To profit or not to profit? That is the question that many socially conscious entrepreneurs need to ask themselves as they embark on starting a business and choosing what type of entity to organize as. Choices range from a nonprofit with a strictly charitable purpose to fully profit‑focused entities and everything in between. Each of these options has pros and cons, restrictions and rewards, as well as tax and employment implications. This article examines the four most used entities that are not entirely focused on profit and addresses frequently asked questions about each.
- Nonprofits
What is a nonprofit?
Nonprofits are entities that hav
e formed under state law, typically as non-stock or non‑profit corporations, and then sought further designation from the IRS to receive tax-exempt status. To receive this status, an entity must show that is has an approved purpose. The approved purposes are: charitable, religious, scientific, public safety testing, literary, educational, fostering amateur sports competition, and prevention of cruelty to children or animals. A nonprofit cannot have a profit-seeking purpose.
Can a nonprofit ever make a profit?
Nonprofits should be operated for public benefit and not for private benefit. That doesn’t mean a nonprofit itself shouldn’t make money. Nonprofits are allowed to amass income directly related totheir purposes from a variety of sources such as donations, grants, and fundraisers. Additionally, nonprofits can earn what is called “unrelated business income” which is derived from activities not tied to the nonprofit purpose. Sometimes unrelated business income is taxed, even though the rest of the entity’s actions are tax-exempt.
How do nonprofits handle salaries and earnings?
A nonprofit is guided by a principle of no private benefit, which means that it is not a vehicle for providing money or other benefits to those who run it. This means that profits cannot be transferred to the nonprofit’s operators through dividends. If you are looking to receive distributions from your entity a nonprofit is not for you.
That said, nonprofits can pay reasonable salaries to its operators. The IRS has defined “reasonable compensation” as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” All compensation paid out to directors, officers, key employees, the five highest-compensated employees, and the five highest-compensated independent contractors who receive more than $100,000 must be reported to the IRS.
Additionally, nonprofits must be mindful of “excess benefit transactions” when a person close to the nonprofit (e.g., a director, key employee) receives an economic benefit,
directly or indirectly, that exceeds the value of the consideration (e.g., service to the organization) received by the nonprofit.
How do nonprofits handle taxes?
When an organization achieves tax-exempt status it no longer has to pay federal income tax. Along with this benefit, and perhaps more importantly, the organization has the ability to receive tax-deductible charitable contributions. This trade-off both legitimizes the organization for those seeking to donate by showing it has the IRS’s seal of approval, but also provides an incentive for donations. Notably, however, nonprofits must still pay some employment taxes.
What are the pros?
- Exemption from income taxes
- Ability to receive tax-deductible donations
- Eligibility for exclusive grants from foundations and governments
- Publicly recognizable and legitimate entity
- Clear statement of public benefit purpose
What are the cons?
- Extensive formation process with considerable start-up costs
- Significant annual reporting requirements
- Not allowed to financially benefit to private individuals
- Inflexibility due to rules, regulations, and oversight
- Inherently has shared control, typically boards must have at least three members
- Benefit Corporations
What is a benefit corporation?
A benefit corporation has a traditional for-profit structure but is governed with two purposes: (1) making a profit for shareholders and (2) promoting a social cause. A benefit corporation has one foot in each world. Benefit corporations have elected to follow “higher standards of purpose, accountability, and transparency.” Some examples of benefit corporations are: Allbirds, Ben & Jerry’s, Patagonia, and Warby Parker.
What are the requirements for benefit corporations?
Twenty-nine states currently allow for benefit corporations and have statutes governing the formation and regulation of the entity. Typically, boards are asked to consider a wider range of factors including shareholders’ interests, employees’ interests, community and societal considerations, local and global environment, and the named public benefit purpose when choosing how the corporation should act. Additionally, a benefit corporation must prepare a yearly report that sums up the actions taken in support of the purpose and an assessment of the corporation’s efforts in that purpose. These reports are supposed to provide a clear accountability standard for the benefit corporation.
How do benefit corporations handle salaries and earnings?
The salaries and earnings of benefit corporations are generally handled in the same way as a for-profit corporation. Where benefit corporations differ is in their need for accountability and taking their dual purposes into consideration. Benefit corporations frequently donate a large amount of their profits instead of passing them straight along to shareholders, pay more reasonable salaries, and have stricter policies on when and how dividends are paid out. In this way, a benefit corporation is neither a non-profit strictly forbidden from financially benefitting its founders and operators, nor does it dispense its profits entirely to shareholders.
How are benefit corporations taxed?
Benefit corporations do not qualify for tax-exempt status. Thus, benefit corporations will be taxed in the same way as a for-profit, traditional corporation. Additionally, any ‘donations’ made to a benefit corporation are not tax-deductible. If you, as a customer, take advantage of the socially conscious marketing efforts that benefit corporations make, that does not give you the right to charitable deductions. For example, Bombas has a one purchase/one donated policy where they donate one pair of socks for each pair purchased. The donated pair of socks is not a donation the customer can claim on her taxes.
A benefit corporation is funded much in the same way as a traditional corporation—by selling shares, seeking loans from banks and lenders, or finding investors. In the age of more socially conscious investing, a benefit corporation can be a more attractive choice for a purpose‑driven investor. There are, however, no statutory or tax benefits for investing in a benefit corporation as opposed to a traditional corporation.
What are the pros?
- Flexibility to pursue both a beneficial purpose and provide profits to shareholders
- An option that is well recognized across the county and available in many states
- Statutory guidance to help directors understand how to navigate the dual purposes
- Attractive to customers, employees, and investors
- Less regulation and reporting than a nonprofit
What are the cons?
- Statutory reporting and governance requirements
- Significant oversight and red tape
- Full corporate taxation
- No tax-deductible donations to the business
- Low-Profit Limited Liability Companies
What is a low-profit limited liability company (L3C)?
In short, an L3C first and foremost puts a charitable purpose above profits but is still able to turn some attention toward
s financial concerns and increasing profits. This entity is meant to provide greater flexibility than the corporation models discussed above and allows founders to work towards both social purpose and financial profits. Currently, L3Cs are recognized in eight states and Puerto Rico, with Vermont being the first to allow their creation beginning in 2008.
What are the requirements for L3Cs?
An L3C must satisfy three requirements, which align with requirements that the IRS imposes on businesses that can receive program-related investments (PRI) from charitable foundations. The requirements are as follows:
- The company must further the accomplishment of one or more charitable or educational purposes identified in § 170(c)(2)(b) of the Internal Revenue Code and that purpose must be the core reason for the company’s formation.
- The company cannot have a a strong purpose of producing income or appreciating property.
- The company must not have a political or legislative
How do L3Cs handle salaries and earnings?
As a L3C is a for-profit, if not entirely profit-focused, entity, any salaries and earnings are handled in the same way as a LLC. Importantly, salaries and earnings are still limited by the statutory requirement that there is no focus on appreciating property or producing income. If an LLC is amassing large enough profits to fund excessive salaries or large dividends it would both call this requirement into question and, likely, turn away the attention of a foundation looking to make a PRI. Thus, it is a best practice to consider the IRS’s guidance on “reasonable compensation” for nonprofit entities when designating salaries.
How are L3Cs taxed?
One of the most important things to note about a L3C is that, despite its connection to charitable purpose and its desire to focus beyond profit, a L3C is still a for-profit entity and is, thus, taxed. In the eyes of the IRS, a L3C is taxed in the same way as a LLC. In accordance, an L3C is not able to receive tax-deductible donations. An L3C may receive a donation that is charitable in nature but is no different in the eyes of the IRS.
What are the pros?
- L3Cs are able to receive high-confidence PRIs from foundations
- Flexibility and nimbleness associated with LLCs, including ability to chose tax status between corporation and LLC
- Less IRS oversight than the level of a 501(c)(3) nonprofit
What are the cons?
- Benefit corporations are substantially similar but do not need to meet the PRI requirements that an L3C does
- The IRS has not made a definitive announcement about L3Cs automatically qualifying for PRIs
- Few states currently allow for this type of entity
- Hybrid Entities
What is a hybrid entity?
Hybrid entities are technically two entities—a for-profit entity with a nonprofit entity attached to it, which allows for yet another way to attempt to have the best of both worlds. This choice has emerged to solve challenges that nonprofit organizations face, such as managing unrelated business activity, activities that separate from the charitable purpose, and protection of assets. The hybrid can be structured in two ways: i) as a parent-subsidiary, where the nonprofit is the parent organization and the for-profit is a subsidiary that is owned by the non-profit; and ii) as a brother-sister, where the two entities are operated entirely separately.
How do hybrid entities handle salaries and earnings?
For hybrid entities, salaries and earnings must be handled separately between the two identities. The for-profit entity can payout salaries and earnings as it wishes, but the nonprofit is still bound by the restrictions discussed above.
Importantly, funds to flow from the for-profit entity to the nonprofit through donations, but, due to the restriction on nonprofit’s assets being permanently dedicated to charitable causes, the nonprofit could not return the favor.
How are hybrid entities taxed?
In a hybrid entity, each individual entity will be taxed as appropriate for that entity’s status. The non-profit can apply for 501(c)(3) status and become tax exempt, but the for-profit entity will be taxed as the corporation or LLC that it is. Similarly, donations made to the non-profit will be tax deductible, as discussed above for non-profit entities, but that will not extend to any donations made to the for-profit entity.
One concern for hybrid entities is that the connection between the two could jeopardize the non-profit’s tax-exempt status. If the for-profit is seen to be controlling, influencing, or receiving benefits inappropriately from the nonprofit, the IRS will enforce penalties or, perhaps, rescind tax‑exempt status. In these determinations, the IRS looks at a variety of factors including but not limited to:
- Whether the officers, trustees, or employees of the tax-exempt parent are a majority of the for-profit subsidiary’s board,
- If the boards are identical,
- If the activities between the parent and subsidiary are done at arm’s length
- If the parent is involved in day-to-day management of the subsidiary.
What are the pros?
- Provides the ability to take investments, receive grants, offer tax-deductible donations
- Allows for pro bono and for-profit services
- No limitation on revenue generating activities under the for-profit
- Potential for cost sharing and shared resources
What are the cons?
- Complex structure
- Requires many hands to staff all boards and ensure proper integration and separation
- Requires effort to upkeep and manage
- Requires navigation of complex legal issues like fiduciary duties and conflicts of interest.
