Utilizing Nonprofit Organizations as Vehicles for Social Ventures
By: Ray Dinning, JD, LLM (taxation)
December 2, 2009
Domestic and international joint ventures involving nonprofit organizations are excellent vehicles for social ventures. See Sanders, “Joint Ventures Involving Tax Exempt Organizations (Wiley & Sons 2004). Generally, nonprofit organizations are permitted to conduct for-profit, commercial activities which can be structured in a variety of ways. In this article, we will discuss three principal (and basic) ways that a nonprofit can be used for social ventures:
First, a simple nonprofit corporation (without federal tax exempt status) can be used as the structural vehicle for a social venture. Although nonprofits are often thought of as charitable, tax-exempt entities, the two are not the same. Nonprofit corporations are a created under state law whereas tax exempt status (which allows for tax deductibility of charitable contributions among other things) is a function of federal tax law. Thus, utilizing a nonprofit corporation created under state law as a “taxpaying nonprofit” would allow a social venture to conduct commercial activity in support of its corporate purposes. This has advantages for social entrepreneurs under the specific circumstances where a common purpose – even a common business purpose – is pursued but where the social venture does not require much capital and the generation and distribution of profit is not a significant concern.
Although nonprofit corporations under state law are not “owned” by anyone in the classic sense, these nonprofits typically have members who exercise the same kind of control as the owners of a business, and those members can engage in a wide variety of transactions with the nonprofit entity. The organization itself is formed for a nonprofit purpose, so the managers are legally obligated to further the nonprofit’s social mission rather than focusing solely on maximizing profit for the owners. This basic structure is rarely used but is effective for social ventures where the business activity and the revenue generated in not substantial. The benefits are simplicity of start-up cost and simplicity of use.
Second, a tax-exempt charitable organization under Section 501(c)(3) may be utilized as the structural vehicle for social ventures. A charitable, tax-exempt organization is permitted, for example, to carry on a business that supports it charitable purposes, so long as no individual or entity is receiving financial benefits except as reasonable compensation for services rendered. A tax-exempt organization created to reduce unemployment, for example, can operate a clothing manufacturing business that employs disadvantaged individuals and which sells its clothing on the open market at a profit. If it wants to use recycled materials or organic cotton, or pay its employees a higher wage, it may do so, even though such measures may impair or eliminate the venture’s profitability. Obviously, the commercial activity of the social venture should further the charitable purposes of the organization and the profits derived therefrom must be used to further the tax-exempt purposes of the organization. The Board of Directors that governs the organization must use care to ensure that the nonprofit stays on mission – similar to a business corporation – but there are no corporate fiduciary duties to maximize profits or act in the best interest of shareholders which allows the Board of Directors to have more latitude to serve the social purpose the organization. If the business is low profit or no-profit, there are a variety of ways in which the organization can receive tax-deductible contributions to subsidize it, which isgenerally not an option for for-profit businesses or taxpaying nonprofits.
Finally, tax-exempt organizations can also enter into joint ventures with other non-profits or for-profit businesses to conduct one or more social ventures. Although more complex in its structure, this social venture structure has the greatest flexibility and allows for both nonprofit and for-profit activity to be conducted at the same time through different (but allied) entities. A joint venture is another legal term under tax law that simply refers to a contractual arrangement or understanding whereby more than one person or entity will operate a venture. If two nonprofits want to jointly operate a revenue generating activity, they can do so under general tax rules. Each may contribute capital to the venture and they may divide profits. As stated above, the social venture under these circumstances must further the legitimate interests of each tax-exempt organization.
Under the joint venture structure, nonprofit organizations may utilize limited liability companies (LLC’s) or limited partnerships as vehicles for such social joint ventures, because they offer a flexible structure, pass-through tax treatment, and limited liability, which protects the members of the LLC from being held liable for debts of the joint venture (which is important to tax-exempt organizations).
This is a basic discussion of the nonprofit structures which may be utilized for social ventures. Of course, each social entrepreneur and each social venture has its own specific circumstances, needs and limitations which must be taken into account in structuring any social venture. The tax consequences in each transaction must be examined to ensure that all applicable state, federal (and international) laws are complied with by the social venture. For more information, please contact your tax professional for legal and tax guidance. For more information or to speak with a tax professional, please feel free to contact Ray Dinning, JD, LLM at (757) 232-2619 for specific guidance or information in structuring your social venture.