slide) but with even less liabilities for directors, as well as less accountability from

third-party standards

• The two-thirds vote of outstanding stock requirement for a conversion or change in the purposes creates a lock-in benefit

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