Structuring Social Ventures: Choice of Legal Structure
By: B. Ray Dinning, JD, LLM (taxation)
November 30, 2009
Foundations of Social Venture Legal Structures
The Foundations of Legal Structures for Social Ventures
In 1992-1994, I was privileged to provide research, drafting and editing skills to my esteemed professor, Mr. Michael I. Sanders, in the creation of his authoritative legal treatise, “Joint Ventures Involving Tax Exempt Organizations (Wiley & Sons). This early work set the stage for the concept of the modern day social ventures. Having structured hundreds of social ventures in the United States and, in fact, worldwide, the choice of entity generally depends on the specific facts of the transaction and the needs of the parties involved. However, generally speaking, the most common legal structures utilized for social ventures, both domestic and international, are the tax-exempt organization, the limited liability company (LLC) and various partnership entities. When used in a strategic manner designed to meet the needs of the social venture, a legal structure can be created which will allow the social venture to meet both charitable, social needs and also pursue the profit-making activities in a fairly straightforward and simple to use structure.
Tax-exempt, nonprofit organizations are generally designed to provide a structure for its directors and members to pursue a fairly well-defined set of charitable, exempt purposes. However, they are not conducive for the operation of for-profit business activities. Additionally, tax-exempt organizations are generally not able to raise capital, sell stock or borrow without significant restrictions. Nonprofit corporations cannot issue stock and therefore have no “owners.” Revenues generated by the nonprofit organizations must remain within it and cannot be paid out to investors or other stakeholders except as reasonable compensation for services rendered. Its income must be devoted to charitable purposes. The board of directors of a nonprofit corporation is duty-bound to give its primary attention to pursuit of the social mission rather than the production of net income. Organizations exempt from federal tax under Section 501(c)(3) of the Internal Revenue Code (often referred to generically as charities) must abide by even greater restrictions that prohibit payments to insiders and impose taxes on any business activity that is not directly related to the organization’s tax exempt purposes. As you will see, however, tax-exempt charitable organizations have been conducting “business” for decades using a typical joint venture structure which allows the charitable organizations to pursue both non-profit activities via the tax-exempt organization and also the for-profit social venture via the “parallel” venture entity – typically a limited liability company or limited partnership.
Take for example, the tax-exempt, nonprofit university dedicated to charitable, educational, scientific and other charitable purposes. Many large universities make millions of dollars per year on corporate sponsorship, advertising, concessions and branding of their sports programs such as college football. Hospitals conduct a myriad of non-profit and for-profit activities under the large umbrella of a tax-exempt organization. Low income housing tax credit ventures link profitable developers and construction companies to non-profit housing development agencies to provide low cost housing to those in need. These non-profit and for-profit purposes have co-existed since the 1970s under the careful structuring of a few legal professionals who possess the requisite skills to provide tax, corporate, partnership and non-profit legal advice. With the recent advent of “social ventures” and the skyrocketing use of these social entrepreneurship projects worldwide, it is actually the lawyers, accountants and governmental agencies who are trying to play catch-up which is much of the cause of the confusion.
For-profit business corporations, on the contrary, have shareholders (owners) and a board of directors (carrying out the general business of the organization) and perhaps officers and managers (who do the day to day operating of the business). The directors of the corporation have certain fiduciary duties to the business and the shareholders which require them to always act in the best interests of the shareholders and the corporation. Unless a link exists which can tie their social venture activities directly to some business purpose, the managers and directors of for-profit companies may be sued for breach of their fiduciary duties and misuse of corporate assets. Only in cases where the owners of the business are in agreement with the idea of operating in a socially responsible manner, or dedicating a percentage of profits to charitable causes, can such activity take place. Even then, this fragile balance of business and social purposes can be destroyed by a drop in corporate earnings or an unforeseen consequence of the social venture or the lack of reaching the projected profits from a social venture or the complaint of one or more shareholders.
So, what is the answer to the question of proper legal structure? That begins Part III of the Series.
B. Ray Dinning is a United States attorney specializing in nonprofit joint ventures and public private partnershps Ray Dinning assisted Professor Michael Sanders with the research and drafting of the authoritative legal text in this area called “Partnerships and Joint Ventures Involving Tax Exempt Organizations by John Wiley & Sons in 1994 with later editions. Mr. Dinning can be reached at (757) 232-2619.