social enterprise: a legal context - adler & colvin · 2017-12-30 · social enterprise: a...

Social Enterprise: A Legal Contextby Robert A. Wexler

Rob Wexler is a principalwith Silk, Adler & Colvin, SanFrancisco. The author wouldlike to thank Amy S. Acker-man, Betsy Buchalter Adler,and Rosemary Fei for their as-sistance in framing and editingthis article.

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IntroductionTen to 15 years ago, many

in the exempt organizationlegal community viewed so-cial enterprise as a meretrend, but now, social enter-

prise is a viable and intricate part of the exempt organi-zation landscape. New social entrepreneurs continue tosurface, and social enterprises continue to thrive. Thisarticle is a call to action to the exempt organization legalcommunity to help further this important movement andto help change the law to accommodate new approachesto philanthropy. Although written for lawyers, this articleis also intended for social entrepreneurs to help themunderstand the legal framework through which exemptorganization attorneys will view their social enterprisebusiness plans.

The first step in representing any new type of businessor social model is becoming familiar with the culture ofthe movement and the language used by those involved.Exempt organization attorneys who represent this newbreed of innovators need to develop a working knowl-edge of the new language of social entrepreneurs andbecome familiar with the many foundations, universities,and other entities that fund them, write about them,sponsor conferences about them, and bestow awards onthem.

Ten years ago I would have been reluctant to indulgea social entrepreneur client who indicated her intent toestablish an exempt organization to ‘‘partner’’ with otherorganizations and to make ‘‘investments’’ in ‘‘socialenterprises.’’ I would immediately correct the client andinstruct her not to use the word ‘‘partner’’ or ‘‘partner-ing’’ unless she really intended to set up a legally bindingpartnership under applicable state law. I would cautionan exempt organization not to use the word ‘‘invest-ment’’ to describe an outright grant, especially if theorganization was a private foundation, because suchlanguage could trigger all kinds of problems undersection 4944 (jeopardizing investments), when all the

client really intended was a grant with conditions. Overtime, however, I have become more flexible in notattempting to limit a client’s use of the language of socialenterprise, as long as the legal documents properlydescribe the legal relationship.

The second step in representing social enterprises ishelping innovators work within a tax regime that issometimes not flexible enough to accommodate thesenew ideas and new methods. Exempt organization attor-neys who want to help social entrepreneurs need to thinkabout how to use the established legal constructs in away that encourages and fosters the creativity of thoseentrepreneurs. Ten years ago I would have been reluctantto advise a client to carry out substantial charitableactivity through any vehicle other than a 501(c)(3) entity.My views have changed.

Also, recognizing that the current legal constructsmight not be sufficient to accommodate the vision ofsocial entrepreneurs, exempt organization attorneysmight help social entrepreneurs think about ways toamend the Internal Revenue Code to support socialenterprise activity. The United Kingdom has alreadymoved to accommodate social entrepreneurs by offeringa new type of legal entity called a community interestcompany, or CIC, which is discussed below.

This article first reviews how the social entrepreneursthemselves define what they are doing. Second, it con-siders why this movement has been strengthening overthe last 10 or 15 years. Third, it describes how exemptorganization attorneys might help give legal structure tosocial enterprise under existing law. This third sectionmay be too basic, in places, for experienced exemptorganization tax practitioners, but it might be useful forsocial entrepreneurs trying to understand how lawyersthink about their business plans. Fourth, the articlesuggests that it may be time to follow the U.K. model andoffer social entrepreneurs a new form of legal entity tocarry out their important work.

I. Social Entrepreneurs and Social Enterprise —Who Are They and What Is It?

The social enterprise movement has done a thoughtfuljob of defining itself. Let us start by looking at the terms‘‘social entrepreneur’’ and ‘‘social enterprise’’ from theperspectives of a professor, a foundation, and an associa-tion of social enterprises.

The Professor: Prof. J. Gregory Dees wrote ‘‘The Mean-ing of ‘Social Entrepreneurship’’’ in 1998 (reformattedand revised in 2001). (It is available at http://www.fuqua.duke.edu/centers/case.) Dees’s article contains anextended and well-considered analysis of what it means

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to be a social entrepreneur. Dees notes that entrepreneursserve as the ‘‘change agents’’ for the economy (page 1),and he offers what he calls an ‘‘idealized’’ definition ofthe social entrepreneur as follows:

Social entrepreneurs play the role of change agents inthe social sector by:

• Adopting a mission to create and sustain socialvalue (not just private value);

• Recognizing and pursuing new opportunities toserve that mission;

• Engaging continuous innovation, adaptation, andlearning;

• Acting boldly without being limited by resources;and

• Exhibiting heightened accountability to the con-stituencies served and for the outcomes created.(page 4)

The Foundation: The Skoll Foundation1 was founded byJeff Skoll, one of the entrepreneurs who founded eBayand who now produces thought-provoking films. Itfocuses on recognizing and funding social entrepreneurswith the Skoll Awards for Social Entrepreneurship andthrough funding the Skoll Centre at Oxford University.The Skoll Foundation Web site (http://www.skollfoundation.org) defines a social entrepreneur as ‘‘soci-ety’s change agent: pioneer of innovations that benefithumanity.’’ The Web site notes that ‘‘just as entrepreneurschange the face of business, social entrepreneurs act asthe change agents for society, seizing opportunities oth-ers miss and improving systems, inventing new ap-proaches and creating sustainable solutions to changesociety for the better. However, unlike business entrepre-neurs who are motivated by profits, social entrepreneursare motivated to improve society.’’

The Alliance: The Social Enterprise Alliance sponsorsconferences and otherwise represents the interests ofsocial enterprises. It defines a social enterprise as ‘‘anorganization or venture that advances its social missionthrough entrepreneurial, earned income strategies.’’(http://www.se-alliance.org)

For purposes of this article, which examines the morecomplex legal issues involved in the movement, it isenough for us to consider social entrepreneurs to be thoseindividuals who take the lead in forming and operatingsocial enterprises. Social enterprises can be nonprofit orfor-profit; tax-exempt or taxable, but there is usuallysome nonprofit, tax-exempt component. Social enter-prises are enterprises because they use earned income orrevenue-generating strategies, and they are social be-cause they are doing something innovative to benefitsociety, not just to generate revenue. Often these enter-prises seek to become self-sustaining, but they usuallyrequire help, especially in the early years.

Traditionalists will say that as there have always beennonprofit organizations involved in revenue-generatingactivities that benefit the community, so there have

always been social enterprises, and the leaders of thoseenterprises have always been social entrepreneurs. Hos-pitals, schools, and low-income housing organizations,for example, are income-generating nonprofits that servethe community. But 21st-century social entrepreneurs arelooking for new strategies to benefit society, strategiesthat might involve using both charitable contributionsand private investment capital and that use the Internetand other new technologies. This is not to say thathospitals, schools, and low-income housing providers aredoing anything wrong or are even uninteresting. Itsimply means that we have laws that have evolved andcontinue to evolve to deal with these more traditionalinstitutions, while the laws related to the ever-changingworld of social enterprises are significantly less well-charted.

The definitions of social enterprise and social entre-preneurship can seem abstract until we consider ex-amples of the many social enterprises operating in theUnited States and abroad.

Technology: Many organizations are beginning to useinnovative technology to benefit society.

Envirofit International Ltd. (http://www.envirofit.org) creates and distributes technologies that help devel-oping countries address the health hazards of pollution.Envirofit is retrofitting up to two million two-strokepowered vehicles with cleaner, more efficient direct in-jection technology that eliminates 90 percent of hydrocar-bon and 70 percent of carbon monoxide emissions fromtwo-stroke engines.

Kickstart (http://www.approtec.org) is a nonprofitorganization that develops and markets new technolo-gies in Africa. These low-cost technologies are bought bylocal entrepreneurs and are used to establish small busi-nesses. The U.S. branch of Kickstart helps fund thesesocial enterprises abroad.

Beneficent Technology Inc. or Benetech (http://www.-benetech.org) is a Silicon Valley-based organization. Itspredecessor, Arkenstone, began by developing and sell-ing inexpensive reading machines to the blind. Benetechnow focuses on projects such as an Internet-based book-sharing community and technology-based human rightsprojects. Its founder, Jim Fruchterman, has won a numberof awards, including a MacArthur Foundation award in2006.

Job Training: Organizations continue to use job trainingto help the disadvantaged.

In 1971 Mimi Silbert began Delancey Street Founda-tion, which is not really part of this new social enterprisemovement. Since the early 1970s, Delancey Street hasbeen helping former felons and substance abusers learnthe skills they need to rebuild their lives. Delancey Streethas also developed more than 20 social enterprises run byunskilled workers. Those businesses include a restaurant,a moving and trucking company, a bookstore, a coffeehouse, and an art gallery.

Juma Ventures (http://www.Jumaventures.org) is aSan Francisco-based organization that uses businessenterprises to provide opportunities to young peoplewho have traditionally lacked access to them. Jumaoperates, among other things, Ben & Jerry’s ice creamshops and concessions at AT&T Park in San Francisco.

1Many of the organizations described in this article arevalued clients of Silk, Adler & Colvin. All factual informationabout organizations, whether or not clients, is readily availableon organization Web sites.

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These businesses are all used for job training purposesand to make money for the organization.

Microfinance: Social entrepreneurs are using micro-credit or microfinance to fight poverty in the U.S. andabroad.

Grameen Foundation USA (http://www.grameenfoundation.org) uses microfinancing to fight povertyaround the world. It makes tiny loans and providesfinancial and technology assistance to small, self-startingbusinesses. The foundation maintains a relationship withthe Grameen Bank of Bangladesh. Muhammad Yunus,the 2006 Nobel Peace Prize winner, began Grameen Bankin 1976. He discovered that poor women could breakthrough poverty by taking tiny loans to start or expandbusinesses. Microfinance loans have become one of thebest examples of how social enterprise can becomeself-sustaining and also do good.

The Acumen Fund (http://www.acumenfund.org) isanother nonprofit venture fund that tries to solve theworld’s problems through entrepreneurial creativity, in-cluding microfinance loans.

It is important to also have a sense of who is studyingand writing about social enterprise, who is funding it(business enterprises require seed capital; social enter-prises require seed grants or loans), and what organiza-tions are representing its interests. The list that follows isillustrative:

The Scholars

• Harvard Business School (http://www.hbs.edu/socialenterprise/) began its Social Enterprise Initia-tive in 1993. Jed Emerson and others have writtenarticles and resource guides on social enterprise.

• The Center for the Advancement of Social Enter-prise at the Fuqua School of Business at DukeUniversity (http://www.fuqua.duke.edu/centers/case/) is also a leader in this arena. Dees, mentionedabove, teaches and writes in this program.

• Stanford University houses the Center for SocialInnovation (http://www.gsb.stanford.edu/csi/),which also publishes the Stanford Social InnovationReview.

• Oxford University’s Said School of Business spon-sors the Skoll Centre for Social Entrepreneurship(http://www.sbs.ox.ac.uk/skoll/).

• Columbia University Business School also offers aSocial Enterprise Program (http://www.2.gsb.columbia.edu/socialenterprise/).

• New York University, Stern School of Business,sponsors the Satter Program in Social Entrepreneur-ship (http://www.stern.nyu.edu/berkley/social).

• Yale University School of Management offers theProgram on Social Enterprise (http://www.pse.som.yale.edu/).

The grantmakers and award givers

Many grantmakers support social enterprise. A fewexamples are:

• The Roberts Enterprise Development Fund, orREDF (http://www.redf.org) was one of the firstgroups to identify and invest in entrepreneurialnonprofit organizations. REDF began by selecting

some 501(c)(3) social enterprises and investing inthem by offering conditional, recoverable grants toprovide them with seed money. REDF also providedtechnical support to the entrepreneurs.

• The Ashoka Foundation’s mission is ‘‘to shape acitizen sector that is entrepreneurial, productive andglobally integrated, and to develop the profession ofsocial entrepreneurship around the world.’’ (http://www.ashoka.org). Ashoka provides fellowships forsocial entrepreneurs.

• The Draper Richards Foundation also provides fel-lowships to social entrepreneurs (http://www.draperrichards.org).

• The Schwab Foundation for Social Entrepreneurshipoffers the Award for Outstanding Social Entrepre-neurs (http://www.schwabfound.org).

• The Skoll Foundation offers the Skoll Awards assecond-round funding, in the form of grants, loans,or a combination of the two (http://www.skoll.org).

Other foundations and organizations, including theMacArthur Foundation, the Ford Foundation, the GatesFoundation, Google.org, and the Omidyar Network, alsofund social entrepreneurship. While Ford, MacArthur,and Gates are traditional private foundations, albeit withcutting-edge programs, both the Omidyar Network andGoogle.org provide social enterprise funding through acombination of private foundations and for-profit enti-ties, in part because they view the rules governingprivate foundations as too restrictive to accommodatesocial enterprise funding.

Representing and Educating Social Enterprises

Other organizations also provide resources throughconferences, newsletters, and other vehicles for socialenterprises. See, for example, the Social Enterprise Alli-ance (http://www.se-alliance.org), Social Venture net-works (http://www.svn.org), Changemakers (http://www.changemakers.net), and Social Edge (http://www.socialedge.org). Social Venture Partners is acommunity of social investors, with different, geographi-cally based chapters (http://www.svpi.org).

II. Why Has the Movement Grown So Quickly?

Academicians and social entrepreneurs have offeredwell-considered theories on the rapid growth of themovement. Having represented many social enterprisesand social entrepreneurs, I believe social enterprise hasevolved considerably in the last 10 to 15 years, primarilybecause of the following:

• During the 1990s a new generation of young entre-preneurs emerged, particularly in Silicon Valley.They had charitable notions and goals that were notsteeped in traditional philanthropy. Some of themalso had access to significant amounts of cash andstock, and they wanted to do socially useful workwith that cash. To a more limited extent, this trendcontinues today.

• The Internet provided a platform for many entre-preneurs to become successful quickly, and it thenprovided a platform for innovative ways of thinking

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about charity and social enterprise. The Internet wasand is a technological catalyst for the social enter-prise movement.

• People began to realize that U.S. dollars could go along way in developing nations. Much social enter-prise is conducted in developing nations.

III. Working Within the Law

How do we as exempt organization attorneys advisethose who want to fund social enterprise and those whosee themselves as social entrepreneurs?

Imagine two clients, one of which is husband and wife(H&W), both age 40-something. They tell the attorneyproudly that they have built a technology company thatthey have just taken public. They say they want tobecome social entrepreneurs and to invest $50 million ina to-be-formed charity that will fund social enterpriseprojects. They are not interested in being traditionalphilanthropists, and they believe the expertise they havedeveloped in building their company will be directlyapplicable to the skills they will need in funding socialenterprise. They want to help create self-sustainingprojects that solve important social problems, and theywant to do so in a way that has not been done before.

The unprepared attorney might have various reac-tions. One experienced lawyer might think, ‘‘You arereasonably young; you know nothing about philan-thropy; why don’t you follow Warren Buffet’s recentexample and give your money to someone who has beendoing this kind of work effectively for a while?’’ Anotherlawyer might think, ‘‘I have no idea what H&W just said,but these folks can obviously afford to pay; how do Imove this forward?’’

Having heard some version of this introduction be-fore, our attorney tells H&W he is interested in workingwith them. He suggests that the three of them talk firstabout what has already been accomplished. Then he canhelp H&W access some of the resources that they willneed to develop a more coherent charitable/businessplan. The attorney says they can discuss some of thepossible legal structures, which might involve a 501(c)(3)organization, a for-profit corporation or limited liabilitycompany, a 501(c)(4) organization, or some combinationof any of the above.

The attorney makes it clear, however, that he does notwant H&W to start by conforming to what 501(c)(3)private foundations have done. Rather, he wants them tofigure out what they want to do and then he will workwith them to develop legal structures to best accommo-date their ideas.

The second new client, S.E., is also in her 40s. She hasa strong medical practice, but now wants to help indigentchildren get better medical care, particularly in poor anddeveloping countries. S.E. has some ideas of how tobetter manufacture and distribute medical devices andvaccines and of how to get care to the people who needit. She needs a legal vehicle to accomplish her work, andshe needs funding. She considers herself to be a socialentrepreneur but is less concerned about what scholarsthink that term means than about getting her work done.She believes some funding will be available from foun-dations and maybe also from private investors. S.E. says

she has also considered ways of manufacturing medicaldevices and distributing them to middle-income andwealthier individuals in the United States. She believesthat because she will be manufacturing medical productsfor distribution to the poor, she might as well also sellthem at market value to those who can afford to pay tohelp subsidize her charitable endeavors.

The attorney discusses the different legal options ofestablishing a 501(c)(3) charity to raise funds and afor-profit corporation or limited liability company toattract investors. He notes that sales of medical equip-ment and devices at market value may generate taxableincome, rather than exempt income.

How do all of these new ideas and this new languagefit within the legal framework of the section 501(c) taxexemption?

A. Husband and Wife

It is clear that H&W do not want to be social entre-preneurs themselves; rather, they want to fund socialentrepreneurs and social enterprises. In the next meetingwith H&W the attorney will want to address the mostimportant issue: What type of legal entity should H&Westablish, or affiliate with, to accomplish their goals?H&W might be duly impressed when the attorney offersthe following choices:

• The entity could be a new entity or an existingentity;

• The entity could be a for-profit or a nonprofit;• If the entity is a for-profit, it might be a corporation

or a limited liability company, each having advan-tages and disadvantages;

• If the entity is a nonprofit, it could still be eithertaxable or tax-exempt. Although unusual, a taxablenonprofit corporation can be ideal in some situa-tions;

• If the entity is tax-exempt, it could be a section501(c)(4) social welfare organization or a section501(c)(3) charity;

• If the entity is a section 501(c)(3) charity, it could bea private foundation or a nonprivate foundation;

• If the entity is not a private foundation, it could bea publicly supported charity or a supporting orga-nization; or

• H&W could use a donor advised fund or a field ofinterest fund at an existing public charity, mostlikely a community foundation.

The attorney cannot tell H&W what he recommendsuntil he finds out what characteristics are most importantto them. He might ask the following questions:

1. Gathering Information

Do H&W expect a personal financial return in addition toa social return on their investment? Social entrepreneursoften refer to the combination of a social return oninvestment and an economic return on investment as adouble-bottom-line return. If H&W expect a financialreturn on their investment, the attorney should steerthem toward a for-profit model. The attorney mightsuggest that H&W invest in one of the emerging types ofinvestment partnerships that focus on double-bottom-line investing, in the microfinance arena (for example,

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investments discussed at http://www.shorebankcorp.com). H&W could also set up their own venture capitalfund that is geared toward promoting double-bottom-line products and services. If H&W are not interested ina personal financial return, the attorney should steerthem toward a nonprofit vehicle, and probably a tax-exempt vehicle.

What tax benefits do H&W expect or need? If H&W areinterested in a charitable contribution tax deduction, theattorney should consider a section 501(c)(3) organizationbecause there would be no deduction for a contributionto a for-profit entity or even to a section 501(c)(4) socialwelfare organization. A 501(c)(4) organization generallypays no taxes on its income, but it is also ineligible toreceive tax deductible charitable contributions. H&Whopefully understand by this point that the world of501(c)(3) organizations is further divided between pri-vate foundations and, for lack of a better phrase, publiccharities, but H&W may be less clear on the advantagesof making contributions to a public charity.

What type of property are they planning to donate to theentity? The attorney would inquire about their overalladjusted gross income in relation to the proposed gift andtheir tax deduction needs. A contribution of $50 million issizable and certainly enough to warrant setting up a neworganization. H&W need to understand that tax deduc-tions will be more limited for gifts to a private foundationin two ways. First, property other than cash or unre-stricted publicly traded stock will be deductible only atbasis. Second, gifts of cash to a private foundation arelimited to 30 percent of the donor’s AGI, while gifts ofcash to a public charity are deductible against 50 percentof the donor’s AGI (20 percent and 30 percent, respec-tively, for gifts of stock). If H&W plan to deduct $50million in donated unrestricted publicly traded stock inone year, and if they make no other contributions thatyear, they would need $166,666,667 in AGI to deduct theentire gift to a public charity, but they would need $250million in AGI to absorb the entire gift to a privatefoundation. In either case, the unused portions in oneyear can be carried forward for up to five years. The chartat the top of this page, with the following additionalnotes, illustrates these concepts:

• The amount of deduction not used in the year of giftcan be carried forward for up to five years.

• Publicly traded stock generally refers to unrestrictedstock and, in the case of the private foundation, toqualified appreciated stock described in section170(e)(5).

• Most other property that is not listed above isdeductible at basis only.

Do H&W expect to raise other funds? Entrepreneursoften believe they can encourage their other newlywealthy friends to join in and support their cause.Sometimes this involvement means an investment in anew LLC that the entrepreneur may establish. Usually,support means a charitable contribution to a 501(c)(3)organization. The attorney would explain to H&W that itis much less likely, for a variety of reasons, that H&W’sfriends would contribute to a private foundation than toa public charity.

If H&W decide that they absolutely need a publiccharity to take full advantage of their deductions and toencourage their friends to donate, they would considerseveral possibilities, none of which, in my experience,will typically appeal to folks like H&W.

First, H&W might consider setting up their ownpublicly supported charity. It can, of course, be moredifficult to encourage others to contribute to a privatefoundation than to a public charity, but it might beextremely difficult for an entrepreneur to muster a levelof public support that would enable a charity to satisfythe public support tests of sections 509(a)(1) and170(b)(1)(A)(vi), especially beyond the initial start-upphase. To meet the technical tests for public support,H&W, who are contributing $50 million, would need toraise at least $25 million from other donors — none ofwhich contributed much more than $1.5 million — orthey would need to find some existing public charitydonors, which is unlikely. The alternative 10 percentfacts-and-circumstances test is less likely to be useful fora foundation that H&W closely control.

Second, H&W could consider establishing a section509(a)(3) supporting organization. A supporting organi-zation has two distinct disadvantages from the stand-point of most social enterprise funders. H&W could notcontrol the supporting organization, which is usually adeal-stopper for entrepreneurial-minded donors. Also,the supporting organization would have significant lim-its on its ability to make grants to fund social enterprises,particularly foreign social enterprises.

Third, H&W could consider a donor advised fund orfield-of-interest fund at a community foundation. H&Wwould not control those funds, which would also havelimited ability to make grants to noncharities and toforeign organizations. Though a donor advised fund is agreat vehicle for more traditional charity, it may not be asuseful for H&W’s less traditional grants.

Gifts by IndividualsDuring Life

Amount of Deductionfor Gifts to Public

Charities(or private operating

foundations)

% Limitation on Giftsto Public Charities

(or private operatingfoundations)

Amount of Deductionfor Gifts to Private

Foundations

% Limitation on Giftsto Private

FoundationsCash Face Value 50 percent Face Value 30 percentPublicly traded stockheld for more thanone year Fair Market Value 30 percent Fair Market Value 20 percentReal estate held formore than one year Fair Market Value 30 percent BASIS 20 percent

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How important is the halo effect of having a charity? H&Wmay want to live, work, and play in the world ofphilanthropy by establishing a recognized foundationthat borrows their name. They may want to attendconferences with other private foundation leaders andhave their name associated with a foundation that willendure over time. Many social entrepreneurs are not atall concerned about being associated with the traditionalprivate foundation world, but some are. This is anintangible issue that may affect the structuring decisions,and the attorney should explore it with H&W.

Do H&W want control? Entrepreneurs who have builttheir own businesses often demand complete controlover the charity that they fund. Unless H&W will estab-lish a for-profit company, there is no substitute for thecontrol available through a private foundation. It isdifficult for a donor-advised fund or a supporting orga-nization to offer the operational flexibility, let alone thecontrol, that the entrepreneur wants. A 501(c)(4) is atax-exempt vehicle that H&W could control, but ofcourse it could not offer H&W or other donors a chari-table contribution deduction.

2. Recommending a Solution

In the end, the organizational choice of H&W dependson many of the factors that we usually discuss with awealthy client who wants to set up a charity. Consider thechart at the top of this page. In all likelihood, thecharitable contribution deduction will be of some conse-quence to H&W, so we can assume they will want at leastpart of their planning to include a 501(c)(3) entity.

It is also possible for some individuals like H&W, withaccess to a great deal of charitable capital, to elect to formboth a charity for more traditional activity and to use anLLC or corporation for social enterprise funding that isdifficult under section 501(c)(3). They can then maketraditional grants from the 501(c)(3), but make less tradi-tional investments, loans, and grants from the for-profitentity. Indeed, this type of dual giving approach may

become more popular if the code is not adjusted to takeinto account the changing goals of social entrepreneurs.

Like many wealthy donors, H&W will likely reject anyvehicle that does not place them squarely in control. Forthis reason, a community foundation and a supportingorganization, though they can be excellent vehicles formany, do not usually accommodate the entrepreneurialgrantmaker. H&W probably will decide to form a privatefoundation to house at least some of their social capital.

What about using a section 501(c)(4) organization? A(c)(4) might be an interesting choice for a donor who doesnot need a charitable contribution deduction; wants to beable to proclaim publicly that he operates through anonprofit, tax-exempt organization; does not want to besubject to the constraints governing private foundations;wants to have control; and wants his assets to be perma-nently restricted for social welfare purposes, withoutprivate benefit. H&W might consider a (c)(4) for aportion of their assets, but they probably will want aprivate foundation to take advantage of a charitablecontribution deduction.

3. Understanding the Consequences

Though entrepreneurs are typically comfortable withthe level of control and the tax deductions offered by aprivate foundation, they are often frustrated by the limitsimposed by sections 4945 and 4944. Those limits causesome individuals who want to fund social enterprise togive up a charitable contribution deduction in favor ofmaintaining more flexibility over grants and program-related investments (PRI).

H&W want to fund social enterprise in the U.S. andabroad. Section 4945 requires expenditure responsibilityfor all grants to nonpublic charities or the foreign equiva-lent of public charities, and sections 4944 and 4945require PRI treatment for loans and equity investments.An attorney can usually find a legitimate way to fashiona loan or equity investment in a deserving project as aPRI, but the required restrictions often run contrary to the

CommunityFoundation DAF

SupportingOrganization

PrivateFoundation 501(c)(4)

For-Profit LLCor Corporation

Tax benefitsMaximumdeductions

Maximumdeductions

Deductions withlimits for gifts to aPF No deductions No deductions

ControlNone, but canmake advice

None, but canhave a board seat

Can control, butaccountable to AGand IRS

Can control, butaccountable to AGand IRS

Total control ispossible, withminimalaccountability

Outside fundingOther donorspossible

Other donorspossible, but lesslikely

Other donors notlikely

Unlikely since notdeductible, butpossible

Other equity in-vestors posssible

Limits on grants

Must be forcharitable pur-poses, and furtherlimits onrecipients

Charitablepurpose, plusspecific limits onrecipients under509(a)(3)

Limited, andexpenditureresponsibility forsome grants

Grants must be topromote socialwelfare Not limited

Limits on loansand investments

Must be forcharitablepurposes

Charitablepurposes andlimits onrecipients

Program-relatedinvestments withexpenditureresponsibility

Must be topromote socialwelfare Not limited

Halo effect Maximum Mixed Strong Limited None

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entrepreneurial spirit of the funder. It is essential thatH&W understand the limits. Also, but less often, thesection 4941 self-dealing rules and the section 4943 excessbusiness holding rules might cause problems, particu-larly if H&W were to donate significant shares in theirown company.

Before establishing a private foundation, the attorneywould want to ensure H&W really understand the limi-tations that a private foundation would impose. It islikely that even after explaining the rules, H&W will befrustrated over time by the limitations that the privatefoundation rules impose, but at least the attorney willhave done his job by ensuring that H&W understand therules of the game before it is played. Materials explainingthe private foundation limitations are available from theCouncil on Foundations (http://www.cof.org) or evenon the author’s Web site (http://www.silklaw.com). Buthow are those rules likely to influence the goals of H&W?The attorney will explain at least the following:

a. Section 4940. Section 4940 requires a 2 percent tax onthe foundation’s net income, including most capitalgains, but the tax can be reduced to 1 percent in somesituations. This tax is not likely to impose any significantburden on H&W’s foundation that would not apply toany other private foundation. If H&W want to reducetheir tax from 2 percent to 1 percent, they should set upa spreadsheet with their accountant to understand howto satisfy this test on an ongoing basis.

b. Section 4941. Section 4941 greatly limits the founda-tion’s ability to engage in any transactions with H&W ortheir family or any business owned by H&W. The attor-ney should ask H&W to explore any possible problemareas, including any equipment-, personnel-, or space-sharing arrangements that H&W contemplate betweenthe foundation and H&W or any compensation or feesthat H&W expect to receive from the foundation. In alllikelihood, H&W will not find the self-dealing rulestroublesome because H&W are not looking for anypersonal benefit from the foundation.

c. Section 4942. Section 4942 requires that the founda-tion pay out at least 5 percent of the value of its assetsthat are not used for charitable purposes in some combi-nation of grants, PRIs, or direct charitable activities,including foundation administration. Do H&W under-stand that they will need to make grants and otherqualifying distributions of at least $2.5 million a yearbased on a $50 million corpus?

H&W also must understand the implications of sec-tion 4942 for PRIs. They should understand that a PRIloan or equity investment will be a qualifying distribu-tion that counts toward the 5 percent payout requirementin the year made, but that the amount will come back toincrease the payout requirement in the year it is repaid.

Unless there is an ongoing and consistent PRI pro-gram, large, long-term loans or equity investments cancause problems. Suppose the H&W foundation, with a$50 million asset base, makes a PRI loan of $20 million inyear 1. The H&W foundation, which is required to payout approximately $2.5 million a year (5 percent), hasnow made a $20 million qualifying distribution in year 1that can be carried forward for up to five years before itexpires. In year 8, the $20 million PRI is repaid and nowadds an additional $20 million payout requirement.

However, the H&W foundation is unable to use anyexcess qualifying distribution carryforward from year 1(because the carryforward expired in year 5), so it mustnow make another significant grant or PRI in year 8 tosatisfy its section 4942 obligations. For that reason, itmight make sense to plan a consistent PRI program thatdoes not overly burden the H&W foundation in a par-ticular year.

d. Section 4943. Section 4943 limits the foundation’sability to hold more than 20 percent of an active business,when combined with the interests of H&W and theirfamily. This provision is usually no more of a problem fora socially active foundation than for any other privatefoundation.

e. Section 4944. Section 4944 requires that any invest-ments that the foundation makes either qualify as pru-dent investments or as a PRI. H&W should understandhow PRIs work. Most of the PRIs that H&W will suggestto counsel over the years won’t be covered by the basicexamples in the section 4944 regulations. H&W founda-tion and legal counsel will need to work together tostructure PRIs that work from a business, charitable, andtax law standpoint. As a basic matter, however, theattorney can explain to H&W that an investment mustmeet three requirements to qualify as a PRI:

• the primary purpose of the investment must be toaccomplish an exempt purpose;

• the production of income or the appreciation ofproperty may not be a significant purpose of theinvestment; and

• no electioneering and only limited lobbying pur-poses may be served by the investment.

Assuming that H&W are not interested in lobbying orpolitical activity, the attorney will want to explain thefirst two requirements. This will be important to H&W,who are likely to do much of their work through PRIs.

To satisfy the primary purpose test, the investment,whether it is a loan or equity, must significantly furtherthe foundation’s exempt activities. Second, the invest-ment must be such that it would not have been made butfor its relationship to the foundation’s exempt activities.The PRI recipient can be noncharitable so long as thepurposes of the investment are within section170(c)(2)(B).2 How can H&W understand when an activ-ity, particularly a loan or investment in an enterprise thatis not a 501(c)(3) or foreign equivalent, significantlyfurthers the foundation’s exempt purposes? To H&W,anything they propose furthers the foundation’s pur-poses, or they would not propose it.

The somewhat dated regulations contain 10 examplesof investments involving noncharitable recipients, 9 ofwhich qualify as PRIs. In the first five examples, privatefoundations that loan funds to business enterprises toincrease economic opportunities for minority or low-income persons and prevent community deteriorationare described as making PRIs.3

The IRS has ruled in at least one private letter rulingthat a foundation’s investment in a for-profit business

2Reg. section 53.4944-3(a)(2)(i).3Reg. section 53.4944-3(b), examples 1 through 5.

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enterprise still met the primary exempt purpose test andqualified as a PRI.4 Although the foundation operated‘‘much like a venture capital organization,’’ its equityinvestment was intended to encourage the creation ofjobs and economic development in underdeveloped anddisadvantaged areas, and therefore it furthered charitablepurposes.

In other rulings, the IRS has approved section 501(c)(3)status for organizations formed to make low-cost orlong-term loans to business enterprises to combat com-munity deterioration in economically depressed areas,demonstrating that loans to businesses may serve acharitable purpose in the nonprivate foundation context.5

Similarly, the IRS has treated as PRIs loans made totaxable nonprofit mutual benefit or cooperative corpora-tions controlled by member charities, even though theservices provided by the borrowers were not inherentlycharitable. For example, the IRS approved as a PRI a loanto a noncharitable cooperative organization that pro-vided communication technology and related services tomember nonprofits at the lowest possible cost, enablingits section 501(c)(3) members to use their charitable fundsmore efficiently.6

In other instances, the IRS has ruled that a charity maypromote charitable purposes through activities that arenot themselves inherently charitable.7 And, of course,assisting in the administration and operations of chari-table entities is also a proper PRI activity.8 Some of theactivities that H&W propose may be similar to theseexamples, but some may not.

No significant purpose of the investment can be theproduction of income or the appreciation of property.This requirement can be particularly confusing to socialentrepreneurs who anticipate a double-bottom-line in-vestment that does good while making money.

The regulations point out that the IRS will considerwhether investors solely concerned with profit would belikely to make the investment on the same terms. How-ever, that an investment produces significant income orcapital appreciation is not, in the absence of other factors,conclusive evidence that income or appreciation was asignificant purpose of the investment,9 and it thereforedoes not preclude the investment from being a valid PRI.

Example 3 of reg. section 53.4944-3(b) discusses asituation in which a private foundation purchases sharesof common stock in a business enterprise on the samefooting as other stockholders. It concludes that ‘‘thepurchase of the common stock is a program-relatedinvestment, even though Y may realize a profit if X issuccessful and the common stock appreciates in value.’’

Following that example, the IRS has approved PRIsconsisting of the purchase of shares of common stock infor-profit corporations on the same terms as would applyto commercial investors. In LTR 8549039, a private foun-dation was permitted to purchase voting stock in aprivate company formed to transform a blighted areainto a marketplace. The corporation sought to raise aminimum of $15.5 million, with minimum subscriptionamounts of $100,000. The IRS recognized that it was acivic investment and that the corporation’s failure to raisethe necessary capital would end the entire endeavor. TheIRS found that the investment in corporate stock was‘‘quite speculative’’ and provided ‘‘no assurance that itwill result in the return of a stockholder’s capital invest-ment,’’ and it concluded that the foundation’s desire toinvest was ‘‘motivated by . . . charitable purposes, andnot by any significant expectations of economic gain.’’

In LTR 199943944, a foundation provided seed moneyto start-up businesses to promote economic developmentin underdeveloped and disadvantaged areas. The foun-dation’s criteria for selecting its investments requiredthat each project be based in a depressed economic areawith high unemployment and have the potential forcreating quality employment for underemployed andunemployed individuals. The for-profit business inwhich the foundation invested signed a written agree-ment requiring that a percentage of its employees bemembers of the previously unemployed or underem-ployed targeted group. The IRS found that the founda-tion’s equity investment in the business was intended topromote economic development and create jobs, and thefact that the investment might be profitable did not affectits charitable nature.

In LTR 200136026, a private foundation proposed toinvest in a for-profit corporation formed to finance andpromote the expansion of environmentally oriented busi-nesses that would contribute to conservation and eco-nomic development in economically or environmentallysensitive areas. The corporation had dual goals of pro-viding a rate of return for investors and demonstrating aclear environmental benefit through each investment.Only companies that met environmental guidelines wereeligible for investment. The corporation also created anadvisory committee to scrunitize each investment thatincluded representatives of public charities interested inpreserving the environment. The foundation representedthat the rate of return alone would not compensate forthe speculative nature of the investment and overall riskassociated with the corporation’s unique investmentcharacteristics. The IRS determined that although thefoundation expected a financial return, the investmentwas made directly to accomplish the foundation’s chari-table goals and thus qualified as a PRI.

Several other private letter rulings have approvedPRIs in which noncharitable organizations were alsoinvesting on the same terms. In LTR 8710076, a $10

4LTR 199943044.5Rev. Rul. 74-587, 1974-2 C.B. 162; Rev. Rul. 81-284, 1981-2

C.B. 130.6LTR 8445096.7See, e.g., reg. section 53.4944-3(b), Example 10 (financing the

construction of housing for low-income families is a charitableactivity, although building houses is not inherently charitable);accord, LTR 8923071; LTR 8728053 (financing the construction ofa research center for an exempt organization is a charitableactivity, although research is not inherently charitable).

8See, e.g., Rev. Rul. 67-149, 1967-1 C.B. 133 (providing finan-cial assistance to section 501(c)(3) organizations by receivingand disbursing income on their behalf is an exempt activity);LTR 8708067 (lending money to an exempt organization tocreate an endowment for it is a section 170(c)(2)(B) charitablepurpose).

9Reg. section 53.4944-3(a)(2)(iii).

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million limited partnership was established with a tax-able general partner, and limited partnership interestswere offered to a small group of private foundations andprivate individuals. The limited partnership was createdto go beyond informational services and to providefinancial support to actual enterprises seeking to demon-strate that privatization of human services is a viableconcept. A private foundation’s $600,000 investment inthe partnership was approved by the IRS as a PRI.10 PRIloans to for-profit limited partnerships are also a com-mon mechanism for private foundations to support low-income housing and economic development in blightedareas.11

H&W must be willing to have each PRI independentlyreviewed by the foundation’s program staff and by legalcounsel. The process can be cumbersome but is necessaryfor this level of activity.

f. Section 4945. Section 4945 limits the ability of thefoundation to make distributions to individuals and toorganizations other than public charities. If the founda-tion wants to make grants to individuals for scholarshipsor fellowships in the form of prizes and awards or forspecific projects, it will need to have the IRS preapprovethose grantmaking procedures under section 4945(g).

If the H&W foundation wants to make grants, loans,or equity investments in organizations that are not publiccharities or that are not the foreign equivalent of a U.S.public charity, it must exercise expenditure responsibility,which requires adequate staffing to review and monitorthe projects. Basically, expenditure responsibility requires(1) a pregrant inquiry, (2) an appropriate written grantagreement, (3) grantee reporting to the grantor, (4) report-ing of the grant on Form 990-PF, and (5) follow-up withthe grantee if the grantee fails to use the funds correctly.The attorney should explain to H&W that many founda-tions engage in expenditure responsibility grants, butthey must follow the rules. Sometimes entrepreneurialfunders want to give their grantees maximum latitude tocarry out their programs without the burden of cumber-some reporting and other limitations. H&W have tounderstand upfront what they are getting into.

B. S.E.

S.E. is a true social entrepreneur. She knows what shewants to do, but does not know how to fund her vision.Her primary concern should be what type of entity toestablish to maximize her ability to accept money and tooperate without restrictions.

1. Gathering Information

To what extent does S.E. plan to solicit private equity versusgrants? If S.E. intends to raise charitable contributions,she must form a 501(c)(3) charity. If S.E. intends to seek

private equity, she will need a for-profit vehicle. If she isinterested in both charitable contributions and equityinvestments, she may have to consider a hybrid vehicleinvolving both a charity and a for-profit, although U.S.law is not particularly amenable to this combination.Because there is no true hybrid vehicle available in theUnited States, she would have to set up two organiza-tions that would operate side by side, while avoidingpotential state law self-dealing issues and excess benefitissues under the code. For wealthy individuals such asH&W, operating a for-profit and a charity side by sidecan be less burdensome because the for-profit couldprovide the charity office space and personnel withoutthe need for reimbursement. For S.E. it may not befinancially feasible for a struggling for-profit to subsidizea charity, and there may be potential cost-sharing prob-lems related to joint operations. These issues can generatepotential excess benefits under section 4958 if nothandled properly.

Are S.E.’s proposed projects consistent with section501(c)(3)? We need more facts. The attorney must get aspecific charitable/business plan from S.E. The attorneydoes not want section 501(c)(3) to limit S.E.’s vision, andS.E. should understand what she can and cannot dowithin a section 501(c)(3) entity.

The attorney explains to S.E. that under section501(c)(3), to qualify as a tax-exempt charitable organiza-tion, an entity must be organized and operated for one ormore of the exempt purposes listed in section 501(c)(3),and it must refrain from inurement, electioneering, andsubstantial lobbying.

The attorney explains to S.E. that her charity willsatisfy the organizational test because its articles ofincorporation or certificate of incorporation will containall the necessary language and none of the prohibitedlanguage. The attorney then learns that S.E. is not inter-ested in lobbying or political activity or in any privatebenefit, private inurement, or excess benefit transactions.We are left with the operational test of section 501(c)(3).

Section 501(c)(3), taken literally, requires an organiza-tion to be operated exclusively for exempt purposes. Theregulations, however, add some flexibility to what isknown as the operational test. They make clear that acharity may qualify as such if it is operated primarily forexempt purposes. An insubstantial part of the charity’sactivity may be devoted to nonexempt purposes.12 Thus,a charity may operate a trade or business whose conductis not related to the achievement of its exempt purposeswithout losing its charitable status under the tax law.

What makes the operational test especially challeng-ing is that there is no single legal standard for whether anactivity is consistent with section 501(c)(3)’s operationaltest. The law has evolved different rules and differenttests for different types of activities, particularly revenue-generating activities. In analyzing whether an income-generating activity is an appropriate exempt activity, theIRS and courts have examined a variety of factors, manyof which ultimately result in a test: Does the activityappear more like a commercial or an exempt activity? As

10See also LTR 9016078 (purchase of a large equity interest ina holding company affiliated with a for-profit enterprise, todevelop business in a depressed area) and LTR 8807048 (invest-ment in construction of low-income housing, accomplishedthrough limited partnerships with for-profit corporations).

11See, e.g., LTRs 9112013, 8923070, 8923071, and 8637120. 12Reg. section 1.501.(c)(3)-1(c)(1).

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the U.S. district court recently said, does the activity havea ‘‘commercial hue’’? (Airlie Foundation v. IRS, 283 F.Supp. 2d 58 (D.D.C 2003).)

The attorney would explain to S.E. that the more anactivity fits within the realm of activities that havetraditionally been recognized as charitable, the morelikely the activity is to generate exempt income. The lessthe activity resembles a traditional charitable endeavor,the more scrutiny the IRS will apply. For example, it isrelatively easy for hospitals, schools, and activities thathave traditionally been exempt to qualify for exemptionas long as they do not improperly benefit insiders, do notdiscriminate, and provide an appropriate level of serviceto those who cannot afford to pay. On the other hand, thetests are more difficult to satisfy in areas such as publish-ing, fee-based management, or consulting services.

Most of the projects that S.E. is proposing are likely tobe ‘‘charitable.’’ Going back to basics, the regulations tellus that the term ‘‘charitable,’’ as used in section 501(c)(3)in its generally accepted legal sense, can include activitiesthat might also be described as educational, religious, orscientific. The term includes: (1) relief of the poor anddistressed or of the underprivileged; (2) advancement ofreligion; (3) advancement of education or science; (4)erection or maintenance of public buildings, monuments,or works; (5) lessening of the burdens of government;and (6) promotion of social welfare by organizationsdesigned to accomplish any of the above purposes or to:(a) lessen neighborhood tensions; (b) eliminate prejudiceand discrimination; (c) defend human and civil rightssecured by law; or (d) combat community deteriorationand juvenile delinquency.

To fit within the established rules of section 501(c)(3),S.E.’s activities would have to aid the poor and distressedby providing needed medical and technology items at asubstantial discount, probably below cost. Based on S.E.’sgoals, it should be possible for her activities to qualify ascharitable under section 501(c)(3). Because she wants toprovide medical equipment and vaccines to the poor forfree or substantially below cost, this is a fairly easyanalysis.

Are any of S.E.’s activities outside the scope of section501(c)(3)? S.E. said she was considering selling some ofher products at market value to middle-income orwealthy individuals in the U.S. to subsidize her otheractivities. It is important to explore with S.E. the extentand scope of these noncharitable activities. The attorneyshould explain that any section 501(c) organization withunrelated business income (UBI) pays unrelated businessincome tax on that income at the regular corporate taxrates.13 Sometimes an entrepreneur with a great ideawants to sell an item at a deeply discounted rate to thepoor and distressed but then sell the same item at marketrates to individuals who can afford them. The latteractivity may be unrelated; it is not enough that themarket sales will bring income to support the below-market sales.

A section 501(c) organization generates UBI when itrecognizes net income from a trade or business that is

regularly carried on and that is not substantially relatedto the organization’s exempt purpose. Selling medicaldevices to middle-income and wealthy persons at marketvalue will normally generate UBIT.

None of the typical UBIT exceptions is likely to applyto S.E.’s market value income. Under the UBIT rules,income that otherwise is subject to UBIT is excepted fromUBIT if:

• the income is interest income, dividends, and annu-ities (section 512(b)(1));

• the income is from royalties (section 512(b)(2));• the income is from rents derived primarily from real

estate and a limited amount of personal propertyleased with the real estate (section 512(b)(3));

• the income is from the sale of capital assets (section512(b)(5));

• the income-generating activity is conducted for theconvenience of members, students, patients, or em-ployees (section 513(a)(2)). (This exception typicallyapplies to venues such as college bookstores ormuseum or school cafeterias);

• the income-generating activities are conducted en-tirely by volunteers (section 513(a)(1));

• the income is from the sale of donated merchandise(section 513(a)(3)); or

• the income is qualified corporate sponsorship pay-ments (section 513(i)).

How much of S.E.’s activity is likely to generate UBIT?The attorney explains to S.E. that organizations musthave a core activity that is exempt in nature. If anorganization operates a legitimate exempt activity, it mayalso operate even a substantial unrelated trade or busi-ness without losing its exempt status as long as itsprimary purpose and activity is exempt (reg. section1.501(c)(3)-1(e)).

If an organization operates a core exempt activity, howdo we know the amount of unrelated activity that ispermitted? Organizations are sometimes concerned thatif they generate too much money from an unrelatedbusiness activity, they will lose their exemption as de-scribed under section 501(c)(3). Organizations sometimessay they believed that if their UBI exceeds a percentage,such as 25 percent or 33 percent, they will automaticallylose their exemption. The good news is that there is noautomatic percentage rule.

Rev. Rul. 64-182, 1964-1 (part 2) C.B. 186, sets forth the‘‘commensurate in scope’’ test, which is still followedtoday. This ruling stands for the principle that an organ-ization may receive a significant amount of UBI (whethertaxable or nontaxable under an exception) as long as itcarries out charitable programs that are commensurate inscope with its financial resources. In that ruling, theorganization presumably received 100 percent of itsincome from renting real estate, but it engaged in grant-making activities that were commensurate in scope withits financial resources.

Other rulings expand on this concept to suggest thatwe do not look entirely at the percentage of income froman unrelated activity, but at the full scope of operations ofthe charity. How much time is the charity spending on its13Section 511.

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exempt activities in relation to the time it is spending ongenerating income from investments and nonexemptactivities? 14

A leading treatise on the taxation of exempt organiza-tions explains the test well:

If the tax-exempt organization carries on one ormore activities that further exempt purposes, suchas operating a museum, hospital, school . . . andalso conducts a clearly commercial activity, such asoperating a restaurant, a determination must bemade as to whether the effort expended to carry outexempt purposes is commensurate in scope withthe organization’s financial resources. This requiresan evaluation of the time and effort undertaken bythe organization in the conduct of the exemptactivity or program, the impact of the exemptactivity or programs, how the organization holdsitself out to the public, and the use of net after-taxUBI. (Footnotes omitted)15

As a practical matter, if it is a close call as to whetheran unrelated activity is beginning to overshadow theexempt purposes and activities of the organization, theattorney would likely recommend dropping the businessactivity into another organization, usually a for-profitcorporation.

2. The Solution

Eventually it becomes clear that S.E. really has no planto sell anything at market value and wants to focus onher charitable mission; she just wants to keep the marketvalue option open. Because she wants to obtain charitablecontributions and grants to get started, in hopes ofbecoming self-sustaining at some point, she will need toestablish a section 501(c)(3) public charity or she willneed to find a very accommodating existing charity towork with her.

S.E. will find that matters become more complex whenshe begins to work abroad because she must check thelocal laws of each area in which she plans to distributemedical aid. She may have to work with local charities orset up her own organizations in different countries. Shemay find hurdles in transferring currency abroad and inworking within nations that the U.S. government consid-ers hostile. There are a number of nontax issues she mustconsider.

3. Consequences of Success

If S.E. does decide to move forward with her market-level sales of medical devices to the middle- and high-income, she then must consider whether to carry out thisunrelated business activity within her charity or whetherto establish a for-profit entity to carry out the activity. The

attorney should review at least two options with S.E.:keeping the activity within her charity or forming a newsubsidiary.

a. Option A: Keeping the unrelated activity within theexisting charity

Keeping the unrelated activity within S.E.’s existingcharity has at least two advantages:

• Business activities can freely use the charity’s nameand goodwill, as well as tangible assets and humanresources, without the complexity of entering intolicensing, rental, or resource sharing agreementsbetween two entities.

• If S.E. terminates the business activities, any appre-ciated assets used in those activities belong to thecharity.

The option also has potential disadvantages:• If the charity already has substantial UBI, and new

activities will be so substantial that exempt activitiesof the charity appear secondary to the unrelatedactivities, the charity’s exempt status will be injeopardy.

• The taxable activity may appear inappropriate forthe charity from a public relations standpoint.

• Any potential liabilities associated with new activi-ties will be liabilities of the charity.

b. Option B: Forming a subsidiaryThe advantages of forming a for-profit corporate sub-

sidiary are as follows:• If properly implemented, it eliminates the risk to the

charity’s exempt status.• The subsidiary enables S.E. to raise funds from

outside investors.• This option eliminates possible confusion in the

public eye concerning the charity and its activities.• If properly structured and operated, this option

provides insulation from liabilities arising from newactivities that are now localized in the subsidiary.

• Dividends received from the subsidiary are nottaxable as UBI (although dividends are also notdeductible by the subsidiary).

The following are disadvantages of a separate subsid-iary:

• Because these market-rate activities are unrelated tothe charity’s exempt purposes, investment in thenew corporation must satisfy a prudent investmentstandard. This must be a sensible use of the charity’sresources.

• There are greater start-up and ongoing expenses inmaintaining two separate corporations.

• If the charity owns more than 50 percent of thesubsidiary, any income from rents, royalties, orinterest from the subsidiary to the charity will resultin UBIT.

• On eventual dissolution of the subsidiary, transfer ofany appreciated assets to the charity will constitutea deemed sale of the assets, taxable at the subsidiarylevel.

There are, of course, other practical and legal issuesthat must be addressed before the charity would estab-lish a subsidiary. In the end, the attorney will likelyadvise S.E. to begin a new section 501(c)(3) public charity.If she decides she needs outside investors to operate an

14See LTR 200021056 (this ruling reached the correct resultthrough some unusual reasoning); see also TAM 9711003 (charityretained exemption when 95 percent of its income was UBI); seealso LTR 8038004.

15Taxation of Exempt Organizations, Hill and Mancino, Warren,Gorham & Lamont of RIA, pp. 21-17 through 21-18, updatedregularly.

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unrelated activity that will be significant in size com-pared to her charitable activities, she might consider asubsidiary.

Ultimately, though, the hybrid entity that S.E. dreamsabout, an entity that could receive grants and also haveinvestors, does not exist under U.S. law.

IV. Changing the LawThere is no single or perfect way to form a social

enterprise or to fund a social enterprise under U.S. law. Itcan be cumbersome to design a social enterprise underthe dense and unaccommodating passages of the code.And because of abuses, both actual and perceived, in thecharitable sector, Congress seems more intent recently oncurbing the ability of charities to operate (see, for ex-ample, the Pension Protection Act of 2006) than on tryingto accommodate new approaches.

Typically, when Congress wants to encourage commu-nity development and social enterprise, it does so byenacting limited tax credits such as the low-incomehousing tax credit (section 42) and the new markets taxcredit (section 45D). These credits are good vehicles toencourage for-profit institutions to invest in housing orother community development projects. Low-incomehousing and new market tax credit transactions are,arguably, a form of social enterprise, but they are limitedin scope, amount, and flexibility. The rigidity of statenonprofit laws coupled with a code that is better suited totraditional philanthropy than to cutting-edge ideasmakes it difficult for social entrepreneurs and socialenterprises to work as effectively as they could in theUnited States.

In the United Kingdom, the law tried to accommodatesocial enterprise. The community interest company (CIC)is a new type of legal entity established by the U.K.government as part of the Companies (Audit, Investiga-tions and Community Enterprise) Act of 2004, whichbecame effective July 1, 2005. CICs are created specifi-cally to benefit social enterprises. For more information,see http://www.cicregulator.gov.uk.

CICs are limited companies under U.K. law, a formthat is already familiar to U.K. investors and legalcounsel. However, a CIC must include the words ‘‘Com-munity Interest Company,’’ ‘‘CIC,’’ or ‘‘Community In-terest Public Limited Company’’ in its title, presumablyso its status is clear to the public.

A CIC must apply for CIC status from the governmentby satisfying a broad community interest test. Its pur-poses and activities must be such that a reasonableperson might consider them to be carried on for thebenefit of the community. The community served by theCIC does not have to be located in the U.K, suggesting

that a CIC might even be a tool that a U.S. socialentrepreneur might consider.

As with a typical U.S. public benefit corporation, theunderlying assets of a CIC are subject to an ‘‘asset lock.’’They are permanently dedicated to community and/orcharitable purposes. This way, socially motivated inves-tors can have greater confidence that their investmentwill not be used for unintended purposes. Unlike publicbenefit corporations, however, a CIC may pay dividendsto its shareholders, subject to a dividend cap. The divi-dend option allows investors to receive some return oncapital, even though they will never receive their originalinvestment back.

The CIC does pay taxes on its income, and investorsdo not receive a contribution deduction for contributionsto a CIC, which may make CICs less useful than theyotherwise might be.

The United States might also consider adopting a newform of entity that allows for private investment with asocial benefit purpose. For example, consider a new typeof section 501 organization with the following character-istics:

• The entity would be formed as a nonprofit corpora-tion with members, under state law.

• Members could receive limited current income inthe form of dividends, which could be capped.

• Memberships could be transferable.• Members would have no right to a return of their

initial investment, which would be forever dedi-cated to public or social benefit purposes.

• Because the purposes of the entity go beyond thatwhich section 501(c)(3) permits, the members wouldnot be entitled to a charitable contribution deduc-tion.

• As with a 501(c)(4) social welfare organization, theincome of the organization would be tax-exempt,although members would pay taxes on dividends.In this way, the U.S. model could differ from theU.K. model, which is subject to tax.

• The assets would be limited to public benefit andsocial benefit purposes, but not subject to all of thecurrent 501(c)(3) limitations.

• There would be clear prohibitions on self-dealingand excess benefit transactions.

• The entity would have to be eligible to receiveprivate foundation grants and PRIs.

Of course, there are many ways to change the laws toestablish new forms of hybrid entities. To be credible,those entities would have to contain strict prohibitions onany excess benefits to insiders. There is already muchdiscussion and speculation about whether it’s time for anew hybrid entity. I for one believe the time has come!

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social enterprise: a legal context - adler & colvin · 2017-12-30 · social enterprise: a...

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