Non-Profit? For-Profit? Both? Choosing an Entity for a Social Enterprise

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Social enterprises involve some social or environmental mission plus a money-making business model. If this describes your new enterprise, you might be considering starting a non-profit organization, but not sure whether you should start a for-profit company instead or in addition. This article will show you which legal entities make sense for what kinds of purposes. My goal is to help you turn your idea into a specific plan of action and help you talk to your lawyer about it. A blog post about legal entities is not a replacement for legal advice.

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Let’s first look at an example of how non-profit and for-profit entities can work together for social enterprises. King Lizzy is a store selling urban art in the form of apparel, from a storefront in Chicago’s Humbolt Park neighborhood. It’s actually a project of the non-profit organization, The Stewards Market, whose mission is to build successful communities by creating entrepreneurial and educational opportunities. King Lizzy is a pipeline through which people can travel from an entry-level job where they can learn basic job skills, to a management position, to being trained in all aspects of operating a business, to owning their own businesses. The Stewards Market is a 501(c)(3) tax-exempt organization because its purpose is educational (and possibly charitable). It also operates a revenue-producing business, and its goal is to spin off independent businesses that are the result of empowering its students. Those businesses could be for-profit subsidiaries of the non-profit, or they could be independent corporations or LLCs.

Here’s how to start figuring out what entities you need:

1. Is this a money-making venture for you and your team? If so, skip this whole bit and look at for-profit business entities.

2. Get clear on what your purpose is. Only the purposes listed in section 501(c)(3) of the U.S. tax code are tax-exempt purposes. Those are: “religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition … or for the prevention of cruelty to children or animals[.]” Usually social enterprises have educational and/or charitable purposes. On the other hand, you might just be interested in creating some empowering local economic development. Great! Skip the non-profit and choose a for-profit entity.

3. If you’re still in the non-profit boat, next, clearly describe the activity that makes money. Now, does that activity directly achieve your tax-exempt purpose? For example, operating the King Lizzy store directly accomplishes the goal of providing job training. However, consider a non-profit urban farm with an educational purpose that operates a farm stand to sell its produce, and it also sells jam and soap made by a friendly neighbor, on commission. That other sales activity supports the farm’s purpose by making some extra income for the farm. But selling the jam and soap does not directly educate people about growing produce and eating healthy food.

4. Consider the scale of your different activities. How much money will come from donations? How much from an activity that directly accomplishes your purpose? How much from another business activity?

RESULTS:

Non-profit: A business with a charitable or educational purpose, where the business activity directly accomplishes that purpose, where the business won’t make significantly more than you need to operate, and where the founders aren’t in it to make more than a reasonable salary for themselves: this can be a non-profit, tax-exempt organization. If this paragraph describes your enterprise, then organizing as a non-profit, tax-exempt organization gives you the benefit of not having to pay tax on the organization’s income, other state and local tax advantages, and the public perception that your organization serves a worthy mission.

Seeking profit: Any business where you’d like to distribute the profit to yourself, your team, or someone else needs to be a for-profit entity.

Does a significant amount of your income come from a business activity that does not directly accomplish a tax-exempt purpose? If running that business is really your primary or your only planned activity, then there is little reason to set up a non-profit in addition to the for-profit entity you’ll need to use for the business.

Significant charitable or educational activity, plus significant “unrelated” business activity: this is the situation where it makes sense to use both a non-profit and a for-profit entity. The non-profit runs the charitable or educational programs. This allows you to solicit tax-deductible donations for those programs. As soon as you know there will be a significant amount of business activity, where the business activity doesn’t directly achieve a tax-exempt purpose, that business needs to be carried on by a for-profit, taxable entity. And that for-profit business can pay some of its income to the non-profit.

Non-profits are said to add a “halo effect” to the activities associated with them. These days, though, people are starting to recognize that making money can be part of doing good in the world. The Benefit Corporation and the L3C are entities for for-profit businesses that do create some positive buzz and do connect you to a small but growing community of like-minded business-people who will go out of their way to do business with you.

This blog post is meant to give you useful information, but it’s not legal advice because different circumstances can make a big difference in your legal decision-making process. When I recommend you get help from a lawyer:

Just before you start to operate. This could be when you have some programs planned and you’re seeking donations to pay for them, or when you start to conduct a business, and especially when discussions with a potential business partner start to get past the theoretical stage. You can incorporate or form your own LLC, if you want, but you should get help from a lawyer to draft bylaws or an LLC operating agreement.

Your lawyer should help you create a short-term and long-term strategy that will take into account how the business might change over time, and how to set up the project to last longer than any one person’s involvement.

If you have a non-profit that will make a significant amount of income from a “related” business activity, get a written opinion from your lawyer that your business activity really is “related.”

If you are setting up both a non-profit and a for-profit, have a lawyer structure the for-profit and the agreements between them in a way that maximizes the tax advantages of the non-profit.

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