The Taxable Nonprofit and the Tax-Exempt For-Profit: Clever Innovative Structures or Ugly Ducklings?
Nonprofit or For-Profit, That is the Question
In the US, we broadly classify legal entities as non-profit or for-profit. We distinguish them mostly through the lens of commerciality: for-profits trade in the marketplace and make money, and non-profits do good and give money away. This dichotomy is reflected in law, as most states have separate but parallel corporate laws for business and nonprofit entities. It is also illustrated through accounting, which has similar systems, and our tax system, which generally gives tax exemption to nonprofit entities but requires for-profit entities to pay taxes. Nonprofits can make money, but all of it has to be reinvested in the nonprofit. For-profits can do good work and give money away, but they have very little tax incentive to do so, and doing benevolent work at scale is very difficult. For today’s social entrepreneur, trying to do good and make money simultaneously (not make money and then give it away), it is sometimes hard to know how to fit in or what structure works best.
Social Enterprise Tends to Exist in this Middle Area, Where Profit and Purpose Co-Exist
The idea of social enterprise is to do good AND do well, not one or the other. In many cases, these dual purposes can be accomplished within a single entity, such as a profitable business that treats its employees fairly, avoids polluting, and donates profits to charity. Or a charity that is funded primarily by tax-deductible grants and contributions, but conducts some profitable commercial activity as part of its charitable activities or to raise funds. But operating a truly balanced venture using just one form or the other is challenging.
When a single entity does not suffice, many entrepreneurs turn to hybrids, which are strategic combinations of non-profit and for-profit entities operating as single ventures. These can take the form of joint ventures, hybrids formed through overlapping control, contract hybrids, branded hybrids, and other types. Frequently, the charity has control over mission, and the business has control over operations, but there are no fixed rules. These hybrid arrangements generally require one or more written agreements and must comply with at least two sets of regulations, so they can be more complicated than some entrepreneurs need.
Some Terminology You Need to Know:
As a practical matter, most people, including most practitioners, treat the terms “non-profit” and “tax-exempt” as synonymous. Similarly, most of us assume that “for-profit” entities are taxed. For the most part, this is true. However, there are many forms of for-profits and nonprofits. From “pure” forms of business that seek to maximize profit without regard to impact to equally pure forms of charity that seek to maximize impact without regard to profit, there are many shades of grey in between. Each of these different forms is treated differently for tax purposes, and the tax laws are complex. As a result, an interesting paradox emerges: some nonprofits have to pay taxes, and some for-profits don’t pay any taxes at all. For social entrepreneurs, this creates some interesting possibilities.
Enter the Ugly Ducklings: the Taxable Nonprofit and the Tax-Exempt For-Profit
The taxable nonprofit is simply a nonprofit legal entity that is not tax exempt—in other words, it pays taxes. Typically, a taxpaying nonprofit is a non-profit corporation. However, it can be any entity that (a) has no owners or beneficiaries aside from other nonprofits, and (b) is formed for a nonprofit, i.e., a non-economic purpose such as making the world a better place. Legally, it is a “nonprofit” subject to the state laws that govern nonprofit corporations. However, because it pays taxes like a business, it is not subject to any of the rules that govern tax-exempt organizations, from limits on compensation and political activity to reporting and disclosure rules, and it is not subject to the intrusive and arbitrary regulation of the IRS and state charity regulators. It is free to conduct any kind of business it wants, in any manner it wants, and yet it remains firmly nonprofit. Because taxable nonprofits are not tax-exempt, grants and contributions to support them are often made indirectly through intermediaries. This practice is generally fine as long as the funds are ultimately used for tax-exempt purposes. Private foundations may engage in a specific type of due diligence process known as expenditure responsibility to safely make grants to taxable nonprofits, but only to further charitable objectives.
The tax-exempt for-profit, on the other hand, is a for-profit entity that pays no taxes because its business qualifies for tax credits or other preferential tax treatment or because its mission-related expenses are high. Essentially, it is managed so that it pays no tax. While not feasible for enterprises that are very profitable, or which have to pay returns to investors, this structure may be ideal for low-margin businesses, or businesses where employee benefits or supply costs are deliberately high (i.e., the company is purchasing ocean plastic or carbon credits from NGOs at a fixed rate, or paying more to buy fair trade goods or from worker coops that pay a fair wage). Under IRS rules, benefit corporations may lessen their tax burden by donating up to 100% of their profits to charity and taking a business deduction. Other corporations are generally limited to the charitable tax deduction, which only allows them to give away 10% of their profits tax-free.
In the idea land of make-believe, we could form a single legal entity and use it seamlessly for charitable and commercial activities, combining philanthropic capital and risk capital, serving public and private interests transparently, and behaving in a responsible manner. Until that day comes, however, we make do with the tools we have—ugly or not.