LAW AND SOCIAL ENTREPRENEURSHIP

SOCAL ENTERPRISE BY NON-PROFITS AND HYBRID ORGANIZATIONS

I am pleased to announce the publication of a new Bloomberg BNA Tax Management Portfolio: Social Enterprise by Non-Profits and Hybrid Organizations, No. 489-1st. Attorneys Elizabeth Minnigh and Robert Wexler joined me in writing this new Portfolio that we hope will become a valued resource for academics, practitioners, and students researching social enterprise law. The Portfolio addresses the legal and tax aspects of social enterprise as conducted by tax-exempt organizations and by hybrid for-profit legal forms.

A more detailed summary of the Portfolio (taken from Bloomberg BNA’s description) follows:

“This Portfolio begins with a look at traditional social entrepreneurship by tax-exempt organizations. It considers the overall tests for tax-exemption and then focuses on specific operational activities, including job training, microfinance, low-income housing, technical assistance, the sale of products to the poor, and publishing, to evaluate when those activities can be conducted within a tax-exempt organization. The Portfolio reviews other key issues that affect tax-exempt social enterprises, including the unrelated business income tax rules, the joint venture rules, and the use of for-profit subsidiaries of exempt organizations.

This Portfolio then examines the federal income tax and state law issues affecting investments in, or grants to, for-profit entities by tax-exempt organizations. Types of investments discussed include socially responsible investments (SRIs), mission-related investments (MRIs), and program related investments (PRIs). This Portfolio also examines expenditure responsibility grants to for-profit entities.

Finally, this Portfolio looks at the emergence of hybrid organizations in the United States, which are single for-profit legal entities that simultaneously serve a traditional business purpose and a social or charitable purpose. Specifically, within the past five years, twenty-five states and the District of Columbia have enacted statutes authorizing distinct types of legal entities that cater to social enterprise. The two primary types of such hybrid organizations are the benefit corporation and the low-profit limited liability company (“L3C”). Both types of such hybrid organizations, as well as certain other variants, are discussed in detail in the final portion of this Portfolio.”

REPEAL IRC § 4944 TO ENCOURAGE INVESTMENT IN SOCIAL ENTERPRISE

A while ago, I posted to this blog a short (mildly humorous???) story illustrating how certain federal income tax rules generally prohibit “risky” investments by private foundations, even when those investments have potential for tremendous social or environmental benefit. The so-called “jeopardizing investment” rules of IRC § 4944 impose a minimum 10% (with a possible 25% additional) tax on investments by private foundations that “jeopardize the carrying out of [the foundation's] exempt purpose.”

In my prior post, I hypothesized a private foundation considering an early-stage investment in a company developing an inexpensive, solar-powered car. I further hypothesized that the private foundation’s manager reasonably and rationally believed that an investment in the car company could have substantial environmental benefits. Further, the investment was on fair terms and involved no self-dealing or other economic benefit to the private foundation’s insiders. Unless the purchase of stock in the car company qualified under the narrow program-related investment exception, however, the investing private foundation could be subject to a 10% (and possible additional 25%) penalty tax under IRC § 4944. Moreover, the investment in the solar-powered car company could be penalized even though an outright grant by the private foundation to benefit environmental causes clearly would be permissible (and even encouraged).

Thus, from a tax standpoint, a private foundation manager seeking to support environmental causes is better off investing in BP and then giving away returns to Green Peace than making a “risky” investment in a solar-powered car company—even when that investment might have a much larger and more lasting positive impact on the environment. This makes no sense.

Actually, the most compelling illustration I can provide as to why the “jeopardizing investment” rules of IRC § 4944 ultimately make no sense comes directly from the implementing Regulations. Specifically, Reg. § 53.4944-1(c) provides:

A is a foundation manager of B, a private foundation with assets of $100,000. A approves the following three investments by B after taking into account with respect to each of them B’s portfolio as a whole: (1) An investment of $5,000 in the common stock of corporation X; (2) an investment of $10,000 in the common stock of corporation Y; and (3) an investment of $8,000 in the common stock of corporation Z. Corporation X has been in business a considerable time, its record of earnings is good, and there is no reason to anticipate a diminution of its earnings. [Imagine BP.] Corporation Y has a promising product, has had earnings in some years and substantial losses in others, has never paid a dividend, and is widely reported in investment advisory services as seriously undercapitalized. Corporation Z has been in business a short period of time and manufactures a product that is new, is not sold by others, and must compete with a well-established alternative product that serves the same purpose. Z’s stock is classified as a high-risk investment by most investment advisory services with the possibility of substantial long-term appreciation but with little prospect of a current return. [Imagine Y or Z as our solar-powered car company.] A has studied the records of the three corporations and knows the foregoing facts. In each case the price per share of common stock purchased by B is favorable to B. Under the standards of [IRC § 4944], the investment of $10,000 in the common stock of Y and the investment of $8,000 in the common stock of Z may be classified as jeopardizing investments (emphasis added), while the investment of $5,000 in the common stock of X will not be so classified. B would then be liable for an initial tax of [$1,000 (i.e., 10 percent of $10,000)] for each year (or part thereof) in the taxable period for the investment in Y, and an initial tax of [$800 (i.e., 10 percent of $8,000)] for each year (or part thereof) in the taxable period for the investment in Z. Further, since A had actual knowledge that the investments in the common stock of Y and Z were jeopardizing investments, A [the foundation manager] would then be liable [personally] for the same amount of initial taxes as B.

WHAT??? So the investment in Y is “promising” and at a “favorable” price, but still subject to a penalty tax? The investment in Z has “the possibility of substantial long-term appreciation” and is at a “favorable” price, but likewise is prohibited? Er, okay, let me get out my crystal ball and discern between a “promising” or “substantial long-term” investment and a “jeopardizing” one. Suppose that in the above example X corporation represented Enron instead of BP? In hindsight, an investment in Enron would have been the ultimate jeopardizing investment, but it would have been perfectly fine under IRC § 4944. Oh, and that’s not all! Incredibly, if Y’s “promising” product (e.g., an inexpensive, solar-powered car) would benefit the environment, then even if the investing private foundation’s mission was protecting the environment it could be penalized under IRC § 4944 for buying stock in the company.

The federal income tax rules thus support a bizarre paradox for private foundations: a foundation can give its money away to an organization supporting the foundation’s mission, but if it makes a risky but “promising” investment in support of its mission, the foundation faces the threat of penalty taxes.

If a private foundation is not engaged in self-dealing or otherwise benefitting its managers and other insiders, why do we care how its money is invested? The rules presume that a “risky” investment is a waste. But for whom is a “risky” investment a waste? Where does the “risky” money go? Does it just vaporize into thin air? No, it goes to pay third-parties for services, or products, or ideas, or research, or whatever. From my perspective, nothing would be better than the Gates Foundation spending its billions on risky, unproven, but promising investments potentially benefitting the environment, education, and healthcare. Can you imagine the jobs that would be created? Can you imagine the innovations that might result? At worst, the money spent goes to work in the broader economy rather than being stockpiled. Who says such risky expenditures are “jeopardizing investments”? The only real jeopardy is to social enterprise companies that could use the money to take reasonable and rationale risks for the benefit of us all.

We need to fix this.  Let’s repeal IRC § 4944.

WHAT SHOULD MY PRIVATE FOUNDATION DO FOR THE HOLIDAYS?

First and foremost, let me wish everyone who reads SocEntLaw the safest and happiest of holidays.

Next, I want to share something that, as the Grinch would say, has me “puzzled and puzzled ‘till [my] puzzler [is] sore.”*

Specifically, I cannot figure out why the Brewer Family Foundation’s tax lawyer, Ebenezer Scrooge, is insisting that the Foundation may buy $500,000 of stock in BP or give $500,000 to GreenPeace to celebrate the season, but that the Foundation cannot risk investing the same amount in SunSleigh, Inc. a “social enterprise” developing an affordable solar-powered car. I think old Ebenezer finally has lost it, and the Foundation needs a new tax lawyer.

Let me explain. Although not huge in terms of value, the imaginary Brewer Family Foundation’s mission is nonetheless a big one: to save the world, especially the environment. The Foundation’s endowment is $100 million and as required for tax purposes every year the Foundation distributes to charity at least 5% of the value of the Foundation’s assets. We’ve already met our 5% goal this year, but because our endowment is really well managed and generating an average 10% annual return, we’re feeling more generous than usual this December and have an extra $500,000 to spend. We’ve narrowed down our choices to the following three:

• Buying stock in BP (because we think BP stock is a really good investment right now even though it runs contrary to our mission of protecting the environment); or
• Giving money to GreenPeace expressly because we think GreenPeace hates oil companies and cares about the environment more than any other charity (except, of course, the Foundation); or
• Investing in SunSleigh, a local, privately-held company raising money to develop an affordable solar-powered car.

Personally, I would like the Foundation to invest the extra $500,000 in SunSleigh, but Ebenezer says we can’t.

More background: As I mentioned, SunSleigh is a private “social enterprise” company located here in Atlanta that is developing an affordable solar-powered car. A $500,000 investment in SunSleigh would equate to 1% of the SunSleigh stock. Like the Foundation, the owners of SunSleigh are so committed to the environment that they plan to sell the SunSleigh for as little as possible so long as they can generate a 2% return on invested capital. No doubt the investment will be very risky, and the Foundation might lose all $500,000, but in my well-considered judgment, SunSleigh really could help save the environment if it is successful. In fact, I sincerely and realistically believe that the Foundation might do more to save the planet by investing in SunSleigh than it could ever accomplish through all of its other investments and annual grants to environmental charities like GreenPeace. Moreover, SunSleigh really needs the Foundation’s $500,000 because it has been unable to attract normal investment capital due to SunSleigh’s commitment to keep the car’s costs low and pay only a 2% dividend forever.

So, I called my favorite tax lawyer, Ebenezer Scrooge, just to make sure that I was on solid legal and tax ground if the Brewer Family Foundation invested $500,000 in SunSleigh. After grilling me on all the particulars of the Foundation’s assets, mission, tax filings, annual distributions, and SunSleigh’s ownership, business plan, and stock offering—which, by the way, were all fine and legally compliant as far as Ebenezer was concerned—I was extremely disappointed to hear Ebenezer tell me that if the Foundation invested $500,000 in SunSleigh it could face a $50,000 penalty tax. Even more outrageous, Ebenezer said that I personally might have to pay a $50,000 tax as well. Further, if the Foundation invested in SunSleigh and lost the $500,000, then according to Ebenezer the IRS conceivably could revoke the Brewer Family Foundation’s tax exempt status.

I couldn’t believe my ears! After listening at length to Ebenezer explain in detail the complicated and confusing tax law applicable to private foundations, and after getting more and more frustrated, I finally said somewhat angrily to Ebenezer: “You mean to tell me that, in carrying out the Foundation’s mission to protect the environment, for a mere one-half of one percent of the foundation’s assets the tax law would prefer that I buy stock in BP or give the same amount of money to GreenPeace instead of investing in an idea that could make both BP and GreenPeace obsolete?”

Ebenezer sheepishly said, “Yes, that’s right.”

Then, I exclaimed, “You and the tax law are nuttier than a Christmas fruitcake.” I immediately hung up the phone and poured myself a spiked glass of eggnog to calm my nerves.

Do you know why Ebenezer probably is right? Revisit SocEntLaw in the future for the answer.

* “And the Grinch, with his Grinch-feet ice cold in the snow, stood puzzling and puzzling, how could it be so? It came without ribbons. It came without tags. It came without packages, boxes or bags. And he puzzled and puzzled ’till his puzzler was sore. Then the Grinch thought of something he hadn’t before. What if Christmas, he thought, doesn’t come from a store. What if Christmas, perhaps, means a little bit more.”
― Dr. Seuss, How the Grinch Stole Christmas

GEORGETOWN LAW GRADUATE TEACHING FELLOWSHIP IN SOCIAL ENTERPRISE AND NONPROFIT LAW CLINIC

The Social Enterprise and Nonprofit Law Clinic at Georgetown University Law Center is seeking a Graduate Teaching Fellow.

Description of the Clinic

The Social Enterprise and Nonprofit Law Clinic at Georgetown University Law Center will open in Fall 2013. The Clinic introduces and orients law students to the materials, expectations, interactions, and vocabulary of corporate law practice while also challenging students to reflect on and innovate legal reforms that further nonprofit law and the social enterprise movement. The Clinic embraces a focused and explicit use of clinical education to enhance law students’ commitment to laws and business practices that promote triple-bottom line corporate sustainability, which in its most expansive meaning includes financial and environmental sustainability as well as the physical, psychological, and social well-being of individuals and communities.

In the Clinic, law students learn about corporate governance and contexts, shareholders and stakeholders, business relationships and operations, and business documents. Students are taught how to become partners in enterprise for their clients with the understanding that innovative business lawyers understand both the legal and non-legal incentive structures that drive business organizations.

The Clinic’s clients consist of (1) social enterprises, i.e., nonprofits and select for-profit small businesses that employ innovative business strategies with the primary mission of accomplishing social and environmental goals, and (2) nonprofit organizations and foundations working in a wide range of fields including social services, education, youth development, technology, health, sustainable agriculture, and civil rights.

Description of Fellowship

The two-year fellowship is an ideal position for a transactional lawyer interested in developing teaching and supervisory abilities in a setting that emphasizes a dual commitment—clinical education of law students and the promotion of triple-bottom line corporate sustainability. The fellow will have several areas of responsibility, with an increasing role as the fellowship progresses. Over the course of the fellowship, the fellow will: (i) supervise students in representing nonprofit organizations and social enterprises on transactional, operational, and corporate governance matters, (ii) share responsibility for teaching seminar sessions, and (iii) share in the administrative and case handling responsibilities of the Clinic. Fellows also participate in a clinical pedagogy seminar and other activities designed to support an interest in clinical teaching and legal education. The fellowship start date is July 1, 2013, and the fellowship is for two years, ending June 30, 2015.

Qualifications

Applicants must have at least 3 years of post J.D. legal experience. Preference will be given to applicants with experience in a transactional area of practice such as nonprofit law and tax, corporate law, intellectual property, real estate, or finance. Applicants with a strong commitment to economic justice and corporate sustainability are encouraged to apply. Applicants must be admitted or willing to be admitted to the District of Columbia Bar.

Application Process

To apply, send a resume, an official or unofficial law school transcript, C.V., and a detailed letter of interest by December 1, 2012. The letter should be no longer than two pages and address a) why you are interested in this fellowship; b) what you can contribute to the Clinic; c) your experience with transactional matters and/or corporate law; and d) anything else that you consider pertinent. Please address your application to Professor Alicia Plerhoples, Georgetown Law, 600 New Jersey Ave., NW, Suite 434, Washington, D.C. 20001, or electronically to socialenterprise@law.georgetown.edu.

Teaching fellows receive an annual stipend of approximately $53,500 (taxable), health and dental benefits, and all tuition and fees in the LL.M. program. As full-time students, teaching fellows qualify for deferment of their student loans. In addition, teaching fellows may be eligible for loan repayment assistance from their law schools.

HOW TO STRUCTURE SOCIAL ENTERPRISE FOR IMPACT

 

This is a full two-hour lecture at Harvard’s iLab on how to structure your social enterprise for impact. The lecture addresses the three types of social enterprise business models, then compares and contrasts seven legal structures including:

  • Corporation
  • B Corp Certification
  • Benefit Corporation
  • Flexible Purpose Corporation
  • LLC
  • L3C
  • Nonprofit

PROFIT + PURPOSE

Over the last year, I’ve been lecturing at Harvard Law and Stanford Law about structuring social enterprises for impact. I always have people asking me to see the slides, but have never publicly shared the slides. Today I’m releasing those slides to the public.

This is meant to be an introductory presentation that touches on the possible legal structures for social entrepreneurs. The presentation discusses Corporation, B Corp Certification, Benefit Corporation, Flexible Purpose Corporation, L3C and Nonprofit legal structures. Within each legal structure, the presentation touches on Formation, Management, Taxation and Capital.

Click below to access the presentation. Leave your feedback in the comments section. Thanks!

 

SOCENTLAW LIVE! – NYC

This fall you have not one, but two, opportunities to attend a live lecture about the legal structures for social enterprise in New York City. Click on the date below for more details.

 

October 11th / 7:00 PM / Skillshare HQ

November 8th / 7:00 PM / General Assembly 

 

Class Description:

Have a great idea for social innovation, but trying to figure out whether it should be a nonprofit or a for-profit? Have you heard something about these new hybrid legal structures but can’t figure out what the heck they do? If so this course is for you! We’ll be digging into:

  • 501(c)(3)
  • L3C
  • Benefit Corporation
  • B Corp Certification
  • LLC
  • Corporation
This course is taught by Kyle Westaway. Kyle believes in the power of the market to create a positive social and environmental change. He has helped build Biographe – a sustainable style brand that employs and empowers survivors of the commercial sex trade. Kyle is the founding partner at Westaway Law – an innovative New York City law firm that counsels social entrepreneurs.Kyle is a Cordes Fellow. He lectures at Harvard Law School and Stanford Law School. He launched Socentlaw – a blog about the legal side of social enterprise. Kyle has been featured by We Are NY Tech and Dowser; and writes for Huffington Post, GOOD, and Social Earth. He is Chairman of the Board for both the Excel Charter School in Brooklyn and The Adventure Project – a nonprofit that seeks to add venture capital to social entrepreneurs in the developing world.

 

photo: elsonpro

A NEW ROAD FORWARD

Have you ever tried to organize a social enterprise and find yourself frustrated by your options for legal structure? Well… we know the feeling. As a social entrepreneur and an attorney, I’ve dealt with this frustration both personally and on behalf of my clients.

As a leader of a social enterprise, you are an innovator, but the current structures stifle that innovation. You are forced to chose between two out-moded options: either organize as a for-profit or nonprofit entity, and maybe use some Frankenstein-like techniques to find something that sort of works, but is sub-optimal to say the least. The bottom line is that neither the for-profit not the nonprofit entity addresses the needs of social enterprise.

There must be a new road forward.

Fortunately, there is a group of legal minds around the country that are starting to cut a new road across the U.S. legal landscape. We are creating a new corporate form that will empower social enterprises. This is an exciting time in the social enterprise movement as a whole, but specifically in the legal structures supporting the movement.

This blog is a space dedicated to discuss and disseminate information on the legal structures, both old and new, including Nonprofit, For-Profit, L3C, the For-Benefit Corporation and other emerging legal structures connected to the social enterprise movement. We hope that be aggregating and curating the knowledge about this area of law, social enterprises will have an understanding of all their options, and make decisions that will set them up for success.