By John R. Owen and Susan A. Ott Rhoades & Wodarczyk, LLC Suite 1030, 330 Grant Street Pittsburgh, PA 15219 jowen

1. PPGC 2011 Emerging Philanthropy ConferenceApril 28, 2011Earned Income Ventures and Social Enterprise for Tax-Exempt OrganizationsTax, Legal and Organizational Considerations By John R. Owen and Susan A. Ott Rhoades & Wodarczyk, LLC Suite 1030, 330 Grant Street Pittsburgh, PA 15219 jowen@rwattorneys.comsott@rwattorneys.com Telephone: 412.765.1020 Telephone: 412.417.7313 Facsimile: 412.765.2240 Facsimile: 412.765.2240

2. Social Enterprise or Entrepreneurialism “The open and accepted conduct of businesses by exempt organizations, on a for-profit basis, to the end of supplementing or even supplanting charitable contributions and grants.” Bruce R. Hopkins The Law of Tax-Exempt Organizations, Eighth Edition, 2006, Cumulative Supplement

3. Social Enterprise • Mind-set shift • Away from generating revenue by asking for and managing donated assets • Toward generating revenue by selling goods or services

4. Achieving Tax-Exempt Status Achieving tax-exempt status means that: • Your organization advances a charitable purpose • Your organization relieves the government of some of its burden • An indefinite class of persons is the beneficiary (public benefit); • No private inurement is allowed; and • Private benefit must be exceeded by charitable purposes

5. Social Enterprise Involves Commercialism • Business opportunities • Marketing • Return on investment, etc.

6. Potential Clash • Money over mission; • Marketing to the general public; • Laws governing private inurement and private benefit; • Intermediate Sanction Rules; and • Unrelated business rules (All of which are expanding).

7. THE BEST MOVE The best move when considering a social enterprise venture for your tax-exempt organization is to: • Remain mission driven; and • Guard tax-exempt status.

8. Tests for Tax-Exemption • Organizational: – Articles of incorporation, bylaws, corporate formalities • Operational: – No private inurement • No politics • Compliance • Forms • Substantiation and disclosure

9. Operational • “Exclusive” means “Primary” • Can have institutional non-exempt activities

10. Orange County • 1/3 of activities are from a for-profit race track • Tax exemption revoked Orange County Agricultural Society v. Commissioner, 893 F.2d. Affirmed 55 T.C.M. 1602 (1988)

11. Private Benefit Test • Must be incidental/insubstantial • “Substantial” may be defined by time spent or expenditures, but may also be defined simply by “importance”. Financial success is irrelevant to a determination of “substantial”. • Private interests – members, directors, officers, key employees The Nationalist Movement v. Commissioner, 102 T.C. 558, 559, 1994. Affirmed, 37 F.3d 216 (5th Cir., 1994) Industrial Aid for the Blind v. Commissioner, 73 T.C. 96 (1979).

12. Redlands • Flunked private benefit test • Surrendered effective control to for-profit parties Redlands Surgical Services v. Commissioner, 113 T.C. 47 (July, 1999)

13. Benefits of Federal Tax-Exempt Organizational Status Such organizations: • Usually exempt from paying federal income tax • Have the ability to receive tax deductible charitable contributions; and • Have the ability to access capital through tax-exempt bonds • Can sponsor 403(b) plans

14. Tax-Exempt Organization Tax-exempt organizations: • May qualify for some state tax exemptions on income, sales, use, excise and property taxes

15. Tax-Exempt Organization But, • Tax-exempt organizations may still have to pay other federal taxes such as excise and employment taxes And, • Almost any tax-exempt organization could be subject to tax on unrelated business income.

16. Unrelated Business Taxable IncomeRules for Tax-Exempt Organizations • Were enacted in 1950 • Have been modified directly or by “companion laws” up through 2002 • Tax Reform Act of 1969 differentiated public charities from private foundations, and • Imposed taxes on aspects of private foundations and revised debt-financed property rules.

17. Unrelated Business Taxable Incomefor Tax-Exempt Organizations Primary purpose of the unrelated business rules: • Eliminate Unfair Competition • (But also raises money for the federal government, providing an incentive to enforce the Rules). • Note: IRS scrutiny of charities (and UBI) is expected to increase. Since 2008, audits of charities have jumped 46%.

18. UBTI and Social Enterprise Ventures In considering a “social enterprise venture,” the biggest issue for a tax-exempt organization will be minimizing or avoiding unrelated business income tax.

19. UBTI Unrelated business income rules: • Generally apply to income from activities that are unrelated to tax-exempt purpose

20. Too Much UBTI • More than 15-20% of gross total revenue from UBI could mean loss of tax-exempt status • Remember Orange County v. Commissioner, where 33% UBI meant loss of tax-exempt status. Orange County Agr. Society v. Commissioner, 893 F.2d 647 (2d. Cir. 1990) Affirmed, 55 T.C.M. 1602 (1988)

21. What is UBI?3 Elements 1) Trade or business – Is the activity a necessary element for selling products or services for the purposes of making money? 2) Regularly carried on • Frequency – regular vs. occasional (Ex. Donut sale 1 time per year vs. every day) • Continuity – year-round vs. sporadically • Commercial Manner – generally comparable to taxable organizations

22. What is UBI?3 Elements 3) Not Substantially Related • Activity is not substantially related to exercise or performance of tax-exempt mission • Must contribute importantly to exempt purposes – substantial or causal relationships. (Example – symphony or ballet tickets). Must be more than a fundraising effort.

23. UBI Exceptions • Volunteers – must be no involvement by paid staff • Thrift shop – selling merchandise which has been received by the organization as gifts or contributions • Qualified conventions/trade shows • Qualified public fairs/expositions promoting agricultural and education purposes • Convenience of members – university book stores, hospital gift shops, museum restaurants • Low cost articles – incidental to solicitation and mailing lists

24. MORE UBI Exceptions • Hospital service • Bingo and other games of chance • Utility pole rental • Some associate member dues • Corporate sponsorship payments

25. Modifications – Exempt Income • Dividends • Rents • Interest • Royalties • Annuities • Capital gain property • Revenue from controlled organizations • Commercial insurance activities • Research income • Foreign source income • Religious order rule • Passive – but watch debt-financed income

26. “Hot” UBI Issues • Travel Tours • Affinity Credit Cards • Exclusive Marketing • “Royalties” • Coupon – selling • Rental of mailing lists • Recreational facilities – use as a “perk” for major donors • Corporate sponsorships • Sales of group insurance to members • Associate member dues • Advertising income • Parking lots

27. UBT and Typical Fundraising Activities • Events • Generally no UBTI for a non-continuous event • Advertising for sponsors is not UBTI if event is intermittent • Sponsorship • Payment by sponsors not considered UBTI if sponsor’s name and contribution are merely acknowledged • Website advertising of event mentioning a corporate sponsor is acknowledgment and not advertising subject to UBTI* • True advertisement or promotion of sponsor are subject to rules for substantial return benefit* *Private Letter Ruling 200320362

28. How to Structure?Choices: • Keep the social enterprise venture within a tax-exempt (new entity or old entity) • Create a for-profit entity – new corporation, partnership, LLC

29. State Law Issue • For-profit – file organizational documents • Not-for-profit – is a designation requiring compliance with not-for-profit laws, but does not give tax-exempt status • Planning point – can organize a not-for-profit that pays federal tax

30. Legal SeparationFor Profit or Not-for-Profit • Advantages • Insulate existing charity from costs and legal risks • Protect tax exemption • Permit development of new board/new expertise

31. Legal SeparationFor Profit or Not-for-Profit • Disadvantages • For-profits must always pay tax! • May lose control • Redundant use of staff/resources • Costs of forming and operating a second organization • Dilution of tax-exempt purpose • Can still “pierce corporate veil”; imposing liability on parent tax-exempt • Still can lose tax-exempt status

32. Keeping the Social Enterprise Venture Within The Tax-Exempt • Advantages • Only taxed on UBI • Shared staff and resources • Appeals to volunteers • Access to grants and subsidies • Disadvantages • Tax risks • No access to capital/other for-profit advantages • Subject to liability of activities • No “true” incentive compensation

33. Set-up New Tax-Exempt • Advantages • May avoid UBI in old exempt • Appeals to volunteers • Access to grants and subsidies • Separate risks – tax exemption protected

34. Set-up New Tax-Exempt • Disadvantages • Tax risks • Lose shared staff and resources • No access to capital markets • Loss of forming and operating second corporation • Pierce corporate veil; tax exempt status • No “true” incentive compensation

35. Creating a For-Profit Entity to House the Social Enterprise Venture • Advantages • Access to capital markets • Incentive compensation is easier – private inurement rules are not directly applicable • Write off losses • Freedom to operate and grow • Access to jobs, image and respectability • Separation of Risks/Liabilities

36. For-Profit • Disadvantages • Taxes are definitely due! • False expectations • Lose not-for-profit advantages such as grants/subsidies

37. IF SEPARATE ORGANIZATION IS ESTABLISHED, HOW CAN REVENUE BE PASSED BACK TO CHARITY? • Charitable contributions – deductible up to 10% of profits for a corporation • Rents, interest and royalties – deductible • Dividends – no deduction • Research grants • Fees for support services – watch UBI!

38. Study of Social Enterprise Ventures and Tax-Exempt Organizations Study Results: • Study of 740 organizations; 400 operating a social enterprise venture • Social enterprise ventures are steadily growing • Of successful organizations, 87% want to do more social enterprise ventures • Social enterprise ventures foster an atmosphere of entrepreneurial spirit within an organization Social Wealth Ventures, Inc. and The Social Enterprise Alliance at Duke University, “Study of Social Enterprise Ventures and Tax-Exempt Organizations,” 2010

39. Study of Social Enterprise Ventures and Tax-Exempt Organizations More Study Results: • The top five social venture types are: • Education and Training • Retail/Thrift Shop • Consulting Services • Food Service/Catering • Arts Ventures (classes and theatre companies)

40. Study of Social Enterprise Ventures and Tax-Exempt Organizations More Study Results: • Most organizations operate their social enterprise ventures: • As a part of a division or department – 60% • As a nonprofit subsidiary 8% • As a joint venture – 5% • As a franchise – 1% • Other – 11%

41. Study of Social Enterprise Ventures and Tax-Exempt Organizations More Study Results • Revenue (Earned Income) Produced: • Over $1M per year – 34% • Less than $100,000 per year – 25% • The larger the parent organization, the more likely it will “earn” from a social enterprise venture

42. Study of Social Enterprise Ventures and Tax-Exempt Organizations More Study Results: • Start Up Funding: • Foundation funding (most common) • Then, individual donations • Then, government grants • Only 9% used equity or debt financing

43. Board of Directors –What Should They Do? • Protecting tax-exempt status is a legal duty of care. • Very important to involve Board in any major decision affecting tax-exempt activities or organizational structure

44. Recommended Steps for the Tax-Exempt Board Considering a Social Enterprise Venture • Recognize that the traditional donor approach is different from a donor investor approach J. Gregory Dees, Jed Emerson, Peter Economy, Strategic Tools for Social Entrepreneurs, 2007 at 119.

45. Recommended Steps for the Tax-Exempt Board Considering a Social Enterprise Venture • Review your mission • Establish the risk willingness of your organization • Establish the mission/outcome of the business idea generation • Idea generation • Feasibility studies – preliminary and final – market research – find out what people want • Business plan (including the financials) • Implement plan with accountability Peter Brinckerhoff, Social Entrepreneurship: The Art of Mission – Basic Venture Development, 2000 at 38.

46. More Recommended Questions for Board • If UBI risk is substantial, should a separate organization be formed? Not-for-profit or for-profit?

47. More Recommended Questions for Board • If a separate organization is formed, how will it be capitalized? • Control by tax-exempt? Ownership of stock, election of directors/officers? • How will control be sustained? • How will revenue from venture be passed back to the charity? • Is there a joint venture? See Rev. Rul. 98-15

48. Examples of Social Enterprise and Earned Income Ventures • Life’sWork and Ben & Jerry’s Ice Cream • Manchester Craftsmen’s Guild-Bidwell Center • Photo Antiquities Museum of Photographic History • Sitar Arts Center (Washington, D.C.) • Homeboy Industries (Los Angeles, California) • Triangle Residential Options for Substance Abusers and Movers (North Carolina) • Gulf Coast Enterprise and Employment for the Disabled (Florida)