Structuring a Social Enterprise, Part 3: Protecting Your Existing Non-Profit Organization

Recap: In Part 1 of this Series, we discussed the various options for structuring a social enterprise, and in Part 2, we discussed the unique problem non-profit organizations can face when they generate Unrelated Business Taxable Income (UBTI). But how your non-profit operates its social enterprise can also have a major impact on the organization's tax-exempt status.

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In addition to the potential UBTI issues, non-profits often create separate corporations for their social enterprise endeavors so that the liabilities of one do not threaten the assets of the other. Like any business venture, the question has to be asked—what happens if the social enterprise fails? Will the nonprofit be accused of using funds inappropriately, particularly funds that could have better supported its charitable purpose? Could the failure of the social enterprise impact the non-profit’s financial viability, especially if the non-profit was using its own funds to start the social enterprise? Separately, does the social enterprise itself pose any risks that could be subject to litigation? Non-profit boards must carefully consider the potential risks a social enterprise activity might create. Creating a separate corporation to “house” that risk and operate the social enterprise can protect the non-profit parent organization (and its separate assets).

But (and there’s always a but), creating a separate corporation for your social enterprise activity is not a get-out-of-jail-free-card. Keep reading to learn about best practices to follow when operating both a non-profit and a social enterprise corporation.

By creating a separate corporation, your non-profit generally will not be liable for the debts and obligations of the social enterprise because they are two separate legal entities. However, there are times when the courts will “pierce the corporate veil” between the two entities. This occurs most often when you commingle the two organizations’ assets and generally fail to treat them like two separate organizations.

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The IRS has also been known to consolidate a non-profit organization with its for-profit social enterprise and treat them as one entity in certain circumstances. To avoid this (and the veil piercing problem generally):

• Both entities should have separate boards of directors and committee meetings with separate meeting minutes. Less than 50% of the social enterprise’s board of directors should overlap with the non-profit’s board.
• Transactions between the social enterprise and non-profit organization should be arms-length transactions, meaning they should be at fair market value and on similar terms as would be expected if the two organizations were not related. In particular, there should be written agreements covering any resource sharing (i.e., office space, employees, goods or services, the licensing of any intellectual property, mailing list and equipment rentals, etc.) A majority of the disinterested directors should approve any transactions between the two entities.
• Ideally, the social enterprise should be managed by a person independent from the non-profit organization.
  
• The social enterprise must be adequately funded or capitalized. In simple terms, the social enterprise should have enough of its own funds in its own bank account to satisfy day-to-day business expenses.
  

The last thing your non-profit wants to do is create a separate entity for your social enterprise to avoid UBTI and potential liability issues, only for the IRS to disregard the separate entity and treat them as one. If that happens, the business income of the social enterprise would be attributed to the non-profit, and you would find your non-profit’s charitable status threatened!

If you have questions about your non-profit’s social enterprise, whether it’s an in-house program or a separate legal entity, then:

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