From the Wall Street Journal
By KYLE WESTAWAY
You may have noticed the emerging class of "social entrepreneurs" who are creating companies that seek profit but also are devoted to a social purpose, to create long term, sustainable value.
About the Author
Kyle Westaway is founding partner of Westaway Law in New York, and cofounder of Biographe, a sustainable style brand that employs survivors of the commercial-sex trade. He lectures on social-enterprise law at Harvard Law and Stanford Law, and launched socentlaw, a legal blog for social entrepreneurs.
Social entrepreneurs believe a business can be a part of the solution to some of the world's greatest challenges. It's this kind of thinking that has given rise to such mission-driven companies as Better World Books, TOMS Shoes, D-Light Design and Warby Parker, to name a few.
But, until recently, social entrepreneurs would find themselves in the position of choosing whether to organize either as a for-profit company or a nonprofit organization. The problem was that sometimes a company would be too much of a business to be a nonprofit. Yet, it also might be too mission-driven to be a for-profit.
Fortunately, there are a few innovative legal structures designed for entrepreneurs who are driven as much by mission as money. The cost of using one of these new legal structures will vary depending on lawyer fees, but generally those fees shouldn't exceed more than $10,000 for a start-up with fewer than 10 employees.
Here's an overview:
L3C
Ideal for: companies that want to blend traditional capital with "philanthropic" capital, such as from foundations
Available to start-ups in: Vermont, Michigan, Wyoming, Utah, Illinois, North Carolina, Louisiana, Maine and soon in Rhode Island.
The Low Profit Limited Liability Company is a new class of LLC for mission-driven companies.
An L3C offers the same liability protection and pass-through taxation as an LLC. But it must be organized primarily for a charitable purpose – and secondarily for profit. Unlike a traditional nonprofit, it may distribute its profits to owners.
The L3C is designed to attract both traditional investment and a very specific type of philanthropic money called Program Related Investments (PRI). PRI is capital – in the form of equity or debt – from a foundation to a for-profit company that is doing work in line with the charitable purpose of the foundation.
BENEFIT CORPORATION
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Getty ImagesIdeal for: companies that want to create a measurable positive impact while and providing greater transparency to the public
Available to start-ups in: Maryland, Vermont, Virginia, New Jersey, Hawaii, California and soon New York
The Benefit Corporation is a new class of corporation with a corporate purpose to create public benefit, a broader fiduciary duty and is transparent about its overall social and environmental performance.
By definition, it must operate for the general public benefit – defined as a material positive impact on society and the environment. Every benefit corporation is required to publish an assessment using an independent, third-party assessment tool. To create a material positive benefit, a benefit corporation operates in a manner that not only creates value for the company's shareholders, but also its community, environment, employees and suppliers.
The structure also calls for 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 it performed that year on a social and environmental axis.
FLEXIBLE-PURPOSE CORPORATION
Ideal for: companies seeking to do good on their own terms
Available to start-ups in: California
The Flexible Purpose Corporation a new class of corporation that creates the maximum amount of flexibility for socially/environmentally conscious companies. It is designed for businesses that want to pursue profit along with a special purpose of its own designation.
The structure allows the designation of a special purpose that the company will pursue in addition to profit. For example, a flexible purpose corporation might be a for-profit developer that has a special purpose of building a public park in each of its developments.
This type of corporation must issue an annual report that is available to the public and provides details on the following: the special purpose; the annual objectives that it has set to achieve its special purpose; the metrics used to gauge the success of the special purpose; how it has achieved or fallen short of the stated objectives; and how much money was spent in furtherance of the special purpose. But it does not require any measurement against an independent third-party standard.
12 comments:
William A Price Wrote:
These entity forms are traps for the unwary. They are not needed, since current limited liability company and statutory trust laws explicitly permit operation for any legal purpose, including nonprofit or mixed operation. They add state level reporting requirements, but do not provide anything but possible PR benefits in return, something that the work of their organizations will prove better than the choice of entity form.
To Mr. Tayloe's point, the new entity structures would not change federal law. Entities with some private benefit component are likely to be treated as private foundations, which get the highest possible entity level tax rate on income. The Internal Revenue Code only allows exemption from income taxation if there is no "private inurement" (such as a capital gain on sale for those with equity interests in an entity). State charitable exemptions for income, sales, and property tax relief similarly require strict separation of charitable and non-charitable income and operations.
University researchers often, therefore, operate both charitable institutes and for-profit companies to support the research and commercialization elements needed for new drug or medical treatment development, allocating the exempt income (e.g. foundations grants) to one, and taxable income to the other, and doing exempt activity (like research) in one, and money-seeking (like sales) in another, to obtain the lowest total tax incidence. Social entrepreneurs need good lawyers, not new laws that eliminate the possibility of entity exemption from taxation.
I chaired the committee of the Institute for Illinois Business Laws, and the Corporation, Securities, and Business Law Section of our state bar association that helped draft the first two versions of our state LLC Act, and we opposed the L3C for these reasons, among others. We continue to research ways to make our entity laws more useful for people in Illinois, with active projects now underway on the new uniform LLC Act and the uniform statutory trust law. Laws need to make things easier for entrepreneurs, not to make them think they'll get a benefit, when they may just cost themselves large sums in state and federal taxation.
Hope this helps,
Bill Price
William A. Price
Attorney at Law
www.growthlaw.com
Kyle Westaway Replied:
William-
Thanks for your thoughtful comment. I absolutely agree that laws should be make the lives of entrepreneurs easier. The beauty of these new structures is that they give clear, easy, plug-and-play solutions for social entrepreneurs rather than trying to cobble together a hybrid structure in the old binary model of non-profit / for profit. Form should follow function not the other way around.
Your point about LLC's is certainly valid, specifically related to the L3C. But misses the point of the L3C structure (to attract a mix of philanthropic and private capital) and does not even address the Benefit Corporation and the Flexible Purpose Corporation.
The point of the L3C is to make a clear indication to potential PRI makers that the entity is qualified to receive such funding. The L3C has not been as effective at achieving a huge influx of PRIs, but could potentially do so, with new federal legislation Philanthropic Facilitation Act of 2011 (H.R.3420) that has been introduced into the House. To your point, LLCs can attract PRI investment as well, but the case is much easier with an L3C.
You also failed to adress the important issue of the shift in fiduciary duty from maximizing shareholder value to maximizing stakeholder value, more pronounced in the Benefit Corporation and the Flexible Purpose Corporation. This is a shift of epic proportion that will empower boards to make decisions that are socially and environmentally responsible. This is particularly relevant at liquidity events.
Lastly, specific to the Benefit Corporation, a third party assessment adds a level of transparency and accountability. This is a benefit to consumers and to business owners in that it gives them metrics by which to run their business in a more socially responsible manner and allows the consumer to distinguish a good company from one that just has good marketing.
I understand that there was some opposition to the L3C in Illinois, and your points are intelligent and worth noting, but at the end of the day, the legislature passed the L3C.
Lastly, I agree with your point that entrepreneurs need good lawyers. Isn't the role of a good lawyer to understand every option available for our clients and choose what will serve their interests best? Whether or not you are longing for bygone days when these structures were not available, the reality of the present and the future is that these new legal structures for social entrepreneurs exist and as a counselor should be used when (and only when) it's in the best interest of the client.
Ryan Williams Replied:
Lost in the conversation about what the legal impact of the exemption could or should be is whether or not these are truly charitable entities in the first place. To my eyes, this response from Mr. Westaway boils down to one thing - going out for grants.
Anyone who has actually worked in fundraising knows that grants are more and more difficult to secure because of the unpredictability in markets making their gift planning equally difficult.
I have a hard time believing that this effort to make for-profit corporations able to secure charitable contributions has much to do with achieving a charitable mission and more to do with achieving new revenue streams in a difficult global economy.
Are we to believe that the boards of major corporations are simply waiting for the all-clear to switch off the 'shareholder value' switch so they can start safeguarding the rights of the poor and protecting the environment?
More likely, they are waiting for the all-clear to secure lucrative government grants intended for purely charitable agencies that will end up being diluted and made less effective.
Corporate giving is generally less than 1% of total net revenue for any given company. These are not entities who have been waiting for the opportunity to GIVE more, these are entities who have been waiting for the opportunity to TAKE more.
Present me with a case in which a qualified and established non profit couldn't perform the direct charitable work involved through close collaboration and funding from a corporate partner and I will seriously consider the value of the L3C. Until then, it just smells like the latest form of socialized risk and privatized reward.
Hilary Rushford Wrote:
As an entrepreneur in Brooklyn, NY I'm surrounded by so many people who are running non-profits, doing-good-for-profit companies, passionate about social entrepreneurism. It truly feels like a movement of this generation & it's exciting to see when that tide of energy crests over into the government & laws start to acknowledge & validate this new era. There have always been companies doing good, but they are so much more prevalent now, with so many more that don't necessarily want to be non-profits as many did in the previous decades, but want to be profitable & give back. These structures may be imperfect, as someone noted in the comments -- I'm not a lawyer & can't comment to that. But what's exciting is the general movement to try & help this group of entrepreneurs, & furthermore to acknowledge that they are unique but a growing percentage in the business landscape.
Hilary Rushford
founder, DeanStreetSociety.com
Ryan Williams Replied:
The unfortunate truth is that while a lot of social entrepreneurs and corporate giving programs pat themselves on the back, problems persist. A perfect example is Feeding America, which does much for the corporate image of its partners and the overall marketability of charity, but has not yet managed to significantly reduce hunger anywhere in the U.S. and certainly has not come close to 'ending' hunger at all.
These highly marketable and media-friendly movements create positive energy and that energy should be captured and highly rewarded. However, having 1,000 new non profits all competing for grants and donors when 90% of them aren't providing direct services is not going to help anyone anywhere. It will only dilute the donor base, dilute the tax base, and flood the market with already-tried ideas that look great on a youtube video but do little to help people in need.
Don't get me wrong - I am all for meaningful social contribution. But it has to be meaningful, measurable and non-duplicative. Simply being unable to turn a profit on your product or service and promising to give money to charity is not the same as being charitable.
Kyle Westaway Replied:
Ryan-
For entrepreneurs that want to solve social and environmental challenges with their business. By moving the services to the market, we are actually adding to the tax base (since none of these legal structures are tax exempt).
As far as the federal response goes, most corporate law is handled by the state government. But a bill that will affect the L3C has been introduced into the US House of Representatives. The Philanthropic Facilitation Act of 2011 (H.R.3420) to the U.S. House of Representatives. The act simplifies the utilization of program-related investments (PRIs) that provide unique ways to stimulate economic growth while furthering social missions at no cost to government.
Ryan Williams Wrote:
Since when was "mission-driven" relevant to tax exemption? While reporters are busy drooling over all the new product companies spawned "for a cause", I have yet to see one point out that section 501(c)(3) does not define charity as "mission-driven." Charity is defined broadly by the IRS but in all cases the justification for avoiding taxation comes from the inherent difficulty profiting from activities undertaken.
In simpler terms, it is less important that you have a mission and more important that you are actually providing direct benefit to people who are not likely to be able to pay you market rate for your services.
It is inherently difficult to turn a profit running a homeless shelter. It is not inherently difficult to turn a profit operating a news room, selling bracelets, or creating advertising or mobile apps.
What we have here are a group of people who can't figure out a way to make a decent business model and so are turning to the government for breaks. These L3C's are going to become just another tax shelter for people who should be working for larger groups with a history of providing real charity.
That these groups would rather incorporate on their own and claim they deserve a break because they can't profit is a sure sign that their interests are in a fat paycheck and the letters C.E.O after their names then actually helping people in need.
Kyle Westaway Replied:
Ryan-
Just to clarify. None of these structures mentioned receive tax exemption or even a tax break.
Ryan Williams Replied:
My next question then is how they become eligible for revenue (grants) from tax-exempt foundations. Would they be required to pay tax on their receipt of grant money?
Since so many of the articles I've read about these kinds of structures seem to suggest that many of the same activities could be achieved without them by incorporating as an LLC, I am left asking what the point is.
You'll have to forgive me for being cynical. Corporate philanthropy is clearly an avenue to increase sales and often (most recently in the case of J.P Morgan Chase) skews towards the marketable instead of the results-driven.
Given the two realities that corporate boards are driven by profit and have historically resisted almost religiously the social and environmental causes championed by non profits; and that enormous amounts of revenue sit in charitable foundations where they are doled out in small increments to sustain truly charitable agencies, I just have a very hard time seeing these new structures as anything but a cash grab.
But, I suppose time will tell. If iIn 5, 10, or 15 years we start seeing an end to hunger, disease, and poverty I will be forced to concede that the business community has been the cause.
Gilda Martinez Wrote:
I think the main objective of entrepreneurs will be to engage millions of people in the creation of a common future: the society of mutual responsibility. The future will evolve by mandatory integral education and upbringing. Thus everyone who builds his work on these values will achieve correct results. The formation and development of value based employees will become the key priority for entrepreneurs.
Since the motivation of man will cease to be based on material factors, support will come from the community that provides everything necessary for existence. Society must find new methods to motivate people to work effectively, such as the desire for leadership to benefit society, public recognition, and so on. No enterprise will be able to become part of the new global economic system if it does not pass through inner spiritual renewal, and transformation to accept these new basic values.
Neal Myrick Wrote:
We have operated a nonprofit for 15 years and just launched a wholly owned for-profit subsidiary. We examined all of the available legal structures (in Washington state and Federal) and decided to go with a standard C-Corp (from a federal tax perspective). The nonprofit owns 100% of the shares and can receive dividends to support its nonprofit work.
I totally support the progress being made on new legal entities. There are social and cultural implications that in my mind are more important than the legal ones. I am less optimistic about L3Cs than I am about "Better Corp" and other legislation. For example, L3Cs sounded good to us at first but upon further examination there weren't any significant IRS rulings that clearly supported (or not) PRI investments in L3C organizations. There are some innovative and more risk-taking foundations making PRI investments in L3Cs but given the generally conservative nature of foundations it's not common.
I am also a huge fan of the B-Corp certification process (bcorporation.net). It's not a legal entity but it is great for companies wanting to build their brand around triple-bottom-line and sustainability values. The evaluation process helps you make sure you operationalize all those values. It is also a great community and offers community discounts on goods and services.
I encourage organizations considering these legal structures to seek experienced legal and tax counsel. We found that there are few black and white answers to most of the questions and so it's important to understand and weigh the risks of each structure.
Organizations should also examine the investment of time and other resources it takes to remain "tax-free" and whether or not paying taxes is really worse. I don't have data to support this but my instinct tells me that for some organizations it would be better to pay taxes than to be constrained nonprofit rules and culture.
Lastly, Ryan Williams is taking an antagonist perspective which is awesome. It's important to think critically about what is trying to be accomplished and not get lulled by the romantic notions imbedded in nonprofit culture. We don't need more nonprofits. We need more effective ones.
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