Achieving Social Good Through an Affiliated Nonprofit; Compliance Guidelines for Social Enterprises
As the social enterprise movement continues to grow, more companies are looking for ways to address pressing societal problems and create positive social impacts. Traditionally, companies did so by establishing corporate foundations, which funded grants to charities, employee matching gifts, and scholarship programs. Beyond providing funding, the company was not actively involved in social change work. Today, many companies still conduct their philanthropy through an affiliated corporate foundation. However, many companies are establishing affiliated nonprofits to actively conduct charitable activities that complement the company’s social mission. The two entities working together are able to access philanthropic contributions as well as investment capital. If done correctly, this will enable them to accomplish more than either entity could alone. The relationship between the two entities may be that of a parent/subsidiary, joint venture, or contract hybrid.
Tax-exempt nonprofit organizations must be operated exclusively for charitable purposes that serve the public good. They cannot provide undue benefits to any private interests, including the interests of their founders or directors. Any company that has an affiliated nonprofit must put safeguards in place to prevent the company from receiving such an undue benefit. These safeguards include maintaining the nonprofit’s legal independence, properly addressing conflicts of interest, understanding the private benefit rules, and in the case of private foundations, avoiding all self-dealing transactions.
The nonprofit must be established as a separate legal entity with its own board of directors capable of acting independently from the company. The nonprofit’s directors owe a fiduciary duty to act in the nonprofit’s best interest and are responsible for ensuring compliance with all applicable laws, regulations, and best practices.
To ensure sufficient independence, a majority of the nonprofit’s directors should be independent from the company, meaning that they cannot also be a director, officer, senior manager, significant shareholder, or compensated employee of the company. While this is considered a best practice, it may not always be practical for a majority of the nonprofit’s directors to be independent (as is often the case with corporate foundations). In such cases, at least one independent director is required to handle conflicts of interest.
Conflicts of Interest
The relationship between a company and its affiliated nonprofit will likely be governed by various contractual arrangements, such as contracts for goods or services, grant and funding agreements, shared service agreements, intellectual property licenses, and leases. Each of these agreements must be negotiated at arm’s length and approved by the nonprofit’s independent directors.
Because the non-independent or “interested” directors are legally obligated to act in the best interests of both the company and the nonprofit, they cannot be objective when evaluating a proposed transaction between the two entities. Interested directors may also have a personal financial interest in the proposed transaction due to their position with the company. Both situations create a conflict of interest and must be handled per the nonprofit’s conflict of interest policy. Generally, this policy requires that all interested directors disclose their interest in the proposed transaction to the nonprofit’s board (or a designated committee) and recuse themselves from any discussion or voting on the matter. The transaction should only be approved if the independent directors determine that the terms are fair and reasonable and the agreement is in the best interest of the nonprofit, despite the conflict of interest.
The company is always permitted to donate funds and other assets to its affiliated nonprofit, such as staff time, equipment, and office space. However, if nonprofit assets are to be used by the company, the nonprofit must receive fair value in exchange. The nonprofit also cannot allow the arrangement to confer a substantial and undue benefit on the company or any private individuals (such as the company’s shareholders). For example, a nonprofit may develop a product that the company wants to use. The nonprofit may allow the company to do so as long as the company pays fair market value for use of the product. The company’s use of the product must also be for the primary purpose of furthering the nonprofit’s charitable purpose, rather than enriching the company or its shareholders.
To avoid the creation of undue benefit, the terms of the proposed transaction must be favorable to the nonprofit when compared to the market. The agreement should include specific provisions that protect the nonprofit’s tax-exempt status, including the ability to terminate the arrangement without penalty if the nonprofit’s tax-exempt status is at risk. All such arrangements should be fully documented and independently reviewed and approved by each entity’s board as described above.
Private Foundations and Self-Dealing Transactions
Based on their funding sources, section 501(c)(3) tax-exempt organizations are categorized as either public charities or private foundations. Broadly speaking, public charities receive financial support from a large number of donors. In contrast, private foundations generally receive the bulk of their funding from one donor – as is the case with corporate foundations.
Private foundations are more heavily and strictly regulated than public charities. Most notably, private foundations are prohibited from entering into self-dealing transactions with any “disqualified person.” Disqualified persons include substantial contributors to the foundation, foundation officers and directors, and companies affiliated with or related to the foundation or its substantial contributors, directors, or officers. A company that establishes an affiliated corporate foundation is deemed a disqualified person. That company can make outright donations to the foundation of funds, services, or other assets. However, almost all transfers of value between the company and its corporate foundation are prohibited as self-dealing transactions. Prohibited transactions include sales, exchanges, or leases of property, loans, furnishing of goods or services, payment of compensation by the foundation to a disqualified person (except for reasonable compensation paid for personal services necessary for the foundation to carry out its exempt purposes), and any transfer of the income or assets of a foundation to, for use by, or for the benefit of, a disqualified person. Note that these transactions are prohibited even if they are on terms that are favorable to the foundation. This rule is in contrast to transactions between a company and an affiliated public charity, which are permitted if the terms are favorable to the charity and the company does not receive an undue private benefit.
The following are examples of prohibited self-dealing transactions:
The foundation cannot use its assets to fulfill a charitable pledge or other obligation of the company.
Tickets to a fundraising gala or similar charitable event purchased by the foundation cannot be used by directors, employees, or guests of the company.
The company cannot lease office space to the foundation, even if the rent is below market. However, the company can donate office space to the foundation as long as no rent is charged.
Failure to comply with the prohibition on self-dealing transactions may result in substantial excise taxes being levied against the disqualified persons involved and the foundation’s managers who approved the transaction.