Marquette Legal Initiative for Nonprofit Corporations (M-LINC)

1. Marquette Legal Initiative for Nonprofit Corporations (M-LINC) Social entrepreneurship: what it means for your Wisconsin nonprofit Marquette University Law School April 19, 2012 With support from the Helen Bader FoundationH

2. A Reminder about M-LINC • M-LINC is the Marquette Legal Initiative for Nonprofit Corporations • Housed at Marquette University Law School • Launched in September 2008 • Karin Holmberg Werner, JD, the director of M-LINC ,was hired in July 2008 • Currently serving as a resource for Wisconsin nonprofits with legal questions • M-LINC coordinates FREE legal advice and educational programs on legal issues important to small and mid-sized nonprofits

3. What are we going to discuss today? • First, this program aims to highlight the increasing convergence between the nonprofit and for profit sectors through the social enterprise movement and to provide an overview of the new legal structures that have risen up in many states across the country to embrace this movement. • Second, this program will consider the impact this movement might have on your organization and the important tax considerations for nonprofits who embrace the revenue generating aspects of the social enterprise movement without changing their current legal structure.

4. In particular, we will discuss: • Social Enterprise: Overview • New Hybrid Legal Structures: • L3Cs • Benefit Corporations • “B-Corps.” • Flexible Purpose Corporations • Wisconsin Legislative Activity • Legal Issues for Nonprofits With Income-Generating Activities

5. “It used to be that if you wanted to make a difference, you joined a nonprofit. And if you wanted to make money, you launched a business. These days, it's not so simple. “ - May 2011 Inc. Magazine article

6. Social Entrepreneurship, A.K.A.... “The Missing Middle” “The Fourth Sector” “Doing well, while doing good” “Double Bottom Line” “Triple Bottom Line”

7. Social Entrepreneurship: Defined • “Social enterprise organizations are for-profit firms committed to philanthropic activity.” • -Fishman & Schwartz, Nonprofit Organizations: Cases and Materials, (2010) p.28. • “Social enterprises are businesses whose primary purpose is the common good. They use the methods and disciplines of business and the power of the marketplace to advance their social, environmental and human justice agendas.” • - The Social Enterprise Alliance (a membership organization representing the social enterprise sector) • “Social Entrepreneurs are individuals with innovative solutions to society’s most pressing social problems. They are ambitious and persistent, tackling major social issues and offering new ideas for wide-scale change.” • - Ashoka* (a leading organization in fostering the global social entrepreneurial movement)

8. What Does Social Entrepreneurship Mean for Nonprofits? • “One of the principal contemporary forces with the potential for meaningfully shaping the law of tax-exempt organizations is emergence of what is know as 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. The unabashed aim of organizations undertaking entrepreneurial activities is to make money for the mission, upgrade the quality of staff and other resources, and to become self-sufficient (that is, not dependent on external funders).” - Bruce Hopkins • Make money to support the mission and sustain the organization. • Some in this movement perceive funders and grantors as arcane and confining. • However, the law places significant constraints on nonprofit business activities that are unrelated to the nonprofit’s exempt mission. Such activities could, pursuant to IRC 502, jeopardize the organization’s tax-exempt status.

9. Spectrum of Legal Structures

10. Why New Legal Structures? • A desire by some new entrepreneurs to make a good living while still doing good for others (think TOMS Shoes). For profit designation doesn’t seem to encompass full purposes. • No existing legal structure was specifically tailored to meet this goal. Historic choices are black and white. • Provides firmer protections for for-profit directors who want to consider non-financial factors. • Potentially opens access to additional capital from private foundations making program related investments.

11. L3Cs – Low-profit Limited Liability Companies • In 2008, Vermont became the first state to pass L3C Legislation. • Unlike a nonprofit, the L3C is free to distribute the profits, after taxes, to owners and investors. • Unlike a traditional LLC, the L3C has an explicit primary charitable mission, with profit being a secondary concern. • Though it has been the subject of significant academic debate, an L3C’s explicit charitable mission may allow them to attract additional capital from private foundations (not as easily available to LLCs) because several aspects of L3Cs make them more likely to qualify for program related investments (“PRIs”). • This is important because private foundations can only directly invest in for-profit ventures that qualify as PRIs, or investments with a socially beneficial purpose that is consistent with and furthers the foundation’s mission (IRC 4944).

12. L3C State Legislative Activity • Statute Passed • Vermont • Michigan • Wyoming • Utah • North Carolina • Louisiana • Maine • Rhode Island • Illinois • Statute Introduced • Alabama • Arizona • California • Georgia • Hawaii • Iowa • Indiana • Kentucky • Maryland • Massachusetts • Missouri • Minnesota • New Hampshire • New York • Oklahoma • Virginia • Wisconsin Source: Carter G. Bishop, Fifty State Series: L3C & B Corporation Legislation Table, March 5, 2012

13. L3Cs Created to Date Source: interSector Partners, L3C, (http://www.intersectorl3c.com/l3c_tally.html)

14. L3C Example: “Gorilla Dental L3C” • Based in Crystal Lake, IL • Manufacturers portable dental equipment for use in the field. • Incorporated as a low-profit LLC to improve the efficacy of outreach dentistry and facilitate the delivery of quality dental care abroad.

15. Benefit Corporations • A benefit corporation is a new class of corporation that voluntarily meets higher standards of corporate purpose, accountability, and transparency.   • Key Characteristics: • 1) Purpose: has a corporate purpose to create a material positive impact on society and the environment; • 2) Modified Director Duties: board of directors is required to consider the impact of their decisions not only on shareholders but also on workers, community, and the environment; and • 3) Annual Benefit Report: corporation is required to make available to the public an annual benefit report that assesses the organization’s overall social and environmental performance against a third party standard.

16. Benefit Corporations • Provide clarity to their directors and officers that their expanded fiduciary duties include creation of public benefit and consideration of non-financial interests. • Offer legal protection to directors and officers for considering these interests. • After recent court rulings, directors facing liquidity scenarios in states without a constituency statute must take the highest offer regardless of the impact of that decision on non-financial interests. • Even in states, like Wisconsin, with constituency statutes (permitting directors to consider non-financial interest), the extent to which non-financial interest may be considered remains unclear; moreover constituency statutes are permissive, whereas consideration of non-financial considerations in benefit corporations is required.

17. Benefit Corporation Example: Greyston Bakery • 1st New York Benefit Corporation (Reincorporated in Feb 10, 2012) • Also a Certified B-Corp. • Originally Founded in 1982 • Brownie Supplier to Ben & Jerry’s • Hires disadvantaged workers from the community and trains them to work in kitchen. • Reinvests its profits and uses them to support housing and healthcare services for homeless individuals and people living with HIV/AIDS. Greyston Bakery Video

18. Benefit Corp. State Legislative Activity • Statute Passed • California • New York • Hawaii • Virginia • Maryland • Vermont • New Jersey • Statute Introduced • Florida • Illinois • Iowa • Michigan • Minnesota • North Carolina • Pennsylvania • Wisconsin Source: www.benefitcorp.net

19. “B Corps.” (a Private Certification) • Caution: While the two are often confused, Certified B Corporations (“B Corps”) are distinct from the statutorily-recognized benefit corporations. • B Corps are given private certification after undergoing a comprehensive assessment administered by the nonprofit organization, B Lab. (this is analogous to the LEED certification given to green buildings) • While distinct from benefit corporations, the B Corp Certification works in tandem with benefit corporation statutes by helping to create and publish the statutorily required annual public benefit report.

20. CA Flexible Purpose Corporations • Signed into law (along with benefit corporations) in CA on Oct. 10, 2011 • Instead of organizing around the creation of a “material public impact on society and the environment” like the benefit corporation, California’s flexible purpose corporation requires that a specific qualifying special purpose be included in its articles of incorporation. • The Special Purpose Mission is Anchored Until 2/3 of Each Class of Voting Shares Vote Otherwise • Directors are Protected for Decision-Making Involving Trade-Offs between Profitability and the Special Purpose • Like Benefit Corporations, Flexible Purpose Corporations must Provide an Annual Report on its Impact Toward is Special Purpose and an Assessment of Future Expenditures Anticipated

21. Wisconsin Legislative Activity • On March 15, 2012, AB 742, an Act to create benefit corporations in Wisconsin, was introduced in the State Assembly. AB 742 was not voted on during the most recent legislative session. • On March 26, 2010, AB 902, an Act to create L3Cs in Wisconsin, was introduced in the State Assembly. • The Wisconsin statutes DO currently permit directors to consider non-financial interest in decision making. Wis. Stat. §180.0827 (i.e. WI has a constituency statute).

22. What Does This Mean as More Nonprofits Look to Generate Income to Sustain Themselves? • Nonprofits must educate themselves about the unrelated business income tax (“UBIT”). • Nonprofits must be aware of the Wisconsin rules for collecting and remitting sales tax. • If substantial unrelated income is generated, consider forming a taxable subsidiary (traditional for profit or new hybrid legal form) to hold income-producing activity.

23. What exactly is UBIT? Dissecting the Rules. • A nonprofit organization must pay tax at ordinary corporate income tax rates (15 to 34%) on its profits from business activities unrelated to its exempt purpose. • This is one of the most controversial aspects of the law of tax-exempt organizations. • Source of rule: unfair competition between nonprofits that are not taxed on income and for profits in same line of business. (i.e., University owned pizza parlor) • Generally, nonprofits may earn profits, free of tax, from business activities that are related to the nonprofit’s exempt purpose. • Definition: Unrelated business taxable income (“UBTI”) is the gross income derived by a nonprofit from an “unrelated trade or business” that is regularly carried on by the nonprofit, minus any allowable deductions that are directly connected with the carrying on of such trade or business. (IRC 513)

24. Commerciality Doctrine • At the same time Congress added the unrelated business income tax rules, it also added new Internal Revenue Code section 502, which provides that an organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt from tax under Code section 501 on the grounds that all of its profits are payable to one or more tax-exempt organizations. • This contravenes a 1920s Supreme Court case saying otherwise. • No clear line test for when an organization’s 501(c)(3) status could be jeopardized by such income. Some experts suggest not exceeding 20 to 30% of income.

25. Elements of UBTI • Gross income from a trade or business; • Trade or business is regularly carried on by the nonprofit; and • The trade or business is not substantially related (other than producing income) to the nonprofit’s exempt purposes

26. Trade or Business • Trade or business is any activity carried on for the production of income from the sale of goods or performance of services (Treas. Reg. 1.513-1(b)). • Note: fragment off taxable income from otherwise exempt income. • For example, soliciting, selling, and publishing commercial advertising is a trade or business even though the advertising is published in an exempt organization’s periodical that contains editorial matter related to the organization’s exempt purpose.

27. Regularly Carried On • Regularly carried on is activities pursued in a manner generally similar to comparable commercial activities of for profit entities. • Look at the frequency and continuity of the activity as compared with similar activities of taxable organizations. (Treas. Reg. 1.513-1(c)) • For example, a hospital auxiliary’s operation of a sandwich stand at a state fair for two weeks would not be the regular conduct of a trade or business. The IRS has determined that the stand would not compete with similar facilities that a taxable organization would ordinarily operate year-round. • However, operating a commercial parking lot every Saturday year-round, would be the regular conduct of a trade or business.

28. Related to the Nonprofit’s Exempt Purposes • Key consideration. • Business activities are related to the nonprofit’s exempt purpose only when the conduct of the business activities has a causal relationship to the achievement of the exempt purposes (other than through the production of income). • Activities are substantially related only if the causal relationship is a substantial one. • Thus, the conduct must contribute importantly to the accomplishment of the nonprofit’s exempt purposes. (Treas. Reg. 1.513-1(d)) • Example: Homeless shelter that operates a restaurant. Income is likely taxable unless the shelter uses the restaurant as a vehicle for training residents and teaching them how to find regular employment. • Example #2: Microfinance entity in Central America, with a travel agency component. Taxability depends on how the agency is operated and whether it is “educational”. I.e., does the nonprofit teach residents how to sustain themselves by opening B&Bs in their homes, etc.

29. Exemptions from UBIT • Volunteer Workforce: Any trade or business where substantially all the work in carrying on the trade or business is performed without compensation. (e.g., an orphanage’s retail store where unpaid volunteers perform substantially all of the work). • Convenience: Any trade or business carried on by a 501(c)(3) organization primarily for the convenience of its members, students, patients, officers or employees (e.g., a college laundry for cleaning dormitory linens and students’ clothing). • Donated Items: Any trade or business involving the selling of items, substantially all of which was contributed to the nonprofit (e.g., a thrift shop selling contributed items with the proceeds going to the nonprofit). • Passive Income: UBTI generally excludes passive income such as dividends, interest, annuities, rents from real property, royalties, and gains or losses from the sale of capital assets, except where debt-financed.

30. Items to Note if Your Organization Owes Taxes on UBTI • Form 990-T must be filed if the nonprofit’s gross income from unrelated businesses is $1,000 or more. • Other deductions allowed only if directly connected with the carrying on of the unrelated trade or business. • What if dual use of a facility (e.g., library that is rented out for weddings and corporate parties)? • Should electricity bills and salaries be deducted? • Note: Forms 990-T now available to the public for inspection. • Seriously consider separating income-generating activities out into a for profit subsidiary if taxable (i.e., a trade or business regularly carried on and not substantially related to exempt purposes) and significant. The IRS has not provided a bright line test for when taxable income could jeopardize the organization’s tax exempt status, though some experts have suggested not crossing a 20% or 30% of income line.

31. Sales Tax Considerations • Don’t forget sales tax. • General Rule in Wisconsin: Nonprofits are exempt from collecting and remitting sales tax, unless they engage in a trade or business more than 20 days each year AND generate more than $25,000 from such trade or business. • Note: add all activities together when considering whether threshold has been met. • See an excellent publication on this subject: http://www.revenue.wi.gov/pubs/pb206.pdf

32. Examples • Thrift Shop • Cafeteria in Art Museum • Art Museum Gift Shop • Booster Club • Museum Exhibit Sponsor • University Travel Tour

33. Final Thoughts • The wall separating purpose from profit is a thing of the past. • Those who wish to combine a social mission with a profit motive face a dizzying array of choices. • Generating income is a key option for sustaining many nonprofit organizations, especially those struggling with dwindling government and foundation grants. • Nonprofits can carry out significant income-generating activities, especially if such activities are substantially related to their exempt purposes. • Be aware of the possibility of taxes (UBIT or sales tax).

34. Thank You and Contact Information Thank you for coming today. M-LINC www.m-linc.org (414) 288-5536 mlinc@marquette.edu Karin Holmberg Werner, JD Director of the Marquette Legal Initiative for Nonprofit Corporations Marquette University Law School Office 138D – Eisenberg Suite karin.werner@marquette.edu