This article presents a general overview of entity choices available for social enterprises looking to form an entity. While it uses the law of Illinois as a guide, the big questions are consistent wherever you are. Be sure to consult an attorney in your state for the most up-to-date and accurate information.
It is easy to get overwhelmed by legal and financial issues when starting a social enterprise. With the help of skilled professionals, these issues can be managed. The vision you have for your social enterprise should be at the forefront. In order properly decide upon the entity that allows you to realize your social mission over the long term, you should ask yourself the following questions at the outset:
Initial Questions Every Social Entrepreneur Needs to Ask
The choice of legal structure involves a number of practical considerations. Early in the planning stages of the venture, social entrepreneurs should consider the following questions in advance of meeting with an attorney to put the legal structure in place:
- Who are the founders and what is their expectation in terms of ownership of the organization?
- What is your social purpose (i.e., what problem are you trying to solve)?
- What social impact do you want to achieve and how will you measure it?
- What is your business plan and how will it address the problem you are trying solve?
- Will you rely on grants and donations or other subsidies for regular operations?
- Is it important for your public image to be a particular type of entity (nonprofit, co-op, benefit corporation, etc.)
- Where will you get your startup and ongoing funding?
- Who are your investors/shareholders?
- Who are your beneficiaries/customers/stakeholders?
- Who will control and manage the organization?
- What are your personal and financial goals in starting this organization?
- How long do you intend the organization to exist and what is your exit strategy (for yourself and for investors)?
Social enterprises are broadly classified as either for-profit or nonprofit or some combination. A social entrepreneur should consult with an attorney to determine whether his or her goals and long-term interests may be better advanced through a taxable business entity rather than a tax-exempt nonprofit. Choosing a legal structure for your social enterprise is important as it can have long-lasting consequences and can be difficult and/or costly to change at a later date.
Legal Structure: Key Points
- Any individual can set up and operate a business in his or her own name
- Cannot have nonprofit or charitable status
- Individual is personally responsible for all debts and liabilities of the business
- Unlikely to be viewed as a social enterprise by most investors, government programs, and support agencies
- Minimum of two partners (which can be any combination of individuals, corporations, and other legal entities)
- Can have limited or unlimited liability
- Limited partnership is particularly attractive for enterprises wishing to attract investors
- Option to be taxed at individual level
- More complex to administer in terms of documentation that must be routinely generated and filed
- Separate legal entity that can enter into contracts, acquire property, and be sued
- Double taxation (unless S-election is timely made)
- Must be profit-driven in deference to shareholders
- Offers limited liability from claims made against the business
Limited Liability Company
- Offers limited liability from claims made against the business
- Option to be taxed at individual level
- May pursue charitable or educational purposes similar to a nonprofit organization
- Not precluded from earning a profit
- Does not qualify for 501(c)(3) tax exemption due to its private ownership
- Designed to be a recipient of program-related investments made by private foundations
Benefit Corporation and Flexible Purpose Corporation (CA only)
- May be a recipient of program-related investments by private foundations
- Double taxation (at corporate and shareholder levels)
- Owned and controlled by groups of individuals or businesses united to promote their common economic and social needs
- Exempt from taxation on all income that is distributed to worker-members
- Tax-exempt status limits social enterprise’s ability to pursue profit
- Can get around this by creating a for-profit subsidiary
- Once adapted, can attract mission-driven investors as well as program-related investments
Choices of Entity
1. Nonprofit: U.S. social enterprises are frequently organized under a state’s nonprofit corporate statute. The defining feature of a non-profit corporation is its tax-exempt status, which is governed by federal Internal Revenue Code Section 501(c)(3). That code section requires the organization to be operated primarily for social, educational, recreational or charitable purposes and prohibits the earning of any profit for the benefit of any private individual or stakeholder. In this regard, the non-profit corporation is not the ideal entity form for a typical social enterprise because its tax-exempt status limits the social enterprise’s ability to pursue profit. The non-profit corporation, however, can be adapted for some social enterprise purposes by creating a for-profit subsidiary that generates profit to fund the non-profit corporation.
2. Sole Proprietorship: The sole proprietorship is generally the simplest form of doing business. Legally, the sole proprietorship does not have a distinct existence separate and apart from the owner of the business. As a result, no organizational documents are required for the initiation of operation of the business as a sole proprietorship. However, because there is no separate legal identity, the personal assets of the business owner, including those completely unrelated to the operation of the business, are at risk. It is not generally advisable for social entrepreneurs to conduct business as a sole proprietorship.
3. Partnership: If more than one individual is to be involved in the operation of the business, the most common alternative to incorporation is the general partnership entity. Any combination of individuals, corporations, and other legal entities can constitute the makeup of the general partnership. A general partnership is a legal entity separate from the owners; however, the general partners, like the sole proprietor, are personally liable for the general partnership’s liabilities. A general partnership can be formed by an oral agreement but it is best to have an attorney draft a written partnership agreement. Social entrepreneurs should be careful not to unintentionally create a default general partnership, which, absent an agreement or some form of incorporation, can happen when multiple people run a business.
In a limited partnership, the limited partner’s liability is restricted in virtually all situations to that individual’s investment in the limited partnership just as a shareholder’s liability is limited to the amount of the shareholder’s investment in a corporation. For this reason, the limited partnership entity is particularly attractive for enterprises wishing to attract investors. The limited partners retain the protection against personal liability as long as they refrain from participating in the control of the business.
If the social entrepreneur is particularly concerned about limiting his or her liability, a limited liability partnership should be considered. As a general rule, a partner of a limited liability partnership does not have a risk of personal liability unless he or she is personally negligent or commits wrongful acts, omissions, misconduct, or malpractice.
4. C-corporation: The corporation is one of the most widely used business forms in the United States. However, since the directors and officers of a corporation are liable to their shareholders, they may run into trouble if the social enterprise’s goal is fulfilling its social mission as opposed to profit maximization. In this regard, the corporate form presents serious governance challenges for social entrepreneurs. Additionally, all income is taxed at two levels – first, as income to the corporation and then as income to the owners of the corporation when the income is distributed. This is often disadvantageous for a social enterprise in its early stages.
5. S-corporation: Flow-through tax treatment is a significant consideration to be made in choosing an entity. Flow-through tax treatment means that the entity itself is not subject to tax. Rather, the owner(s) of the social enterprise will be taxed at the personal level. By eliminating the entity-level tax, the overall tax burden on placing the business’ income in the hands of its owners is reduced. It is harder to get investment using this vehicle and only U.S. citizens or permanent residents may be owners of the social enterprise. The S-corporation is ideally suited for service businesses.
6. Limited Liability Company (LLC): A Limited Liability Company is the most flexible structure for social entrepreneurs who want flow-through tax treatment and future investment. An LLC offers the limited liability for claims made against the business without the mandate to generate profits for shareholders. Due to their inherent flexibility, liability protection, and tax treatment, limited liability companies increasingly play a role in for-profit/nonprofit contract hybrid structures.
7. Low Profit LLC (L3C): The Low Profit LLC is an LLC formed with the primary objective of furthering the accomplishment of one or more charitable or educational purposes. Unlike a nonprofit entity, the L3C is not precluded from earning a profit. Like any other LLC, the L3C shields its owners from personal liability for the venture and offers flexibility with regard to corporate governance and tax planning. Most importantly, the L3C is designed to be able to receive “program-related investments” by private foundations and private philanthropic investors.
8. Benefit Corporation and B Corps: The Illinois legislature recently enacted the Illinois Benefit Corporation Act, creating a new business entity designed to encourage social and environmental goals in addition to maximizing its profits for the benefit of its shareholders. The public benefit corporation is a taxable business entity with private shareholders that adopts a corporate purpose that creates a material positive impact on society and the environment. California, Louisiana, Massachusetts, Maryland, New York, New Jersey and Vermont are some of the other jurisdictions which allow the formation of benefit corporations. Whole Foods and Patagonia are two well-known examples of businesses that have reorganized under similarly structured statutes in other states. Benefit corporations are required to have an independent benefit director and officer, and must annually report on the corporation’s compliance with its public benefit purposes. The corporation is also required to annually publish the benefit report to its shareholders and the public. No special tax benefits are currently afforded to benefit corporations. However, the social entrepreneur may find that the good will and public image created by the use of a benefit corporation, and the changes to the fiduciary duties, may warrant the additional reporting obligations.
Similar to Benefit Corporations, B Corps are certified by nonprofit B Lab to meet rigorous standards of social and environmental performance, accountability, and transparency.
9. Flexible Purpose Corporation: The Flexible Purpose Corporation is a corporate form only available in California.
It was designed to provide companies with flexibility to pursue charitable and public purpose activities, beyond just profit maximization. In the same manner as the traditional C-Corporation, Flexible Purpose Corporations are taxed at both the entity level and the owner level and must provide an annual report to its shareholders.
10. Cooperatives (Co-Ops): Cooperatives are businesses owned and controlled by groups of individuals or businesses united for their mutual benefit and to promote their common economic and social needs. The purpose of the cooperative is to provide benefits to its constituents that allow producers to receive marketing services at low prices, receive supplies below cost, and better control the price that they eventually charge to the end consumer of the products or services.
The entity formation stage of developing your social enterprise involves doing lots of research, analysis and critical thinking. It will take time, effort, perseverance, commitment and dedication to launch your social enterprise, but the most important thing is to start.