Deciding on the right legal structure for your organization depends on answering some keys questions first.
By Dirk Sampselle
One of the most common questions I receive as the founder of B Revolution Consulting and B Revolution Capital, and now the leader of our own B Corporation Accelerator, is: Should I be a B Corporation? Or a non-profit? Which is better?
This is a core question any socially and environmentally conscious entrepreneur should ask from the outset: what is the best legal structure to house our mission and business model. Here’s a framework I recommend to triage a for-profit/non-profit choice-of-entity scenario:
1. How Does The Organization Fund (Or Plan To Fund) Itself: Earned Income
If the primary way the organization plans to fund itself is through an earned-income strategy, the organization should likely be a for-profit entity, for the following reasons.
- First, income derived from commercial operations (selling a product or service) that are not themselves directly integrated into the pursuit of the organization’s charitable mission is likely to be considered “unrelated business income,” and subject to the traditional corporate income tax. So, they would be taxed on the income anyway.
- Second, if such income comprises a substantial portion of the organization’s overall income (say, over 20 percent), it is likely or at least very possible that the IRS will consider the organization as having a substantial non-exempt purpose, and therefore revoke the charity’s tax-exempt status. This means the entity would return to traditional taxable-entity status, and potentially have to pay back taxes and fines to the IRS. So, they would risk losing the entire organization’s tax-exempt status, and risk paying fines to the IRS.
The important caveat to this – which many organizations may overlook – is that products or service delivery which is fully integrated into the pursuit of the organization’s charitable mission are not subject to the unrelated business income tax. What does this mean?
Let's review a few examples:
- In Rev. Rul. 73-128, 1973-1 (1973), the IRS determined that a business conducted for the primary purpose of providing skills training to the disadvantaged was operated for charitable purposes.
- “In Aid to Artisans, Inc. v. Commissioner, 71 T. C. 202 (1978), the U.S. Tax Court considered the exemption of a charity that purchased and sold handicrafts from disadvantaged craftspeople. The charity in that case sold the handicrafts to museums and other nonprofit shops and agencies. The Tax Court found that the sale of these items was related to the exempt purpose of the organization because the activity alleviated economic deficiencies in communities of disadvantaged artisans, and the crafts themselves served to educate the public in the artistry, history, and cultural significance of handicrafts from these communities.”
- In Industrial Aid for the Blind v. Commissioner, 73 T.C. 96 (1979), the Tax Court found that, when a corporation purchased products manufactured by blind individuals and sold them to various purchasers, the organization was carrying out primarily its exempt, charitable purposes, and would neither risk its exempt status, nor be subjected to the unrelated business income tax.
Examples of these types of programs today include Delancey Street Foundation, Juma Ventures, and Pedal Revolution. [Case analysis and discussion here are credited to Robert Wexler at Alder Covin, whose article is a useful resource for those considering these issues.]
2. How Does The Organization Fund (Or Plan To Fund) Itself: Grants Or Donations
If the primary way in which the venture plans to fund itself is donative or grant-based revenue streams, the entity should almost certainly be non-profit and tax-exempt.
The reason for this is simple: most grant and donation-based money available in the marketplace is available only to non-profit, tax-exempt entities. This has changed somewhat with the advent of crowdfunding, where hoards of smaller donors will fund a project regardless of its exempt status, purely because it has a mission or cause or focus that the donor appreciates (commonly, it is just a friend they want to support).
But the general rule still stands: organizations who are providing a product or service to a stakeholder group that cannot afford to pay for the product/service, or who cannot otherwise be billed for the product/service provided, should likely be tax-exempt, non-profit entities in order to reap the benefits of grants and donative support for this mission which is difficult to monetize.
Of course, alternative funding models abound, and should be explored: can the project be more efficiently and effectively funded through subsidization, e.g., selling advertising on a platform, or charging sponsors for placement at events?
It may not be so easy to taxonomize future revenue streams for an early-stage venture. Perhaps the venture will start with grant funding, but seek to privatize and commercialize IP developed with the grant funding, flipping from a grant- to a revenue-funded business model. Perhaps the venture will start by distributing a popular gadget, save up revenues, and siphon them into a related foundation which will aggregate even larger sums of donated funds to undertake some extensive and audacious mission-driven work in a foreign country.
Life is not simple. The only categorical recommendation that can be made is to start with a legal structure that fits where the venture is today, and to plan as strategically as possible for where the venture reasonably expects to be five and 10 years down the road.
Who Do The Products and Services Of The Organization Primarily Benefit?
This approach is particularly useful if the organization does not yet know exactly how it will fund itself – this question is a back door into the question 1 framework. If the venture’s products and services primarily benefit the needy or the environment, with no clear stakeholders who are willing to pay for the product/service or access to the value chain established by the enterprise, then the venture likely ought to be a non-profit, tax-exempt organization.
On the contrary, if the venture’s products and services benefit primarily a target audience that can afford to pay for the products and services, the venture is likely commercial in nature and should be structured as a for-profit.
What All Ventures Should Consider
How mission-central is your venture?
This question is crucial for every entrepreneur to answer even apart from legal structure. This is a question of values and character, vision and purpose, end goals and initial intention. The entrepreneur cannot stay steadfast to vision, values, purpose, intention, end goals if he/she does not have any or seek to define them.
The hurried will rush past these questions into developing strategic partnerships, distribution channels, sweet deals on manufacturing, and lofty ideas of what they’ll do with all the money they’ll be making – of course they’ll give some away, probably they’ll have their assistant handle it while they sit in a hammock and sip a mai tai.
A key value of the B Corporation certification and benefit corporation legal entity is that they force the entrepreneur to consider:
- How will the organization’s mission be weighed against the profit interest should they ever become opposed?
- How will the organization measure impacts across the value chain?
- What impacts will the organization seek to prioritize as part of its brand and values?
- When will the organization report its impacts and how will it engage stakeholders?
And perhaps most importantly, how will the organization strategically integrate impact creation with its business model. Will the organization be focused on external impacts or internal process? How will the organization engage with its employees in times of lay-offs and growth? By forcing the entrepreneur to do some serious soul-searching at the outset, the benefit corporation legal entity and B Corporation certification set the stage for more successful, longer-lasting ventures.
You Have Asked The Wrong Question
I close with the most important point because all of the above analysis still applies, but cannot conclude the inquiry. The most important component of the framework to answer this question is that the question need not be framed as “either/or.”
It is increasingly common for non-profits to own for-profit businesses, to engage in joint ventures with for-profit businesses, or to license intellectual property to for-profit businesses in exchange for revenue sharing or some other contractual arrangement.
So the answer may be, “both.”
This practice of creating hybrid organizational structures has become more common as non-profits seek alternative revenue streams to fund their mission, and it is frequently a desirable option for ventures possessing the potential for both donative and earned-income revenue streams.
Some brief notes before closing this segment:
- Structuring a hybrid setup is usually costly, and thus is usually pursued only when one entity has already developed a substantial revenue stream.
- Non-profits cannot be owned by for-profits. For-profits can be owned by non-profits.
- Non-profits setting up and investing money into a subsidiary or joint venture need to beware of some rules regarding how tax-exempt organizations may invest their money in order to be compliant with IRS and other rules.
- When non-profits allow others to earn income from a business in which the non-profit has invested, the non-profit needs to be aware of rules and constraints surrounding what is known as the “doctrine of private inurement,” which precludes non-profits from using their assets to wrongfully benefit private individuals and organizations.
- Non-profits may still be taxed on income received from certain types of investments, including investments in wholly- and partially-owned subsidiaries.
These are the key questions you need to answer in order to determine the right legal structure for your mission-driven organization.