Are you a newly-minted social entrepreneur?

You have a great idea. You want to have social impact. You want to operate as a business, not a charity.

You’ve reached the point where you need to incorporate but don’t know where to begin. You’ve done some Google searches, come across names like L3C, Benefit Corporation (not to be confused with the B-Corporation aka B-Corp), and Flexible Purpose Corporation. You’ve read a bit about them but are still not sure what they’re all about or which makes the most sense for you (if any). We understand you. We’ve been there. We’re here to help!

At engageSPARK, we spent months researching a wide variety of different legal structures for our not-for-profit social enterprise. We distilled most of our research into an easy-to-read legal guide: Incorporating a Social Enterprise: A Simple Legal Guide. We intentionally didn’t go into detail about the 3 social enterprise legal forms that currently exist in the United States (the B-Corporation isn’t a legal form – more on that later). Instead, we promised to do that in this post. Like with our initial simple legal guide, we’ll explain our findings in plain English, discussing the pros and cons of the legal forms in general and each one in particular.

As we mentioned in our previous legal guide, none of the forms we researched made sense for us as a not-for-profit social enterprise. Therefore, at the bottom of this post, we propose a new legal form: the Not-for-Profit Social Enterprise.

Disclaimer: Nothing in this blog post constitutes legal advice; it’s for informational purposes only.

Quick Background on Corporate Law

Let’s first get one thing out of the way: corporate law is state law, not federal law. This means that there is no uniform social enterprise legal form across the United States. Every state allows you to create a C-Corporation, an S-Corporation, and a Limited Liability Company (LLC) – the three most common legal forms for a business (Limited Liability Partnerships (LLPs) are also very common). But not every state offers L3Cs, Benefit Corporations, and Flexible Purpose Corporations.

To date, only nine states allow you to form an L3C, and fifteen have passed laws allowing entrepreneurs to create Benefit Corporations. The Flexible Purpose Corporation only exists in the state of California.

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Image by Lin Pernille

Why is all of this relevant? Because the laws of each state are different. A Benefit Corporation or L3C in one state may provide different benefits and restrictions from a Benefit Corporation or L3C in another state. Analyzing the nitty gritty of each state’s law would take too much time, so in this blog post, we’ll discuss the general characteristics of these legal forms that apply for all of the states. If you’re really interested in figuring out what each state’s social enterprise legal form looks like, you’ll need to do some more research.

(You may want to check out this table comparing each Benefit Corporation and L3C by state on a number of factors. It may not be so useful for non-lawyers because it simply quotes from the various laws, rather than summarizing the factors in plain English.)

The Huge Advantage of Social Enterprise Legal Forms: Prioritizing Your Social Mission over Profits

While each social enterprise legal form is a bit different, they all share one key characteristic: the law permits them to prioritize social good over profits. What, you ask? If you set up a legal entity, you can’t just decide to focus on helping others with it? You need to prioritize making profit? With some wrinkles that we won’t get into, the answer is yes. A for-profit’s core purpose, according to the law, is to earn money, and the directors or managers are breaching their duties to the shareholders / owners if they are not maximizing profit.[1]

Crazy, right? Well, that’s why you need to set up a special type of legal entity if you want to be able to prioritize your social mission over earning profits. If you have a regular company (like a C-Corporation or a Limited Liability Company (LLC)), your investors / shareholders can sue you for violating your duties if you start focusing more attention on helping poor people (or the environment) than on earning profits. In fact, if you set up a C-Corp, any shareholder – even “one holding a very small number of shares, an infinitesimal percentage of the outstanding stock” – can theoretically sue you if you decide to spend some of your resources on social good instead of maximizing return.

With the social enterprise legal forms, the law protects you (for the most part) – it allows you to specify what your mission is, and that mission can take precedence over earning profits for your investors.

L3C: The (Almost) Great Option for Getting Program Related Investments (PRIs)

The L3C is a type of LLC that specifies a social mission in your company formation documents (typically called Articles of Organization). It is supposed to be a ‘low profit’ entity, meaning that it has two purposes; (1) earning profits (but not too much profits; profit earning can’t be its key purpose) and (2) creating social impact. (It also can’t engage in political or lobbying activities). These requirements (intentionally) meet the IRS’s regulations for receiving program related investments (PRIs), giving L3Cs much greater access to PRIs from U.S. private foundations.

What’s a PRI? In short, U.S. private foundations are allowed to invest in for-profit entities that further the foundation’s mission; that investment is called a PRI or program-related investment. But, it’s hard for them to invest via PRIs in normal for-profit businesses because the due diligence required is onerous. Investing in an L3C is easier for U.S. private foundations because an L3C’s Articles of Organization already includes language satisfying the IRS’s requirements on what types of entities (or projects) a PRI can be used for.

The problem is that the IRS hasn’t issued any rules saying that PRIs in L3Cs are automatically legitimate. As one commentator put it, “We hate to disillusion anyone but the IRS is not going to ever rule on the blanket acceptability of the L3C as an entity.” Rather, the IRS reviews PRIs on a case-by-case basis and issues individualized rulings per proposed PRI (assuming the private foundation asks the IRS for a ruling, which isn’t required). Those IRS rulings (called private letter rulings) only apply to the particular PRI at issue and can’t be applied to any other proposed PRI. In other words, if a previously issued private letter ruling (they’re publicly available) on a proposed PRI seems to apply to your circumstances, that isn’t good enough. You can’t rely upon it, and the IRS may rule differently in your situation.

Finally, you probably don’t need to form an L3C to get the benefits of an L3C – you can just create an LLC. The owners (typically called members) of an LLC can simply contract to have a social mission and not to earn large profits (you can’t do that with a Corporation). So, you can essentially create “your own” L3C by putting language in your LLC’s Articles of Organization that mirrors the language in an L3C’s: that the owners contract that the LLC is required to (a) be low-profit, (b) have a social mission, and (c) refrain from political / lobbying activities.

Why would you want to do this? Because setting up an LLC is typically an easier and quicker process. L3C’s are only allowed in 9 states, whereas LLC’s are allowed in all 50 states. And, an LLC allows for more flexibility; you can easily update these factors later on, which you can’t do with an L3C. That said, some U.S. private foundations may prefer to deal with an L3C over an LLC, so an L3C probably is the better option if speed of registration isn’t an issue for you.

In sum, the L3C has some benefits, but we find them to be small over a traditional LLC and believe that they’re outweighed by the disadvantages that apply to all existing social enterprise legal forms (which we discuss below).

Benefit Corporation: A Fully For-Profit Company with a Social Mission

The Benefit Corporation is a social-impact-focused corporation that is also for-profit. In the Articles of Incorporation for your Benefit Corporation, you’ll need to specify a public benefit that your company must focus on. Benefit Corporations have four key requirements. They must:

  1. specify a social mission that benefits the public;
  2. consider their social mission in all corporate decisions, making them accountable to the public and to their shareholders (who typically will be socially-minded);
  3. distribute an “annual benefit” report to their shareholders that specifies the efforts they took to meet their social mission and whether and how they succeeded in doing so (this also must be made available to the public);
  4. appoint a Benefits Director who is a member of the Board of Directors and is required to ensure that the company focuses on its social mission in all of its major decisions (this is to prevent mission creep, i.e., the company moving too far away from its social mission in seeking profits).

The directors and managers (i.e., officers) of a Benefit Corporation also can be sued by their shareholders for not satisfying the corporation’s social mission (the public, though, can’t sue claiming that the Benefit Corporation didn’t meet its public benefit requirement).

What are the downsides to being a Benefit Corporation? First, it makes it harder to raise private investment. Investors focused on financial returns are less likely to provide seed capital to a Benefit Corporation. Second, despite having a Benefits Director charged with ensuring that the company keeps focused on its social mission, in practice that may be harder said than done (see our discussion below on the downsides for all 3 social enterprise legal forms). Third, the reporting requirements are onerous. The “annual benefit” report is not a simple document that you can quickly put together. Rather you’ll find yourself spending a lot of time and money compiling it; especially for small, new social enterprises, it may not be worth the hassle.

Flexible Purpose Corporation: Best for Raising Private Investment

The Flexible Purpose Corporation is very similar to the Benefit Corporation, but differs in two key ways. First, while the Benefit Corporation must have a social mission that is external facing (i.e., it achieves a public benefit like helping the poor), the Flexible Purpose Corporation is allowed to have an internal facing social mission (called a “special purpose”), such as reducing its own carbon footprint or ensuring that its employees aren’t negatively affected by the company’s business decisions.

Second, the Flexible Purpose Corporation’s annual report is not as time-intensive or costly as the Benefit Corporation’s. Related to these differences, the Benefit Corporation’s success in meeting its public benefit mission must be validated by a third party on a number of independent factors. The Flexible Purpose Corporation, on the other hand, internally measures whether it satisfied its special purpose.

Flexible Purpose Corporations operate as typical corporations with an added “special purpose” that is often less burdensome than the Benefit Corporation’s required “public benefit” (and its associated heavy reporting and oversight requirements). Private investors are thus more likely to invest in Flexible Purpose Corporations, which may be the best bet for social enterprises seeking to have some social impact while wanting the best shot at raising seed and growth capital with lower regulatory costs.

The Flexible Purpose Corporation’s downsides are similar to the Benefit Corporation’s, but not quite as bad.  The reporting requirements are onerous, but not as burdensome as they are for the Benefit Corporation. A Flexible Purpose Corporation will have a harder time raising funds than a standard corporation, but not as difficult a time as a Benefit Corporation.

Some commentators raise another downside that is specific to the Flexible Corporation, though we would argue that it is a potential for abuse rather than an actual downside.  These observers argue that the Flexible Purpose Corporation is susceptible to “greenwashing,” that is, to creating a meaningless special purpose that the corporation employs just to make it look good or look as though it is actually doing something good for society when in reality only the corporation benefits from the special purpose. While “greenwashing” is not a downside in itself, it is a potential for abuse that, if abused significantly, could hurt the credibility of the Flexible Purpose Corporation as an attractive social enterprise legal form.

Downsides: All Social Enterprise Legal Forms Have Two Key Downsides – Taxes and Balancing the Social Mission against Maximizing Profits

Downside 1: Taxes – Nobody likes taxes

One key item to remember about these social enterprise legal forms is that they are all for-profit businesses. The IRS does not give any of these entities any sort of special tax status, so whether you set up an L3C, Benefit Corporation, or Flexible Purpose Corporation, you still must pay taxes on all income. You can reduce your tax liability by incurring a lot of “good expenses” in fulfilling your social mission – such as discounts to poor people, distributing educational materials that further your business’s social impact, etc. Those costs will be deducted from your total income, so you’ll have less in taxable profits, and more of your profits will be used for satisfying your social mission.

For organizations like ours, though, which need large profits to be able to build other pro-poor businesses at scale, this isn’t a viable model. If we’re spending too much of our profits from our first business on “good expenses” related to that first business, then we won’t be able to set up other not-for-profit social enterprises.

Downside 2: Balancing your mission against profits – You may face some serious pressure from your investors

Many investors will put pressure on you to have higher and higher returns, and this may take away from your focus on trying to have social impact. Investors might pull out, leaving you unable to grow and making you feel like you need to start acting more like a regular business than a social enterprise. Balancing these competing goals will be tough. Moreover, private investors may be less inclined to invest in you if your formation documents require you to prioritize a social mission over maximizing profits (investors generally expect to earn high financial returns on their investments).

One nice benefit of being an L3C, though, is that it gives you a better shot (as we discuss above) of getting a PRI from a U.S. private foundation. While it may be tougher for an L3C to raise funds from private investors (also because an L3C is by definition a “low-profit” entity – low-profit means smaller returns to investors), it likely will increase your chances of raising funds from U.S. private foundations. Put another way, being an L3C opens up a new line of funding opportunities where the investor must focus on ensuring you maximize your social returns (not your profits). So, as an L3C that exclusively seeks funding from U.S. private foundations is less likely to have to worry about balancing its mission against profits.

Is Impact Investing Canceling out this Downside?

Social enterprises have traditionally had a harder time raising capital than typical businesses because of their dual mission. However, a new crop of investors appears to be popping up that specifically wants to invest in social businesses. These investors are typically referred to as philanthropic or impact investors. Their main goal is to see a social return on their investment (e.g., poor people helped, the environment improved, etc.). Many of them seek only to receive a return equal to their original investment (which essentially means that their investment is a zero interest loan) or to receive a tiny ROI.

This is good news for social enterprise legal forms in two ways. First, these types of investments enable social enterprises to focus mainly on their social mission and reduce the pressure they typically face to bring in significant financial returns. Second, as the pool of impact investors grows, social enterprises will have an easier time raising capital. If this trend continues, taxes will be the main remaining downside faced by social enterprises.

The B-Corporation – It’s Not a Legal Form; It’s a Certification (but a potentially valuable one)

You may have come across the term, B-Corporation (aka “Certified B-Corporation”) thinking that it’s another type of social enterprise legal form. It’s not; a B-Corporation (B-Corp) is not a type of legal entity. No government allows you to register as a B-Corporation. Rather, it’s an ordinary corporation that is certified as being a “socially good” business by a non-profit organization called the B Lab. A B-Corp is not a type of legal form; it’s just a certification by an outside entity, similar to getting a “Fair Trade” certification for your business.

By saying this, we don’t mean to denigrate the B-Corporation; the certification is valuable, as it’s a trusted source telling your customers, your investors, and the public that you are creating social impact – and that’s important. But, (1) we thought it worthwhile to clear up that the B-Corp is not a legal form, as we’ve come across people who have been confused about that, especially muddling B Corps and Benefit Corporations; and (2) you need to pay a fee to get certified by the B Lab, which may not be a worthwhile expense for some social enterprises (though it may be for others).

If you do become a B-Corp, you’ll get to brag to your friends that your company is more similar to Ben & Jerry’s than theirs is – and maybe you can convince Ben & Jerry’s to give you some free ice cream (Ben & Jerry’s is a Certified B-Corp)!

Our Proposal: The Not-for-Profit Social Enterprise Legal Form

While the above social enterprise legal forms can work well for many new social enterprises, none of them fit our model. engageSPARK is the first business that we at Opportunity Labs are creating. Opportunity Labs (and engageSPARK) is a not-for-profit social business. All profits from engageSPARK will be reinvested to subsidize fees for NGOs and for Opportunity Labs to use to develop new not-for-profit social businesses focused on improving poor people’s lives throughout the world.

Because we plan to reinvest our profits into building new social enterprises, taxes are a big deal for us. If we lose a huge percentage of our profits in taxes, we’ll have a lot less money to invest in our new social businesses. As we noted above, social enterprises can significantly limit their taxes by using some of their profits to implement their social mission, for example, as deductible “good expenses.” We need our profits to fund development of new social businesses. If we spend too much of our income on “good expenses” (which would help us minimize our tax liability), then we won’t have enough funds to invest in building new social businesses and to grow them quickly. In short, the U.S. does not offer any legal structures that meet the goals of true not-for-profit social businesses like ours.

For that reason, we believe that there should be a legal form that truly melds the not-for-profit charity with the business-minded social enterprise. We thus propose a new legal form called a Not-for-Profit Social Enterprise. Its key characteristics would be:

1. Low corporate tax rate

If you read our previous legal guide, you’ll remember that even though we have no personal profit motive (i.e., we aren’t trying to enrich any individuals via our profits), we can’t operate as a 501(c)(3) because we also plan to sell engageSPARK services to businesses as a form of fundraising – to generate revenue that we can use for other pro-poor activities. Our services are not charitable at their core, so sales to customers that are not focused on helping the poor would likely be considered unrelated business taxable income (UBTI), and we would have to pay taxes on profits from those sales.

The reason that the IRS requires this – even from 501(c)(3)s that are not driven by personal profit – is that those 501(c)(3)s would get a competitive advantage if they didn’t have to pay taxes on income from business activities that are not related to their charitable purpose. If the 501(c)(3) has a for-profit competitor providing a similar service, the 501(c)(3) would be able to undercut its competitor with lower prices if it didn’t have to pay taxes on income from those sales.

While this is a valid concern, the for-profit competitor is also paying income taxes because it has a personal profit motive. Because the not-for-profit social enterprise doesn’t have that personal profit motive, it should get a tax benefit. Congress should balance the competitive advantage the social enterprise would have against its lack of a personal profit motive.

As a way of balancing these two concerns, we would propose a tax rate of 10% on all of the Not-for-Profit Social Enterprise’s profits. The entity also would not have to face the possibility of losing its low-tax status. 501(c)(3)s may lose their tax-exempt status if too much of their resources are spent on activities that aren’t substantially related to their charitable purpose. The Not-for-Profit Social Enterprise would not need to worry about this, as the only way it could lose its status as a low tax Not-for-Profit Social Enterprise would be if it violates the other proposed requirements.

2. Ownership by the public (no shareholders / private owners)

If you decide to set up a non-profit in the U.S., the first thing you’ll do is set up a legal entity in one of the states (almost always either a C-Corp or an LLC). You’ll include in the Articles of Incorporation (or Organization, if it’s an LLC) that the entity is being formed for charitable purposes and is bound by the 501(c)(3) regulations. You’ll then apply to the IRS for 501(c)(3) recognition. This entity will have 4 main restrictions:

    • No private owners. The entity won’t have any shareholders or owners; it’ll be “owned” by and answerable to the public.
    • No personal financial benefit. The income and assets of the entity won’t be able to personally benefit any individual or private company. Rather, all assets will need to benefit the public.
    • Transparent operations. Each year, the 501(c)(3) must publish significant disclosures, including where its funds come from, where its money goes, who its top paid employees are, who sits on its board, the details of any transactions with insiders, and so on.
    • At winding up, assets must be used for a charitable purpose. If you end up winding up the 501(c)(3) (i.e., closing it down), you’ll have to use any remaining assets for a 501(c)(3) charitable purpose, for example, donating the remaining assets to another charity.

We propose that the Not-for-Profit Social Enterprise be restricted in the same way: owned by the public, can’t benefit anyone financially, mandatory robust transparency / disclosures, and upon winding up all assets must be used for a charitable purpose. This would ensure that the organization’s founders / managers have no personal profit option and that there is oversight by the public.

3. Restrict employee compensation just like 501(c)(3)s

We recognize that some entrepreneurs seeking to maximize personal profits could try to take advantage of the proposed Not-For-Profit Social Enterprise’s low tax rate in mischievous ways. They could, for example, register as a not-for-profit social enterprise, have some social impact (to make sure they have some social purpose that would satisfy the regulators), and then pay themselves huge salaries to get around the “no personal profit” requirement.

Our suggested solution to this is simple: from an employee compensation standpoint, treat the Not-for-Profit Social Enterprise like a 501(c)(3). Unlike for-profit businesses, 501(c)(3)s are required to provide, reasonable compensation that is based on due diligence and is negotiated at arms-length. If the Not-for-Profit Social Enterprise must meet that same requirement, then lavish compensation packages (intended to get around the Not-for-Profit Social Enterprise’s no personal profit limitation) will be avoided.

A Clarification and a final note on our proposed Not-for-Profit Social Enterprise

For those of you who are very familiar with these issues, our proposed Not-for-Profit Social Enterprise legal form might sound like nothing more than a proposal for Congress to simply lower the unrelated business income tax (UBIT) that 501(c)(3)s must pay. But our proposal actually goes further. We propose that the Not-for-Profit Social Enterprise would have to pay taxes on all of its income, even on income that is related to its social mission – not just on unrelated business taxable income (UBTI).

The Not-for-Profit Social Enterprise would also not be subject to losing its “low tax” status for spending too much of its resources on non-charitable activities – as long as it doesn’t violate the other requirements we spell out above (in which case its status as a Not-for-Profit Social Enterprise, and all of the related benefits, would be revoked). Those are the key factors that would distinguish it from a 501(c)(3).

One final note about our proposed Not-for-Profit Social Enterprise legal form: Because we’re proposing a new corporate legal form and a new tax regime, we’d need both (a) states to create this legal form and (b) the U.S. Congress to amend the tax laws to recognize it and treat it differently. Anyone up for lobbying state legislatures and Congress?

Comments

We received excellent comments in response to our initial Legal Guide for Social Enterprises. We’d love to hear your comments about this guide as well. Please leave them below. If you think anything in here is incorrect, please let us know. And if you’ve researched social enterprise legal forms in other countries, please comment about your findings. We know that Canada and Europe – especially the UK – have been dabbling in this arena, but we haven’t had a chance to research them in detail. We’d love to hear your thoughts about social enterprise formation in those countries!



[1] Some commentators disagree with this analysis, but the majority don’t.  As the first comment in that linked article points out, very few lawyers would advise a typical corporation’s directors to prioritize a social mission over maximizing profits – the potential for liability and for facing a crippling lawsuit is too high a risk.