TAXING SOCIAL ENTERPRISE
By Ganahl, Joseph R | |
Proquest LLC |
Since the first hybrid enabling law was passed in
In this Article, we close that gap by thoroughly examining the arguments for tax preferences and the likely consequences that would flow from offering such preferences. We conclude that hybrid entities should not receive tax preferences traditionally offered to nonprofit entities because such an extension of tax benefits would likely have a deleterious effect, not only on the charitable sector and the public fisc, but also on hybrids themselves. Such an extension would almost certainly require a much clearer and narrower definition of public benefit that would undermine the much-touted flexibility offered by the hybrid forms, shift the financial risk of a hybrid not providing significant public benefit from its investors and donors to the public at large, place a substantial and likely unsustainable burden on the federal government to ensure that profitmaking does not trump providing public benefit, and threaten to undermine public support both for hybrid forms and for the existing tax preferences enjoyed by nonprofits. At the same time, we also conclude that some modifications to existing tax laws are appropriate in that they would acknowledge hybrids' virtues while not exacerbating their potential weaknesses.
INTRODUCTION
"Hybrid" legal forms have proliferated over the past half decade, seeking to combine the potential for profit with one or more public-benefitting goals.1 These forms include the low-profit limited liability company (L3C), the benefit corporation, and most recently the flexible purpose corporation. The stated purpose of these entities is to marry the capital and innovation that results from the ability to generate a profit for investors with the public benefit goals that characterize most nonprofits. While academics have sharply criticized the emergence of these forms with respect to both their necessity and feasibility,2 states continue to pass legislation permitting them and private parties have begun to take advantage of this legislation. To date, eight states currently allow the creation of L3Cs, nineteen states and the
There is no single, representative example of the type of business that chooses to use a hybrid legal form. When
To date, supporters of these hybrid forms have focused primarily on encouraging states to permit the creation of these new entities, but there have already been calls for these forms to receive some or all of the tax benefits enjoyed by charities.11 As was the case with the calls to create these hybrid forms in the first place, such calls for tax benefits have met much skepticism. For example, in
More specifically, while for-profit entities or their owners are generally subject to federal and state income taxes, nonprofit entities are generally exempt from those taxes. Furthermore, nonprofit entities that are committed to pursuing charitable, educational, religious, or other public-benefitting purposes-commonly referred to as charities-also enjoy a host of other tax benefits, most prominently the ability to receive tax-deductible contributions and exemption from most other types of state and local taxes. The question raised by the emergence of these hybrids is therefore whether the fact that they pursue public-benefitting goals should entitle them to any or all of the tax benefits enjoyed by nonprofits that also pursue such goals.
In this Article we review the current tax treatment of for-profit entities- including the treatment of their charitable activities-and of charities, as well as the rationales for the different tax treatment of these two types of entities. Against this backdrop, we then consider whether hybrids should receive some or all of the tax benefits enjoyed by charities. Our conclusion is that the bare fact that hybrids have public-benefitting goals in addition to profit-seeking goals does not provide sufficient grounds for giving hybrids these tax benefits for four reasons, each of which arises from the difficulty of defining and policing "public benefit."
First, abrogating the requirement that in order to receive tax benefits an organization must be a nonprofit entity brings to the forefront the difficult issue of defining exactly what activities qualify as charitable or otherwise public benefitting. Current federal tax law, and most state tax laws, avoid this issue in significant part by providing only a vague definition that is backstopped by the inability of public-benefitting organizations to distribute excess funds to owners-if a private party's real motivation is to do well instead of doing good, the nonprofit form makes it difficult to satisfy that desire to the detriment of doing good. The lifting of that nondistribution bar, however, places much greater pressure on the definition of public benefit, especially since most if not all forprofit entities already create a public benefit in the most general sense by providing jobs, desired products or services, and other economic opportunities.
Second, providing tax benefits would effectively shift the not insignificant risk that hybrids will fail to consistently pursue public benefit from the relatively limited and informed group of financial supporters of each hybrid to the relatively broad and uninformed taxpaying public as a whole. To reduce this risk would in turn almost certainly require the government to impose additional restrictions on hybrids and to fund additional oversight of them. Although investors in hybrids choose to take on an additional risk by funding an entity not solely dedicated to making profits, it is far from clear why the public should share in that risk or bear the burden of providing additional oversight for hybrids. The imposition of additional restrictions would also undermine the flexibility that is one of the major benefits of these hybrid forms.
This risk of not sufficiently pursuing public benefit leads to the third reason: tax-exempt charitable nonprofits are subject to an extensive regulatory regime to ensure that they in fact pursue public benefit, of which the requirement of nonprofit status is a critical component. Hybrid statutes seek to make pursuing a public benefit only one of the goals of such entities and lack brightline requirements (such as nonprofit status) to ensure that they in fact provide some minimum quantum of public benefit. Any attempt to modify the statutes to create a more extensive state regulatory regime or to impose other mechanisms to ensure that hybrids produce sufficient public benefit to justify any tax benefits they receive would again undermine the very characteristics that supporters argue make hybrids desirable-the ability to harness private funds for public good and to promote innovation in seeking public benefit.
Lastly, if even a small number of hybrids that enjoy tax benefits fail to provide the promised public benefit, this result could threaten to undermine the already limited support for the existence of hybrid entities. Even more troubling, such misuse of tax benefits could lead to questioning of the provision of tax benefits more generally to incentivize providing public benefit, including by charities. While such questioning would not be new, misuse of tax benefits by hybrids might lead to a reduction in tax benefits for all public-benefitting activity, whether conducted by hybrids or charities.
Part I of this Article describes the emergence of the new hybrid legal forms and their growing adoption by states even in the face of significant criticism. Part II explains the current structure of and rationales for the tax treatment of both for-profit entities and charities, and details how the existing rules treat these new hybrids for federal and state tax purposes. Part III brings together the previous two Parts to answer the question of whether any of the tax benefits enjoyed by charities should be extended to these new hybrids. For the reasons already briefly noted and developed in more detail in this Part, we conclude that the answer to this question is an emphatic "no." Part III does, however, suggest several modifications to the existing federal tax rules to accommodate hybrids and their multiple purposes.
I. THE NEW HYBRID FORMS
In the latter part of the twentieth century, a class of entrepreneurs emerged that was vocal in its desire to consider factors other than the bottom line in making business decisions. Well known within this class were the founders of Ben & Jerry's and craigslist.15 Rather than concentrating solely on profit, these individuals wanted their enterprises to pursue some social mission, but in both cases, that goal was allegedly hindered by investors' appeals to traditional corporate fiduciary duties relating to maximizing profits.
The founders of Ben & Jerry's felt that they were forced to sell their company to the highest bidder, despite the fact that there was no assurance that the acquirer would respect their company's dedication to social causes.16 Some critics point to the broad protection of the business judgment rule-a doctrine that establishes a presumption that directors and officers make their business decisions in an informed and good faith manner to further what they believe to be the best interests of the corporation, which is rebuttable only by showing that the directors or officers failed to act rationally17-however, and argue that the founders of Ben & Jerry's would have been vindicated if they had stood their ground.18
Enter
The corporate form in which craigslist operates . . . is not an appropriate vehicle for purely philanthropic ends, at least not when there are other stockholders interested in realizing a return on their investment. . . . Having chosen a for-profit corporate form, the craigslist directors are bound by the fiduciary duties and standards that accompany that form.20
Some entrepreneurs and academics suggested constituency statutes as a possible safe haven from these concerns because such statutes allow for the consideration of the interests of stakeholders other than shareholders.21 There were new problems with this solution, however. First, constituency statutes exist only in certain jurisdictions, and even in states where they could be used, the lack of clear precedent to demonstrate their protective ability made entrepreneurs nervous.22 Furthermore, the overwhelming majority of constituency statutes are merely permissive-allowing, but not requiring, directors to consider interests other than generating profit for shareholders.23 If a large number of shareholders disagree with the directors' vision for a company, the directors may find themselves voted out or the company may be bought out, constituency statute or not, and the new directors or owners can abandon the company's social mission.24 The factors discussed above led some to believe that the forprofit corporate form itself was a barrier to social enterprise.
The charitable nonprofit form was no more appealing, however, given its inflexibility. Charities usually must have a well-defined mission from which they may not deviate and must devote substantially all of their assets and activities to charitable projects.25 In addition, charities are very limited in the sources of funding that they may attract, making scaling difficult as they grow to meet the demand for their services. To many ambitious social entrepreneurs, this is an unacceptable limitation.26 While charities enjoy significant tax and other legal benefits,27 these benefits often are not sufficient to offset the drawbacks of the charitable nonprofit form. The apparent shortcomings of both the for-profit and charitable models therefore engendered proposals to develop entirely new forms. Those forms include the low-profit limited liability company, the benefit corporation, and the flexible purpose corporation.
A. Low-Profit Limited Liability Companies (L3Cs)
The low-profit limited liability company was conceived of in 2005 and has been promoted since then in large part by
Many commentators opposed the creation of L3Cs. The concerns they expressed included that L3Cs might divert needed funds from existing charities, that they would result in conflicting fiduciary duties for L3C managers, and that they simply represented a desire to trade on the cachet of government imprimatur.39 Moreover, the
B. Benefit Corporations
Beginning operations in 2007, the nonprofit
In a similar manner to how L3C statutes are appended to existing limited liability company provisions, benefit corporation statutes piggyback on states' corporation codes by altering specific defaults within existing corporation law. The core provisions for benefit corporations include:
1) a corporate purpose to create a material positive impact on society and the environment; 2) expanded fiduciary duties of directors which require consideration of non-financial interests; and 3) an obligation to report on its overall social and environmental performance as assessed against a comprehensive, credible, independent and transparent third-party standard.47
Benefit statutes are meant to defeat the problems that Ben & Jerry's and craigslist faced by introducing statutory language that alters the fiduciary duties by which directors of benefit corporations are bound, giving them wider latitude to consider the causes for which they were founded without fear of liability. By incorporating under the benefit corporation form, entrepreneurs can also signal their intentions, which may serve both to discourage solely profitoriented investors and to attract socially conscious investors, leading to a lower probability of conflict in the first place.48
Many of the same commentators who criticized proposals to permit L3Cs also criticized the proposed new benefit corporation form, for many of the same reasons. Those reasons included the risk that the new forms would divert needed funds from existing charities, that directors would face conflicting fiduciary duties, and that the creation of the benefit corporation form could be mistakenly interpreted by the public as government approval or oversight of the publicbenefitting goals of the corporation.49 Again, despite these criticisms the new form has proven relatively popular with both state legislatures and private parties, with almost 200 registered benefit corporations reportedly created as of late 2012 in the twelve states that had enacted benefit corporation legislation at that time (a number which has since grown to nineteen states and the
C.
The impetus for the creation of the "flexible purpose corporation" in
The flexible purpose corporation is a sort of benefit corporation lite: the flexible purpose corporation enabling statute merely requires the disclosure of at least one specific "special purpose" in the articles of incorporation, and directors are thereby protected against liability for giving special consideration to that single purpose, even when it is detrimental to the bottom line of the corpo- ration.54 Some business leaders felt that this new form was preferable to the benefit corporation because of worries that the benefit corporation form's broad obligation to advance social and environmental welfare "forces directors to weigh so many competing interests that it's unrealistic for publicly traded companies" concerned with shareholder lawsuits.55
One of the first, if not the very first, flexible purpose corporations formed under this new law was Prometheus Civic Technologies.56 The company develops and sells software to increase civic engagement and reduce the burden of government.57 According to the company's president, it chose this form over the benefit corporation form because benefit corporations must provide annual assessments that would not be easy to produce given the difficulty of measuring whether Prometheus Civic Technologies had accomplished its social mission.58 The company is owned by a nonprofit, the
While the flexible purpose corporation has generated less attention both because it is relatively new even among hybrids and limited to a single state, it nevertheless merits discussion because that single state is the most populous one. At the same time, it is vulnerable to the same criticisms leveled against L3Cs and benefit corporations.60 Still, since the flexible purpose corporation form became available at the start of 2012 at least fifteen such entities have registered under
D. Other Hybrid Forms
While the L3C, benefit corporation, and flexible purpose corporation have been the most prominent hybrid forms in
The other two significant hybrids are not found in
Going back even further, the Belgian Federal Parliament created the Société à Finalité Sociale (SFS) in 1995. The SFS is one of the earliest attempts to provide a platform for social enterprise by bridging the gap between forprofit and nonprofit entities.71 The SFS allows more flexibility in carrying out commercial activities than the Belgian nonprofit form allows, but, like the British CIC and unlike its U.S. counterparts, it caps the distribution of profits to investors, and upon dissolution the disposition of assets is controlled to ensure that net earnings remain dedicated to charitable purposes.72 Unfortunately, the SFS form offers no significant advantages to offset its strictures, and so apparently has been largely eschewed by entrepreneurs.73
None of these hybrid entities, whether the L3C, the benefit corporation, the flexible purpose corporation, or the other forms in
II. TAXATION OF FOR-PROFIT AND NONPROFIT ENTITIES
The federal income tax system-and to a lesser extent the various state tax systems-treats entities organized to generate profits for the benefit of investors very differently from the vast majority of entities organized as nonprofits. For these purposes, a nonprofit entity is generally defined as an organization that is subject to the "nondistribution constraint," a term coined by
A. Current Tax Treatment of For-Profits and Nonprofits
While
In contrast, the vast majority of nonprofit entities are exempt from federal income tax on all or almost all of their net income.84 While qualification for exemption is limited to nonprofits that are organized and operated in a manner that fits within one the available categories of tax exemption, the number and breadth of these categories is such that almost all nonprofits fall within one.85 State income tax exemption usually follows from federal income tax exemption, although there are exceptions.86 Exemption from other types of state and local taxes is generally limited, however, to nonprofit entities that further charitable, educational, religious, or other public-benefitting purposes and so qualify as § 501(c)(3) tax-exempt organizations under federal tax law, although there may be further limitations.87 Similarly, the ability to receive tax-deductible contributions is also generally limited to nonprofits that qualify as § 501(c)(3) tax-exempt organizations. 88
To ensure that only qualified organizations receive these benefits, a number of significant limitations accompany them under federal tax law, particularly for charities that qualify under § 501(c)(3). These include requirements that the organization be both organized and operated to further the purpose for which exemption is granted and various other limitations on activities.89 For the purposes of this Article, the most important current limitation is that while a tax-exempt organization may earn a profit, it may not, consistent with state nonprofit laws, divert any such profit away from its mission to inappropriately benefit any private party.90 This limitation prohibits a tax-exempt organization from both having owners who have a right to a share of the organization's profits and paying more than reasonable compensation for services to the organization's directors, officers, and other employees.91 Nonincidental benefits running to insiders are commonly referred to as "private inurement" in keeping with the terms of § 501(c).92
A tax-exempt charity is also generally prohibited from operating for the private benefit of outsiders as well-other than the beneficiaries it is intended to aid.93 This prohibition is subject to reasonable limitations in order that it may not hamper the organization's ability to procure goods, services, and financing through arm's-length transactions.94 A tax-exempt organization may even enter into a joint venture with profitmaking entities in order to further its mission, so long as the activities of the partnership are not shown to confer a disproportionate benefit on any non-exempt partners.95
1. Taxing between the lines of for-profits and nonprofits
So what happens if the lines between for-profit and nonprofit entities are blurred? For example, what happens if an otherwise taxable, for-profit entity chooses to engage in charitable activities? In this situation, the tax treatment of such expenditures is governed by § 162, relating to business expenses, and § 170, relating to charitable contributions. According to the language of § 162(b), § 162 deductions for business expenses and § 170 contributions are mutually exclusive.96 A number of revenue rulings dealing with the division between § 162 and § 170 have held that the allocation between the two sections is controlled by the extent to which the expense is connected with normal business activities.97 In the case of corporations, the line between § 162 and § 170 has been defined by the benefit that is expected to accrue to the corporation as a result of the transfer.98 Corporations do not necessarily need to show that the expense was a result of "disinterested generosity," but only that it was not made in anticipation of some future return on the investment.99
As a result of these rules, direct spending on charitable activities-for example, buying lunch for employees who participate in a charitable event such as a
Generally speaking, businesses will prefer, and so will usually try, to deduct expenses under § 170(a) for two reasons. First, there is the advantage of appearing to be concerned with social responsibility, thereby garnering consumer goodwill.103 Second, the forced capitalization of some expenses under § 263 may make it more advantageous to characterize expenses as charitable contributions under § 170 as long as the charitable contributions of the corporation do not exceed the ten percent of taxable income limit on C corporations with respect to deducting such contributions.104 In practice it appears to be relatively rare for the
What about the opposite situation, when an otherwise qualified tax-exempt organization engages in some modest amount of profit-seeking activity that does not further its exempt purposes? Here the unrelated business income tax (UBIT) applies. UBIT is levied on revenues from a "trade or business," "regularly carried on," that is "unrelated" to the purpose for which an exempt entity is organized and operated.106 The introduction of UBIT in 1950107 allegedly was motivated by dual desires to eliminate unfair competition between exempt nonprofits and taxable entities as well as to protect tax revenues.108 Others have argued that those rationales are unconvincing because (1) UBIT does not apply to activities related to the exempt purpose which may be undertaken in direct competition with for-profit counterparts-think daycare centers and hospitals; (2) at the time, almost no one was actually complaining about unfair competition from charitable nonprofits; and (3) the entities actually benefitting from the abuse of tax-exempt status through various arbitrage schemes were for-profits that largely evaded
Active involvement in non-exempt activities will not threaten exemption so long as that activity "is in furtherance of the organization's exempt purpose . . . [and] the organization is not organized or operated for the primary purpose of carrying on" that non-exempt activity.111 Courts have been willing to back up the
When it comes to joint ventures involving both nonprofit and for-profit entities, the activities of the partnership are attributed to the nonprofit both for purposes of assessing UBIT, as well as considering the effect of participation on exempt status.114 If the assets dedicated by a tax-exempt nonprofit to a partnership are substantial and the activities of the partnership are a significant part of the participating nonprofit's overall activities, then involvement in the partnership may place the nonprofit's tax-exempt status at risk.115 The nonprofit can avoid this result by demonstrating sufficient control over the activities of the partnership to ensure that those activities further appropriate exempt purposes.116
2. Rationales for the differing tax treatment
Given the amazing diversity of nonprofits, and even charities, that exist, it is hardly surprising that different theories have been put forward at different times to explain their emancipation from the burden of taxation.117 The most widely promoted justifications for tax exemption fall into two general categories: the subsidy theory and the tax-base theory.118 The subsidy theory is more widely accepted, but the tax-base theory has the merit of explaining the grant of tax exemption to a number of organizations for which the subsidy theory fails to offer a clear rationale.119
a. Subsidy theory
The subsidy theory in its most basic form posits that tax exemption and the other tax benefits provided to charities are the government's way "of subsidizing particular services-such as health care, education, research, and aid to the poor-that nonprofit organizations often provide," rather than providing them directly.120 A general subsidy for eleemosynary activity broadly defined is a useful way for the government to offer both symbolic and substantive, albeit indirect, support for certain public goods, when the usual market for goods and services does not supply them and a lack of political will for direct support prevents government from filling the gap.121 In the 1960s, the observation that tax subsidies can be analyzed more easily as direct government expenditures added to subsidy theory and created an increased interest in measuring the effectiveness of these so-called "tax expenditures."122 The federal government prepares a budget annually to account for the tax revenue "spent" by the government for the benefit of the public through various provisions of the tax code, including the charitable contribution deduction.123
Another take on government subsidy, referred to as the "capital subsidy theory," posits that these tax benefits can compensate for the inefficiencies created in capital markets by the constraints imposed on nonprofit entities by federal tax law.124 The inability of nonprofit organizations to distribute earnings to owner-shareholders limits external financing sources to debt instruments, grants, and donations.125 Even recourse to debt instruments can be hindered by the fact that many nonprofits are not viewed as favorable investments by creditors concerned with the riskiness of investing in an organization lacking access to other reliable sources of capital.126 Relief from income taxes thus allows nonprofits to more quickly build up retained earnings as a source of funds to promote their purpose.127 Exempting donors from personal income taxes on contributions made to § 501(c)(3) organizations also helps to increase financial support through donations, in the absence of easy access to other capital.128
While the subsidy theory is intuitive and defensible, it has certain serious shortcomings. For example, if tax exemption is a de facto government subsidy, then are tax-exempt churches being subsidized by the government?129 Further, can the government withdraw tax-exempt status from politically disfavored entities and grant it to politically favored ones?130 Also, how much benefit does the subsidy-both exemption and deductibility of charitable contributions- generate as compared to the cost it imposes on the federal and state treasuries? Consideration of these issues is, however, well beyond the scope of this Article.
b. Tax-base theory
The tax-base theory approaches the issue of tax exemption by beginning with the assumption that corporate income taxes are rightfully levied on enterprises that exist to produce revenues for private benefit.131 Under this assumption, entities that are not organized for private profit and whose net income is inherently indeterminate should fall entirely outside the realm of taxable organizations.132 This explains tax exemption for entities that engage in activities that the government is prohibited from having a hand in, or towards which the government is simply indifferent.133
A slight variant of the tax-base theory also solves the paradox presented by the subsidy theory with respect to deductions for charitable contributions. These deductions seem disproportionately to benefit the wealthy and give donors-again, mostly the well-to-do-the ability to direct government subsidies.134 Tax-base theorists argue, however, that personal income taxes are intended "to reduce private consumption and accumulation in order to free resources for public use."135 Because donations are put to public use,136 they should be excluded from the tax base if tax is only to be levied upon personal 137 consumption.
Roughly speaking, the subsidy theory therefore looks on tax benefits as a legislative grace that relieves tax-exempt entities of the taxes that they would otherwise rightfully owe, thereby rewarding them for the public benefit that they provide. The tax-base theory, on the other hand, adjusts tax liability according to a more nuanced consideration of what amount of income is appropriately included in the normative base upon which tax is calculated: earnings of-and donations to-public-benefitting entities are simply not a part of the base. Regardless of the exact rationale that one accepts for the tax benefits provided to nonprofits-and none of the explanations fit the existing scope of these benefits perfectly-the benefits and the continuing distinction between for-profit and nonprofit entities are a firm part of the federal and state tax landscape.
B. Current Tax Treatment of Hybrids
Because hybrids are not specifically addressed by existing federal or state tax laws, their current tax treatment must be discerned from the general rules governing for-profit and nonprofit entities discussed above. Since benefit corporations and flexible purpose corporations are formed under existing state corporation laws while L3Cs are formed under existing state limited liability company laws, and since these state law differences generally lead to somewhat different federal tax treatments, it is best to consider them separately.
1. Benefit corporations and flexible purpose corporations138
Both benefit corporations and flexible purpose corporations are formed under the corporation law of their respective states, although with the special provisions noted previously. Because they have owners with rights to share in the entities' profits, they do not comply with the nondistribution constraint. This means they are not nonprofit corporations and so are not eligible for exemption from federal income tax under any of the currently available categories. As a result, and since they are organized as corporations under state law, federal tax law requires that they be classified either as an S corporation or as a C corporation for federal tax purposes.139
As with other types of state law corporations, whether a benefit corporation or a flexible purpose corporation can choose S corporation status depends on whether it meets the eligibility requirements for that status. Those requirements include: having no more than 100 shareholders; having only shareholders who are U.S. citizens or residents, tax-exempt organizations, or certain trusts; having only a single class of stock such that ownership rights between shareholders vary only based on the number of shares owned; and filing the required
If a benefit corporation or flexible purpose corporation is required to be a C corporation because it does not meet one or more of the S corporation requirements, then the organization will be subject to the federal corporate income tax and its state equivalent, if any. The fact that the organization may have publicbenefitting goals as well as profitmaking goals is currently irrelevant for federal and state tax purposes. Such organizations will therefore calculate their taxable income and the tax owed on that income in the same manner as any other C corporation, including with respect to any expenditures for charitable or other public-benefitting purposes.
If instead a benefit corporation or a flexible purpose corporation is eligible to choose S corporation status and in fact elects to do so, then the income and permissible deductions of the organization pass through the corporation to its shareholders. Taxable shareholders, such as individuals, then include their portion of that income and those deductions on their individual tax returns. If the income exceeds the deductions and the taxable shareholder does not have other deductions that she can use to offset the excess, she pays tax on that net income. Furthermore, shareholders that are themselves tax-exempt organizations also generally owe tax if the income allocated to them exceeds the deductions allocated to them from the organization. This result occurs because when
The bottom line is therefore that the net income earned by a benefit corporation or a flexible purpose corporation will be subject to federal income tax, and generally state income tax, either at the corporation level-if the organization is classified as a C corporation-or at the shareholder level-if the organization is classified as an S corporation. This result applies even if the organization is classified as an S corporation and the shareholder at issue is a taxexempt organization.
2. Low-profit limited liability companies146
L3Cs are formed under state limited liability company statutes, although with the modifications noted previously. Domestic for-profit entities that are not corporations, including limited liability companies and partnerships of all types, may generally choose either to be classified as a partnership for federal tax purposes (the default option) or as a corporation and, if they choose corporation status, either to be classified as a S corporation (if eligible) or as a C corporation.147 If such an entity does not choose corporation status and only has a single owner, however, it will be disregarded for federal tax purposes and its activities and income will be attributed to its single owner. If a single individual owns and operates a for-profit enterprise, either directly or through such a disregarded entity, then that enterprise is considered a sole proprietorship, with all of the income and deductions associated with that activity attributed to that individual and included on her individual tax return.
As with limited liability companies generally, the default federal, and usually state, tax rule is that L3Cs are treated either as partnerships or, if they have a single owner, as disregarded entities for tax purposes.148 As a result of this treatment the income and permissible deductions pass through the L3Cs to their owners, who then include that income and those deductions on their tax returns and, if net taxable income results that is not offset by other deductions, the owners will owe tax. Unlike S corporations, however, those owners may include any type of individual or entity and the allocation of income and deductions between owners may vary significantly, and may even be different depending on the type of income or the kind of deduction at issue. This attribute of L3Cs may be particularly attractive, since L3C advocates promote L3Cs as being particularly amenable to a tranched finance structure whereby private foundations make high-risk, low-return PRI infusions into the L3C, thereby attracting socially minded and traditional market members who make lower- risk and higher-return investments.149 L3Cs, like limited liability companies generally, can, however, also choose to be taxed as corporations (C or, if eligible, S), in which case the tax consequences are the same as noted above for benefit corporations and flexible purpose corporations.150
If an L3C is treated as a partnership or disregarded entity and one or more owners are tax-exempt nonprofit organizations, certain special rules apply. First, if the L3C is a disregarded entity with a tax-exempt organization as its sole owner, then the L3C's income, deductions, and activities are treated as those of the sole owner. The most important ramification of this treatment is that the owner's tax-exempt status can therefore be compromised by the L3C's activities. In general terms, this will occur if some or all of the activities of the L3C do not further the purposes that qualify the owner for federal tax exemption (the owner's "exempt purposes") and those activities are so significant when compared to all of the activities of the owner that they result in the owner having a substantial non-exempt purpose.151 The creators of an L3C are unlikely, however, to limit the L3C to a single, tax-exempt owner because by doing so they are failing to take advantage of a hallmark of the L3C form-the ability to attract additional capital from a number of investors seeking to both do good and do well.
The more common form is therefore likely to be an L3C that is treated as a partnership and that has taxable and also possibly tax-exempt owners.152 If an L3C has only taxable owners, the tax effects for the owners are the same as for any partnership. If some of the owners are tax-exempt entities, the activities of the L3C are attributed to the tax-exempt owners as well as their share of the L3C's income and deductions. The tax effect of this attribution depends on whether the L3C's activities are considered to be in furtherance of the taxexempt owner's exempt purposes. Initially the
For a tax-exempt organization that is part owner of an L3C classified as a partnership for tax purposes, this result means that whether the tax-exempt organization's share of income is taxable (as unrelated business taxable income), and whether its participation might threaten its tax-exempt status if the L3C's activities become sufficiently large as compared to the organization's overall activities such that they indicate the organization has a substantial non-exempt purpose, depends on a careful examination of the tax-exempt organization's role with respect to the L3C. The
As noted previously, the supporters of the L3C form also hoped it could simplify the making of program-related investments (PRIs) by private foundations. To date, however, the
3. Conclusion
As the above discussion demonstrates, the creation of these new hybrids does not create any new tax categories or treatments. The different types of hybrid corporations (including
III. SHOULD HYBRIDS RECEIVE SOME OR ALL OF THE TAX BENEFITS RECEIVED BY CHARITIES?
To date, statutory hybrids have not been granted tax-favored status in any jurisdiction. The Hawaiian legislature included exemption from state income tax as an attribute of the hybrid form in its unsuccessful first attempt to pass benefit corporation legislation.158 That idea met with public scorn, however, with an editorial stating "[t]he [tax exemption] proposal is, at best, silly and unproductive, and at worst, a loophole through which more business-paid tax revenue could leak needlessly," and ultimately the exemption provision was one of the stated reasons for the governor's veto.159
For the reasons detailed in this Part, however, granting the tax benefits that nonprofits and particularly charities currently enjoy to these new hybrid forms would be a mistake that would harm not only the public fisc, but also charitable nonprofits, and even the very hybrids that proponents of such benefits support. The arguments in favor of granting such benefits are attractive on their face: what should matter is not legal form but providing public benefit; investors in hybrids are taking on a risk for the benefit of society and so should be supported by society in doing so; and state law provisions governing hybrids ensure sufficient public benefit. The problem is that upon closer examination it becomes clear that either the federal government would not be able to ensure that the recipient hybrids would in fact provide the public benefits that justify providing these kinds of tax benefits in the first place, or the restrictions the federal government or state governments would have to impose to ensure such public benefits would undermine the very flexibility that is the main attraction of these hybrid forms. There are, however, other modifications that should be made to the existing federal tax laws in order to accommodate the unique characteristics of these hybrids. These modifications include either increasing the limit on deducting charitable contributions for hybrids classified as corporations for federal tax purposes, or permitting such entities to deduct more of their charitable spending as business expenses. They also include eliminating the automatic classification of S corporation income as unrelated business taxable income for tax-exempt shareholders when the income arises from ownership in a hybrid classified as an S corporation.
A. Arguments in Favor of and Against Tax Benefits for Hybrids
Arguments have arisen from various quarters that hybrids, being formed explicitly for the purpose of promoting a public benefit, should be eligible for tax exemption and possibly other tax benefits.163 The idea of extending tax exemption to for-profit entities that pursue public-benefitting goals is not new, but the rise of hybrids has changed the legal landscape.164 Hybrids-which are formed explicitly for the purpose of promoting a public benefit-present a particularly compelling case for tax preference. One of the main rebuttals to such a proposal used to involve citing the paucity of for-profit charities, but that counterargument is no longer effective in light of the existence of hundreds of hybrids.165
A deeper look, however, reveals fatal flaws that render the case for extending tax benefits to hybrids far from compelling. The heart of the problem is that it is difficult both to define "public benefit" and to enforce a public benefit requirement absent the type of limitations imposed on charitable nonprofits. More specifically, defining public benefit becomes problematic once it is no longer associated with a nonprofit legal form. In addition, there is insufficient justification for shifting the risk for seeking such public benefit from presumably knowledgeable funders to the generally uninformed taxpaying public absent strict limitations designed to ensure a resulting public benefit. Furthermore, other mechanisms, such as the hybrid enabling statutes, are insufficient to ensure that public benefit is indeed provided. Finally, there would likely be significant and negative ramifications for both hybrids and tax-exempt nonprofit organizations more generally if even a small subset of hybrids that enjoyed significant tax benefits failed to fulfill their public benefit promise.
1. The difficulty of defining public benefit
Hybrids are meant to create public benefits similar to those expected of other tax-exempt organizations. Benefit corporations must "create a material positive impact on society and the environment,"166 and L3Cs must "further[] the accomplishment of one or more charitable or educational purposes within the meaning of Section 170(c)(2)(B) of the Internal Revenue Code."167 Proponents of expanding the availability of tax benefits therefore argue that the business form chosen should not impact the decision to reward them for the public benefit they provide.168 Or, phrased in a slightly different manner: subsidy through exemption and the ability to receive tax-deductible contributions should be based on a showing of public benefit, rather than nonprofit form.169 Whether an entity is for-profit or nonprofit, it still lessens the cost to the gov- 165 166 167 168 169 ernment of providing the same benefits, one of the basic justifications for tax preference under the subsidy theory.170
A number of scholars have pointed out the difficulties inherent in making the dividing line between taxable and tax-exempt activities exclusively a matter of function, however.171 The broad language of § 170(c)(2)(B) and § 501(c)(3) guides the evaluation of organizational aim, but gives no guidance on operational matters or allocation of assets. The nondistribution constraint, voluntarily accepted, provides concrete evidence that the founders and contributors of a venture are not out for their own private good, but for the good of others. If the nondistribution constraint is eliminated, it is crucial to have a substitute that will objectively demonstrate the intent to seek public benefit first, and to seek personal compensation only incidentally.172 Otherwise, almost any profitmaking venture could reasonably argue that it provides a public benefit even as its owners and managers conduct its activities so as to generate the maximum amount of profit for themselves; after all, economic activity generally benefits society in many ways, including by providing employment and desired products or services. Discussing the proposal to give hybrids the benefits of exemption, one commentator provocatively asks: "What would keep a coffee shop (community building), a soap company (health) or an insurance company (disaster protection) from becoming an L3C and thereby potentially getting tax exemption benefits?"173 This risk is heightened for the other types of hybrids, as their enabling statutes do not require a purpose found in § 170(c)(2)(B) and § 501(c)(3) but instead impose vaguer and broader purpose obligations that are not limited to the creation of public benefit within the meaning of those sections.174
Those who propose tax benefits for hybrids are following a valid intuition: companies that want to do good should not be penalized because of their form. What these commentators fail to recognize is that they may be setting two separate baselines in the wrong place. The first baseline, which we will call the "taxability baseline," has to do with tax treatment: is the proper baseline set at "income is taxable" or "income is not taxable?" The second baseline, which we will call the "responsibility baseline," defines what level of corporate good citizenship is expected of a for-profit entity.
As for the taxability baseline, if it is set at "income is taxable," then granting tax-exempt status (and deductibility of contributions for donors) is a reward. On the other hand, if the taxability baseline is set at "income is not taxable," then withholding tax-exempt status is a punishment. The subsidy theory explicitly presumes the taxability baseline for all entities and individuals is set at "income is taxable" and views exemption and deductibility of contributions as extraordinary grants from the taxing authority to compensate either for a public benefit known to be conferred by an entity or for some market irregularity. The tax-base theory also places revenues from profitmaking entities-which hybrids admittedly are-within the realm of the normative tax base.175 Under either theory, the taxability baseline for hybrids and their funders is therefore set at "income is taxable." Taxation is not a penalty. Whether hybrids guarantee a public benefit or suffer from market failure and so merit subsidy is a separate question treated below.
With regard to the responsibility baseline, the question may be phrased thusly: what must hybrids do beyond being responsible corporate citizens? If corporations are expected to be-and are generally viewed as being- impersonal, greedy, and irresponsible moneymaking machines, then a social enterprise that acts from motives other than the sheer maximization of profit is worth rewarding and could merit having tax benefits bestowed upon it.176 On the other hand, if we expect more from our corporate citizens, if we feel that for-profit entities have an obligation to comport themselves in a way that reflects a responsible balancing of profit and social or environmental values,177 175 176 177 then why should a social enterprise-which is merely living up to our expectations-be rewarded? There are laws prohibiting mistreatment of many stakeholders including employees, customers, and the community.178 If companies fall short of their obligations under these laws they should be penalized.179 Theoretically, companies could be rewarded for superlative performance with regard to these stakeholders, but neither benefit corporation nor L3C statutes actually impose specific standards for the requirement of heightened duty toward these stakeholders.180 They are more akin to aspirational statements that merely require that other stakeholders not be completely ignored in the singleminded pursuit of profits.
Paradoxically, the statutory requirements may still leave existing stakeholder interests imperiled. Imagine a benefit corporation with a very popular product that has a strong concern for the environment. It reduces its ecological footprint by investing in new green technology, but compensates for the cost by reducing profit margin, product quality, and employee benefits. This course of action would seem to be consistent with the demands of the benefit corporation statute because solicitude for the environment has been placed before profit- as well as before the investor, the consumer, and the employee. It would be next to impossible to show that the board violated its duty to "creat[e] general public benefit" by balancing the interests of the stakeholders in such a fashion.181 Every business decision involves a tradeoff between opposing values, and the permissive business judgment rule protects directors from liability ab- 178 179 180 181 sent gross negligence, demonstrable conflict of interest, or intentional misconduct.182 Hybrid statutes may actually exacerbate accountability problems by explicitly broadening directors' fiduciary duties and permissible considerations.183
The alternative to the existing structure would be to develop a much more specific public benefit requirement for hybrids to enjoy tax benefits similar to those enjoyed by charities, both in terms of what qualifies as a public benefit and what quantity of such public benefit would be required to obtain the desired tax benefits.184 This arguably is what some states are already doing with respect to nonprofit hospitals that seek to maintain their exemption from property taxes.185 As those state efforts demonstrate, however, developing such a requirement is no easy task under any conditions.
Moreover, such a requirement would undermine one of the much-touted benefits of hybrids, which is their flexibility to balance public benefit-broadly defined-and profit seeking as their leaders and funders choose. Hybrids are widely lauded for their ability to aid entrepreneurs seeking better solutions to social needs due to their simplicity and flexibility.186 Social entrepreneurs are interested in investing their time and money in bringing their ideas to fruition, not setting up their businesses. They also desire the flexibility to seek nontraditional approaches in conducting their business and to access a broad range of capital. The hybrid forms they have turned to were relatively tricky to simulate prior to the passage of enabling statutes, and the "blessing" of tax benefits could turn into a "curse" of new complexities and constraints that would defeat the purpose of these new forms.
2. Risk shifting and its problems
Entrepreneurs and investors who accept the constraints imposed by hybrid statutes in order to ensure the continuity of their enterprise's mission are taking on additional risk directly related to their desire to provide a public good. Like nonprofit organizations that are compensated for their acceptance of capital market constraints, particularly charities through the ability to receive tax-deductible contributions, supporters of extending tax benefits to hybrids can plausibly argue that these investors merit some compensation for their sacrifice.187 In a sense, they are giving up legitimate profits by limiting the means they will use to pursue them to those that confer a public benefit.
It has been argued that the difference between the profits realized and the profits that could have been realized is not taxable, just as a charitable deduction for the same amount would not be available.188 While this argument may be a valid point as far as the investor is concerned, it does not tell the whole story for the entity, however, because the cost of assets that will be used to produce revenues in future taxable periods must usually be depreciated over time.189 Consider the price tag to invest in, for example, environmentally friendly improvements and equipment for a factory. Given the time value of money, there is a significant difference between a charitable deduction today and depreciation deductions over the life of the property. Providing tax benefits would help offset this voluntarily accepted burden.
Others object that the social enterprise shtick is just part of the business plan, a public relations investment that will reap rewards in better business, much like an advertising campaign.190 Supporters of tax benefits respond that motive itself is really irrelevant to the granting of subsidy and that measurable public benefit flowing from an activity is the proper object of public subsidy, not benevolent motives regardless of their value.191 Society should support the creation of such public benefits by extending the tax benefits enjoyed by charities to hybrids, which are especially designed to provide public benefits as well as profits. For example, if an entrepreneur has an idea for a hybrid enterprise that will have a positive public impact, but the market will not support the creation of such an enterprise due to either capital or profit margin constraints, then perhaps the enterprise should receive a boost through public subsidy. Presumably the subsidy would flow to the publically beneficial goals of the enterprise since it cannot survive initially without them.192 A more sophisticated argument is that while social entrepreneurs will create (and in fact are already creating) some hybrids even in the absence of tax benefits, the level of creation is below the economically optimal level because some of the benefits from hybrids are captured by the public as a whole and not by the social entrepreneur.193 Providing tax benefits that increase the returns to investors will therefore encourage the creation of more hybrids (and greater investment in hybrids) and so bring the level closer to the optimal one.
One significant problem with this risk-taking argument is that if the entity turns profitable-which is obviously the hope of anyone who invests in a hybrid-the profits (and the subsidy) will flow to investors, providing a private benefit. Perhaps it will be enough to have some mechanism to turn off the subsidy once the organization stabilizes. Then again, maybe not. Why should the government "prime the pump" while investors sit by and wait for the funds to start flowing?194 The government should not be cast in the role of venture capitalist to seed any number of daring projects for private investors to pick up when they turn out well.195
Though at first glance tax-exempt bonds seem to serve a similar function, the differences are significant. The range of activities that can be funded with tax-exempt bonds that support private, as opposed to governmental activity, is sharply limited, as is the overall amount of such bonds that each state can issue.196 For example, such financing is generally limited to either receipt by certain types of facilities (some of which must be government owned) or use for certain types of purposes, including providing mortgage funds for veterans or purchasers of below-average-cost, owner-occupied residences, providing student loans, funding specific types of redevelopment, or funding property owned by charitable nonprofits used to further those nonprofits' exempt purposes.197 These limitations are designed to ensure sufficient public benefit to justify the subsidy provided by exempting the interest paid on these bonds from federal income tax, which in turn results in the borrowers having to pay significantly lower interest rates. At the same time, these limitations create such a complicated set of rules that the
Further, with the growing class of social investors to which many promoters of social enterprise point, a major justification for subsidy is rapidly disappearing. The capital subsidy theory dictates that tax benefits are meant to correct for broken capital markets, specifically the inability of nonprofits that can provide certain goods or services more efficiently than for-profit entities to access equity markets because of the nondistribution constraint.199 Hybrid entities are not of course subject to this constraint and therefore should have at least some access to equity markets; evidence of increased investor interest in hybrids indeed suggests that is in fact the case and so new tax preferences are therefore unnecessary. Moreover, as
With regard to risk taking for the sake of public benefit, there is little evidence that risk taking, in and of itself, is usually rewarded. There are certain tax credits and deductions available for investments that could be classified as high risk, but they are targeted at very particular goals, not risk taking generally.201 These traditional ways of extending benefits to for-profit entities, based on spe- cific criteria, are much more likely to be amenable to supervision and therefore to be an efficient and productive use of tax dollars.
Furthermore, the result of extending tax benefits to hybrids would in effect be to shift some of the risk from hybrid funders-who presumably are, or at least can be, well informed about the current and expected activities of such hybrids-to the taxpaying public as a whole. The latter group is unavoidably relatively uninformed about the activities of hybrids, including the extent to which any given hybrid is in fact pursuing public benefits.202 To some extent this ignorance could be overcome by deploying some of the regulatory tools applied to existing charities: detailed and publicly disclosed information returns (
3. State hybrid statutes and other forms of oversight are insufficient to ensure public benefit
Unlike constituency statutes, which are largely permissive, hybrid statutes seek to compel consideration of public purpose either in addition to or over and above consideration of profit.208 A traditional for-profit entity, professing a desire to do good when the economy is good, may turn fickle when the economy changes and abandon its best intentions.209 A hybrid, on the other hand, has public benefit locked in by virtue of the enabling statutes, so it should be trusted to stick to its mission in good times and bad. Furthermore, with L3Cs, the foundations that invest through PRIs should have a strong role in the governance of the entity to compensate for the risk involved in their participation.210 These factors could provide the assurance that is needed to extend tax benefits to hybrids, without burdening them with the strictures and additional regulatory oversight that creates such inflexibility in nonprofits.
The problem with this argument is that given the well-publicized difficulty of traditional for-profit and nonprofit directors to look out for the interests of a single constituency, it is hard to believe that hybrid directors and managers will be able to keep the needs of multiple constituencies balanced.211 Entity leaders have enough to think about aside from balancing the competing interests of private owners and the public.212 This concern is sufficient reason to divide entities into two camps and to limit tax benefits to nonprofits: for-profit directors and managers are expected to keep owners' interests foremost while charity leaders are expected to keep public interests foremost.213
In addition, different protective regimes are in place to regulate charities and for-profits, designed to achieve their goals through methods appropriate to the entities they protect. The theory from which securities law has developed is that maximization of shareholder wealth is the goal and measure of a healthy for-profit entity.214 The federal securities laws, state "blue sky laws," and the corporate common law-to which for-profits' everyday affairs are primarily subject-are intended to ensure that shareholders are able to look out for their own interests when they buy, vote, hold, or sell their stock.215 Meanwhile, the hallmark of a successful charity is that it expends the highest proportion of its resources possible in pursuit of its public mission. Various, primarily federal, tax rules-e.g., UBIT, penalties for excess benefit transactions, and the threat of the loss of exemption-as well as the supervisory role usually given to state attorneys general, grant authority to public representatives to keep charities faithful in their service of public interests.216
For-profit enforcement mechanisms, which are designed to protect private interests, are inappropriate in the context of guarding against abuse of a public subsidy. There is a misalignment of incentives for the investors who under traditional corporate law would have the authority to challenge hybrid directors' or managers' failure to adhere to the charitable mission: investors reap profits that may be limited by charitable goals.217 It is also hard to know how a court that is accustomed to framing shareholder suits in terms of liability for failure to maximize shareholder value would proceed with a claim that the company did not adequately protect other interests.218 Moreover, just because investors have below market expectations, that "should not be confused with donative intent or lack of an investor mindset."219 Some may be perfectly happy with the warm glow that comes from investing in a recognized social enterprise without worrying too much about precisely how much public benefit results.220
On the other hand, absent the nondistribution constraint, will nonprofit safety mechanisms work any better? At least one state has subsumed L3Cs into the charitable oversight of the attorney general.221 Attorney general oversight could potentially hold a hybrid responsible for fraud or ultra vires acts. Similar to the quandary faced by a court in the context of a shareholder suit, claims for fraud depend on cooperation from shareholders and presuppose some injury to their financial interests, both of which may be lacking.222 Pursuing a claim for ultra vires acts would also be an uphill battle when the directors or managers are not actually prohibited from making a profit for owners, as long as they do it in the pursuit of a charitable goal. As noted above, current hybrid statutes do not address the issue of how charitable is charitable enough, nor does it appear desirable for them to do so.223
Federal tax law controls like UBIT, penalties for excess benefit transactions, and threats of loss of exemption would be very difficult to apply to hybrids. Given their broad purposes and intentional flexibility, how would "unrelated business" be defined? Would there be a different standard for excess benefit transactions to allow for distributions to owners? For benefit corporations, pursuing commercial ends in a way that confers public benefit-rather than pursuing public benefit in a way that uses commercial tools to provide support and funding, as some charities do-completely negates the current judicial analysis of purpose versus activity and the use of tools such as the commerciality doctrine. On top of the substantive difficulties faced by these nonprofit enforcement mechanisms in dealing with hybrids, there is already criticism of their effectiveness in overseeing the traditional nonprofit sector due to a lack of resources at both the federal and state levels.224 Expecting this overtaxed system to take on the additional responsibility of reliably overseeing the hybrid sector would be costly and likely unrealistic.
It is possible that this concern with oversight could be addressed by strengthening the regulatory scheme for hybrids.225 For example, the creation of the British CIC was accompanied by the establishment of a dedicated regulator solely for such entities.226 Again, however, such a measure would run counter to the flexibility that is the hallmark of hybrids.227 If § 501(c)(3)-like benefits are granted to hybrids, the push for protective regulations will only increase, if only in a well-meaning attempt to guard the public fisc.228 As already discussed, neither of the regulatory schemes typically applied to forprofits or nonprofits fits very well with hybrid social enterprise. It is likely that some sort of "hybrid" regime might be concocted, and it is equally likely that it could spell an early demise for the hybrid project by regulating the benefits right out of the form.229
Relatedly, autonomy is a valuable feature of, and one justification for the existence of the charitable nonprofit.230 Opening the door to investors through tax-exempt hybrids could significantly impact the autonomy of the charitable form.231 Even if investors were only allowed into a limited sector of for-profit charities, their influence might easily be felt throughout the charitable sector. Extending tax benefits to their for-profit counterparts could have a destabilizing effect on charitable nonprofits. The effort to survive in this new milieu could precipitate changes in the practices of charitable nonprofits similar to those that would result from allowing investors direct access to them as they imitate the behavior of their for-profit counterparts.232
4. The risk of broken halos
Scholars often speak of the "halo effect" that comes with the nonprofit form, and with tax-exempt charitable status in particular.233 The public perception that charitable enterprises are valuable and deserve subsidy is vulnerable, however, and attempts by hybrid promoters to tap into that sentiment234 could have serious consequences. If tax benefits are extended to social enterprise based on appeals to charitable impulses, and hybrids' image becomes tarnished, the result could be a backlash against tax-based support for charity generally, and a growing reluctance to subsidize any charitable activity, whether nonprofit or for-profit.235
The microfinance phenomenon serves as a useful example of this risk.236 From meager beginnings, the movement grew with great public acclaim, culminating in the award of the 2006 Nobel Peace Prize to its most well-known proponent,
Giving hybrids the ability to receive tax-deductible donations could be even more problematic. Proponents of for-profit charities argue that dedicated entrepreneurs should be able to reap the rewards of the efficiency they will bring to the charitable arena by pocketing some of the "profit" created through their efforts.243 The use of the term "profit" in the context of a charity that accepts public contributions can be misleading, when the term really seems to mean excess donations that go into the founder's or investors' pockets rather than toward the donor's desired goal. The "profit" that the entrepreneur takes home is the difference between the actual cost of providing the public good in question and the overcommitment of resources to solving the problem. Donors may end up duped into feeling good about lining an entrepreneur's pockets because they received a tax break for donating to "charity," when what they really paid for was his
Commentators have also noted that for some of the current hybrid forms it is relatively easy for the owners to convert back to a standard, for-profit legal form. For example, a L3C can convert into an ordinary LLC merely by ceasing to meet the L3C special purpose requirements without any filing or notification requirements, while benefit corporations can make such a conversion by a supermajority vote of shareholders.245 If while in hybrid form the enterprise had received significant tax benefits, one price of those benefits arguably would need to be a requirement that they be transferred to an entity still eligible to receive them or repaid to the government if such a conversion occurs to prevent misdirection of those benefits (thereby further limiting the flexibility of the hybrid form).
As the above discussion makes clear, the combination of the current vague definition of public benefit, the risk shifting that providing tax benefits to hybrids would generate, and the difficulty of ensuring that all hybrids in fact provide meaningful public benefit creates a situation with significant potential for a substantial number of hybrids and their for-profit investors to take the tax benefits and leave the public benefit behind. While tax-exempt nonprofit organizations, including charities, are not free from such scandals, such occurrences among hybrids could have particularly troublesome results for two reasons. First, the hybrid legal forms are relatively new and not fully accepted-any such scandals could therefore easily undermine the limited support that these forms enjoy, and even lead to repeal of the existing statutes that permit their existence. Second, the tax benefits enjoyed by charities have had their share of critics and problems, so hybrids enjoying the same benefits could easily become fodder for broader criticism of those benefits being provided to all types of organizations, whether fair or not. Both supporters of hybrids and supporters of charities should therefore be wary of extending any of the tax benefits currently enjoyed by charities to hybrids.246
B. Tax Benefits for Hybrids as Hybrids
For all of the reasons detailed above, it would be unwise to extend the current tax benefits enjoyed by charities to hybrids. It would, however, also be unwise to simply ignore hybrids for tax purposes given that they are an increasing part of the legal landscape, and given that hybrids and the public may benefit from several modest tax accommodations that could be offered specifically for entities organized as L3Cs, benefit corporations, or their ilk. These accommodations would not be an attempt to extend the tax benefits enjoyed by charities to hybrids. They would instead be based on the unique character of hybrids as organizations with both profit-seeking investors and public-benefitting goals.
1. Modifying the deductibility of charitable contributions
The first accommodation relates to the deductibility of expenditures for charitable activities. Hybrids, like all for-profit organizations, are free to dedicate a portion of their profits to support charitable ends.247 Unlike individuals who may generally take a charitable contribution deduction for up to half of their adjusted gross income, such deductions by corporations are usually limited to ten percent of taxable income in any given tax year.248 One way to encourage hybrids formed as corporations249 to act on their charitable impulses would be to raise the limit on the deductibility of charitable contributions for these entities in particular.250 Investors in social enterprise are already committed to accepting a limited return on their investment-why not give hybrids more leeway in distributing their profits to charitable causes?
Alternatively, the sharp division between charitable giving and business expenses under § 162(b) could be softened for hybrid enterprises. As noted previously, in most cases the line between § 162 and § 170 is relatively bright.251 In the context of for-profit corporations, whose raison d'être is to make a profit for shareholders, such a rule dividing charitable expense and business expense is sensible. In the context of hybrid enterprises, however, which exist to promote both public and private benefit, there is less reason for such a sharp distinction. For a hybrid, it is possible for expenses to be "completely gratuitous" and "bear a direct relationship to the [hybrid's] business."252 The language of § 162(b) could be modified to allow hybrids to deduct amounts expended in pursuit of their charitable ends over and beyond the ten percent limit of § 170(b)(2)(A). Additionally, hybrids could be allowed to expense, rather than depreciate, assets dedicated exclusively to charitable ends to avoid the trap of § 263.253
2. Eliminating automatic UBIT for hybrid S corporations
One probably unintended consequence of the fact that two of the prominent hybrid forms are corporations under state law is that even if those firms qualify for and choose S corporation status all of their investors are taxed on their share of the hybrids' taxable income. This includes otherwise tax-exempt investors regardless of whether the activity of the S corporation would pass muster as furthering the charitable or other exempt purposes of the tax-exempt investor.254 While this tax treatment has the benefit of simplicity-a hallmark of the S corporation form more generally-it actually reduces the incentive for a taxexempt investor in such an entity to ensure that the hybrid in fact pursues its stated public-benefitting goal or goals. Consideration therefore should be given to whether satisfaction of requirements similar to those applied in the partnership context should be sufficient to exempt a charity's share of income (and gain) from its hybrid S corporation ownership from the otherwise applicable unrelated business income tax.255
3. Other possible modifications
Given the concerns raised by extending existing tax benefits enjoyed by charities to hybrids, it may also be advisable to revisit the limitations on charities engaging in profit-generating activity as an alternate means of providing support for social enterprise activity. For example,
CONCLUSION
The innovation of social enterprise-merging the charitable ends of § 501(c)(3) charities with the equity financing means of for-profit entities- may make it possible to expand charitable efforts to address growing societal needs. The efforts of entrepreneurs to seek new solutions through the creation of new hybrid legal forms should be recognized and encouraged. At the same time, extending nonprofit-type tax benefits to these new entities would be a mistake in that it could threaten the very benefits that their creators sought through their development. Tax preference is not a panacea that relieves all economic problems, but rather a targeted cure that can bring unwelcome side effects if wrongly prescribed.
There are already a number of opportunities under the current tax code and revenue rulings that are open to social enterprises and could assist them in their missions. These include existing tax breaks and the allowance for joint ventures between for-profit and tax-exempt charities. Hybrids that seek to provide affordable housing solutions, promote the production of electricity from renewable energy sources, find cures for rare diseases, or invest in neglected communities-among other charitable ends-already have tax credits tailor-made to their purposes.258 Further, for-profits may partner with nonprofits through joint ventures under the rules promulgated by the
1. See, e.g.,
2. See infra notes 39, 49 & 60 and accompanying text (summarizing criticisms of L3Cs, benefit corporations, and hybrids generally).
3. See DEBRA BOWEN, CAL.
4. See infra notes 41, 50 & 61 and accompanying text.
5. See
6. See, e.g.,
7. See, e.g.,
8.
9.
10.
11. See, e.g.,
12. See H.B. 3118, 23d Leg., 2006 Leg. Sess. § 10 (Haw. 2006);
13. See Hybrid Position Statement, INDEP. SECTOR, http://www.independent sector.org/hybrid_position (last visited
14. See, e.g.,
15.
16. See id. at 14 ("[T]he founders claimed that they did not really want to sell the company to Unilever, and that 'corporate law made them do it.'" (citing
17.
18.
19.
20. eBay
21. Constituency statutes were first introduced in the late 1970s and early 1980s simultaneously with antitakeover legislation, significantly in
In discharging the duties of their respective positions, the board of directors, committees of the board and individual directors of a business corporation may, in considering the best interests of the corporation, consider to the extent they deem appropriate:
(1) The effects of any action upon any or all groups affected by such action, including shareholders, employees, suppliers, customers and creditors of the corporation, and upon communities in which offices or other establishments of the corporation are located.
(2) The short-term and long-term interests of the corporation, including benefits that may accrue to the corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the corporation.
(3) The resources, intent and conduct (past, stated and potential) of any person seeking to acquire control of the corporation.
(4) All other pertinent factors.
15 PA. CONS.
22.
23.
24. Velasco, supra note 22, at 466-67 ("[A]t least on their face, most constituency statutes are silent on the shareholder's rights to elect directors and to sell shares.").
25.
26.
27. See Memorandum from
28.
29. See id. at 17;
30. See Our Story, supra note 10.
31.
32. See FLA. S. COMM. ON COMMERCE, AN OVERVIEW OF LOW-PROFIT LIMITED LIABILITY COMPANIES (L3CS) 8 (2010), available at http://www.flsenate.gov/Committees/ InterimReports/2011/2011-210cm.pdf (noting that the
33. Lang & Minnigh, supra note 28, at 16. The term "program related investments" specifically refers to investments that would be so risky as to jeopardize the foundation's legal classification, but are allowed if they are made for qualifying purposes.
34.
35.
36. Compare VT.
37. Kelley, supra note 26, at 372-73. Promoters of L3Cs have also pushed for federal legislation or regulation to create a presumption that L3Cs qualify for PRIs but without success.
38.
39. See, e.g.,
40. See, e.g.,
41. Here's the Latest L3C Tally, INTERSECTOR PARTNERS, http://www.intersectorl3c.com/l3c_tally.html (last visited
42.
43. See Legislation, supra note 3 (explaining the difference between benefit corporations and "
44.
45.
46.
47. CLARK, supra note 44, at 15. For a summary of the differences between the various benefit corporation state statutes enacted in
48. Cf. Kelley, supra note 26, at 372 (discussing the value of signaling in the context of L3Cs). There is, however, always the possibility that investors may change their outlook and vote out the directors; in fact, they may even vote to change the benefit corporation into a standard corporation, which is usually permitted with a two-thirds vote of shareholders.
49. See, e.g., Culley & Horwitz, supra note 39, at 2, 12, 19 (raising the risk that the public will mistakenly believe hybrid status equals governmental approval and questioning whether hybrids will increase or merely redirect charitable spending);
50.
51. W. DERRICK BRITT ET AL., CAL. WORKING GROUP FOR NEW CORPORATE FORMS, FREQUENTLY ASKED QUESTIONS: PROPOSED AMENDMENTS TO THE
52. Id. at 4.
53. Tozzi, supra note 9.
54.
55. Tozzi, supra note 9. Proponents of the flexible purpose corporation also argued that the specific requirement to promote environmental sensitivity could be inappropriate for an entity with a more narrowly defined mission, for example, targeted economic development in low-income neighborhoods. Id.
56.
57. Id.
58. Id.
59. Id.; see also About Prometheus, PROMETHEUS INST., http://prometheus.org/about (last visited
60.
61.
62.
63. See CORPS. & ASS'NS §§ 4A-1107 to -1108.
64. The L3C must be organized for "one or more charitable or educational purposes within the meaning of . . . [I.R.C.] § 170(c)(2)(B)," and the pursuit of profit may not be a "significant purpose." VT.
65. See 2012 Wash. Sess. Laws 1656-67 (codified as amended at WASH. REV. CODE §§ 23B.25.005-.150 (2013)).
66. Doeringer, supra note 11, at 312. A group including promoters of the British CIC and the American L3C are currently lobbying for the introduction in the
67.
68. Id. at 37-39.
69. Id. at 38-39.
70. REGULATOR OF CMTY. INTEREST COS., ANNUAL REPORT 2012/2013, at 19 (2013), available at https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/ 243869/13-p117-community-interest-companies-annual-report-2012-2013.pdf.
71. Doeringer, supra note 11, at 308-09.
72. Id.
73. Id. at 309.
74. See supra notes 11-13 and accompanying text.
75.
76. See, e.g.,
77.
78.
79. See generally
80. Unless the owner is itself one of these types of entities, in which case the taxable income generally will flow through to the next layer of owners.
81.
82. See JEROME R. HELLERSTEIN &
83. See id. ¶ 12.01 ("[R]oughly 40 percent of state sales tax revenues are attributable to business purchases.").
84.
85.
86.
87.
88. See STAFF OF JOINT COMM. ON TAXATION, supra note 27, at 155 (listing various tax benefits accruing to § 501(c)(3) organizations).
89.
90. See supra note 77 and accompanying text (describing this "nondistribution" constraint).
91. I.R.C. § 501(c)(3) (describing the most common type of tax-exempt nonprofit as an entity "no part of the net earnings of which inures to the benefit of any private shareholder or individual"); see also id. § 4958(c) (defining "excess benefit transactions"); Treas. Reg. § 1.501(c)(3)-1(f)(2)(ii) (as amended in 2008) (imposing a balancing test to determine whether organizations that engage in "one or more excess benefit transactions" will lose their tax-exempt status). Note, however, the development of "intermediate sanctions" in which certain key persons may be subject to penalties, but the organization itself may escape with its tax-exempt status intact.
92. See supra note 77 and accompanying text; see also I.R.C. § 4958(c)(4) (describing "private inurement" by reference to "excess benefit transactions" which involve persons having positions of influence within certain § 501(c) entities, or related persons).
93. See, e.g., Am. Campaign Acad. v. Comm'r, 92 T.C. 1053, 1078-79 (1989) (denying exemption to a school that trained campaign workers because most of the school's students subsequently worked for the
94. Any transaction or agreement with a third party for the provision of goods, services, or financing is likely to provide incidental benefits to the provider in the form of normal profits on the transaction. So long as the terms of the deal are reasonable, however, these types of transactions are not questioned, even if the benefit to the third party is significant. I.R.S. Gen. Couns. Mem. 39,862 (
95. See Plumstead Theatre Soc'y, Inc. v. Comm'r, 74 T.C. 1324, 1333-34 (1980) (holding that there was no impermissible private benefit conferred on non-exempt limited partners who entered into a partnership with a nonprofit theater company to provide funding for the production of a play in return for a reasonable share of any revenues), aff'd, 675 F.2d 244 (9th Cir. 1982). The
96. I.R.C. § 162(b) ("No deduction shall be allowed under subsection (a) for any contribution or gift which would be allowable as a deduction under section 170 were it not for the percentage limitations, the dollar limitations, or the requirements as to the time of payment, set forth in such section.").
97. Rev. Rul. 72-314, 1972-1 C.B. 44 ("Whether payments . . . are 'contributions or gifts,' within the meaning of section 170 of the Code, or are deductible as ordinary and necessary business expenses under section 162 of the Code depends upon whether such payments are completely gratuitous or whether they bear a direct relationship to the taxpayers' business and are made with a reasonable expectation of a financial return commensurate with the amount of the payment." (citing Treas. Reg. § 1.162-15(b)).
98.
99. Id. ("[W]e feel that the subjective approach of 'disinterested generosity' need not be wrestled with and we are of the opinion that our approach coincides perfectly with our reading of section 162(b)."); see also Dockery v. Comm'r, 37
100.
101.
102.
103.
104. See id. at 43-44; see also
105. Knauer, supra note 103, at 36.
106. I.R.C. § 511 (2012) (imposing UBIT on "unrelated business taxable income" (UBTI)); id. § 512 (defining UBTI as "income derived . . . from any unrelated trade or business . . . regularly carried on," less deductions "which are directly connected with the carrying on of such trade or business"); id. § 513(a) (explaining "unrelated trade or business" as "any trade or business the conduct of which is not substantially related [to the] purpose or function constituting the basis for . . . exemption"). There are many exceptions written into the UBIT statute that allow "appropriate" investing or are tailored to the peculiarities of various nonprofits. See, e.g., id. § 512(b) (excluding, inter alia, income from loans, royalties, rents, and most capital gains from the sale of property); id. § 513(a)(3) (excluding revenue from the sale of donated merchandise). There is also an automatic UBIT trigger for S corporation stock. See id. § 512(e) (characterizing income derived from the ownership or sale of S corporation stock as UBTI for most exempt organizations).
107. See Revenue Act of 1950, ch. 994, § 301, 64
108. Treas. Reg. § 1.513-1(b) (as amended in 1983) ("The primary objective of adoption of the unrelated business income tax was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete."); Brody, supra note 91, at 97 ("One congressman, referring to the infamous ownership of Mueller Macaroni by
109. See, e.g.,
110. Id. at 1544-45 ("The UBIT created a tax gradient, taxing the income from certain types of investment activities, but exempting others. . . . The expressly intended result was that charities by and large would avoid taxable activities and concentrate their investment activities in the exempt activities.").
111. Treas. Reg. § 1.501(c)(3)-1(e) (as amended in 2008); see also S.F. Infant Sch., Inc. v. Comm'r, 69 T.C. 957, 966 (1978) (holding that substantial non-exempt purpose, if inextricably linked and necessary to exempt purpose, will not destroy exemption); I.R.S. Gen. Couns. Mem. 34,682 (
112. See, e.g., Better Bus.
113.
114.
115. Rev. Rul. 2004-51, 2004-1 C.B. 974.
116. Id.
117. It is hard to imagine a unitary theory that would equally well explain exemption for the
118. Brody, supra note 107, at 585-86. But see id. at 586-87 (proposing an alternative sovereignty perspective that is implicit in the subsidy and tax-base theories but is also distinct from both).
119. See id. at 590-91.
120. Hansmann, supra note 77, at 66.
121.
122.
123. See, e.g., STAFF OF JOINT COMM. ON TAXATION, 112TH CONG., ESTIMATES OF FEDERAL TAX EXPENDITURES FOR FISCAL YEARS 2011-2015, at 9-10 (Comm. Print 2012), available at https://www.jct.gov/publications.html?func=startdown&id=4385. Note, however, that exemption is only considered a tax expenditure when it applies to "organizations that have a direct business analogue or compete with for-profit organizations organized for similar purposes," id., and so tax exemptions for many nonprofits are not included in this annual accounting. See also infra notes 131-32 and accompanying text.
124.
125. Id. at 72.
126.
127. Hansmann, supra note 77, at 73-74. Hansmann claims that retained earnings may be a good measure of the demand for a nonprofit's services and therefore a way to provide subsidy proportional to the need that the entity fulfills. Id. at 74. In the case of many charitable nonprofits there is a certain perverseness to this benefit, however, in that it is more valuable to entities that are successfully earning a return on their activities, while it is of no value at all to those that fail to show any earnings simply because they are directing a higher percentage of their resources into charitable services. Cf.
128.
129.
130. See id. at 590-91.
131.
132.
133. See supra note 129. The sovereignty perspective articulated by Brody offers another compelling alternative. With respect to mutual benefit organizations that benefit primarily their own members instead of the public at large, they are more straightforwardly seen "as conduits through which the members pursue their own ends." Bittker & Rahdert, supra note 131, at 306 ("The activities of such an organization should be imputed to its members as though there were no intervening entity."); see also STAFF OF JOINT COMM. ON TAXATION, supra note 123, at 10 ("The tax exemption for certain nonprofit cooperative business organizations, such as trade associations, is not treated as a tax expenditure just as the entity-level exemption given to for-profit pass-through business entities is not treated as a tax expenditure.").
134.
135. Id. at 313.
136. Even if the ultimate beneficiary of a charitable donation does use the funds for private consumption, it makes better sense to tax the donation at the donee's marginal rate- likely zero. Id. at 347 ("[T]he consumption or accumulation of real goods and services represented by the funds in question has been shifted to the recipients rather than the donor and should not be subjected to taxation at rates designed to apply to the donor's standard of living and saving."). Under the current law, however, a donee owes no taxes for receipt of a gift.
137. Andrews, supra note 134, at 351 ("[T]he charitable contribution deduction may be seen as eliminating from a taxpayer's return only that consumption which he shifts beyond the confines of his own household . . . ."). Earlier in his article, Andrews argues similarly that "[t]he personal consumption at which progressive personal taxation with high graduated rates should aim may well be thought to encompass only the private consumption of divisible goods and services whose consumption by one household precludes their direct enjoyment by others." Id. at 346.
138. The discussion in this Subpart applies equally to
139.
140.
141. See id. § 1361(a)(2) ("[T]he term 'C corporation' means . . . a corporation which is not an S corporation . . . .").
142. Id. § 512(e)(1).
143. Id.
144. Id.
145. S. REP. NO. 104-281, at 61 (1996), reprinted in 1996 U.S.C.C.A.N. 1474, 1535.
146. The discussion in this Subpart applies equally to Maryland's
147.
148.
149.
150.
151. See supra note 112 and accompanying text.
152. Letter from
153. See I.R.S. Gen. Couns. Mem. 36,293, at 10-11 (
154. See, e.g., Plumstead Theatre Soc'y, Inc. v. Comm'r, 74 T.C. 1324, 1333-34 (1980) (rejecting the government's argument that participation in a partnership with individuals and a for-profit corporation for purposes of producing a play meant the nonprofit involved was operating for private, rather than public, interests), aff'd, 675 F.2d 244 (9th Cir. 1982).
155. See Rev. Rul. 2004-51, 2004-1 C.B. 974-76 (ruling that, in a situation where only an insubstantial part of a tax-exempt organization's activities are housed in a partnership, it will be sufficient for the tax-exempt organization to only appoint half of the partnership's governing body if the tax-exempt organization has other means of controlling the substance of the partnership's activities to ensure those activities further the tax-exempt organization's exempt purpose); Rev. Rul. 98-15, 1998-1 C.B. 718 (suggesting that, in a situation where essentially all of a tax-exempt organization's activities are housed in a partnership, generally the organization's appointees must have voting control of the partnership's governing body as well as other powers sufficient to ensure the partnership's activities further the tax-exempt organization's exempt purpose).
156. See Rev. Rul. 2004-51, 2004-1 C.B. 974-76.
157. See supra note 40.
158. See H.B. 3118, 23d Leg., 2006 Leg. Sess. § 10 (Haw. 2006) ("A company incorporated as a responsible business corporation under this chapter shall be exempt from [ ] per cent of all corporate taxes . . . ." (omission in original)).
159. Editorial, supra note 12; see also Lingle, supra note 12 ("I am not willing to force taxpayers to subsidize an experiment of this sort.").
160. See 2011 Haw. Sess. Laws 682-88 (codified as amended at HAW. REV.
161. See
162. See supra note 11 and accompanying text.
163. See supra note 11.
164. See, e.g., Hansmann, supra note 77, at 66-67 (addressing the question, but rejecting such a policy); Malani & Posner, supra note 14, at 2023 (advocating "decoupling" tax exemption from the nonprofit requirement).
165. See, e.g.,
166. CLARK ET AL., supra note 44, at 15.
167. E.g., VT.
168. Cf. Malani & Posner, supra note 14, at 2023 ("[T]here is no reason to condition the tax subsidy for charitable activities on organizational form.").
169.
170. See supra note 120 and accompanying text. Some contend that for-profits are more efficient than nonprofits, as well.
171. See, e.g., Hines et al., supra note 169, at 1215-16 (discussing the value and widespread use of entity classification to govern treatment under tax law and law generally); see also Fleischer, supra note 76, at 231 (suggesting that "relying solely on Section 501(c)(3) to distinguish between charitable and noncharitable activities" would be an "administrative nightmare").
172. Fleischer, supra note 76, at 231-32.
173. Cohen, supra note 11.
174. See supra notes 47, 54 and accompanying text.
175. Even if the tax-base theory "accepts the challenge" to differentiate between the charitable and taxable activities of a § 501(c)(3) organization, Brody, supra note 107, at 591, this is hard enough to do in valuing the commercial activities of a charity, for example, for the purposes of applying UBIT. Imagine reversing the process to assign a value to the "general public benefit" of a for-profit; who will accept the challenge to define "Related Business Untaxable Income" for a hybrid? Cf. Leff, supra note 76, at 852 (arguing in the context of a for-profit charity that while one may conceive of a way to measure "dollars going directly to the beneficiaries, or count number of children benefitted, it is much harder to make such an evaluation when the donor wants to provide flexibility to enable the entrepreneur to use [assets] in the most beneficial way").
176.
177. This is by no means a new view of corporate responsibility. In 1932,
178. Among the many provisions that protect these stakeholders are employee benefit laws, labor laws, safety regulations, minimum wage laws, consumer protection laws, product liability laws, environmental regulations, and zoning regulations.
179. "The better role for government here is not to hand out candy to its model children in this paternalistic fashion. It's to create laws that draw the parameters of ethical behavior and establish the consequences for failure to comply. And it's to police these laws and see that justice is done." Editorial, supra note 12 (reacting to the introduction of legislation in
180. Though the statutes impose accountability and reporting requirements, there is- not surprisingly-no benchmark for a contribution to public welfare. See, e.g., VT.
181. See, e.g., id. § 3.01(a) ("Every corporation incorporated under this title has the purpose of engaging in any lawful business unless a more limited purpose is set forth in the articles of incorporation."); id. § 21.08(a)-(b) ("A benefit corporation shall have the purpose of creating general public benefit. . . . The articles of incorporation of a benefit corporation may identify one or more specific public benefits that are the purpose of the benefit corporation to create in addition to its purposes under subsection 3.01(a) of this title and subsection (a) of this section."). It is also unclear who could bring an action to challenge such a decision.
182. Even in the case of gross negligence, directors are usually protected by exculpation statutes. See, e.g.,
183. See supra note 23.
184. One scholar has suggested that hybrids could be required to engage in a minimum level of corporate giving merely to maintain their status. Murray, supra note 23, at 46 n.213 ("Few things speak louder on the issues of corporate priorities than how corporations allocate their resources.").
185.
186.
187.
188. See, e.g., Hines et al., supra note 169, at 1189-90 (stating that the low returns associated with social investing are similar to a tax deduction).
189.
190.
191. See id. ("It does not matter whether [the entity] (or its managers or shareholders) acts from altruistic or selfish motives; what matters is that the resulting activity produces social benefits.").
192. Leaving aside the possibility that the organization is simply inefficient, in which case the subsidy is simply supporting a failed or outdated business model.
193. This is essentially a version of the capital subsidy argument development by Hansmann.
194. Even having a special tax to recapture the subsidy previously provided by the government is probably not a workable solution for two reasons. The entity may end up regularly returning a small profit, but any extra burden would sink it. On the other hand, some enterprises may never turn profitable and investors may walk away, leaving the public holding the bag until the company folds.
195. Governor
196.
197. See id. § 142(a) (listing eligible facilities); id. § 142(b)(1) (requiring government ownership of some facilities); id. § 143(a) (mortgages for owner-occupied housing); id. § 143(b) (mortgages for veterans); id. § 143(e)(1) (purchase price limitation); id. § 144(b) (student loans); id. § 144(c) (redevelopment); id. § 145(a) (property to be owned by a § 501(c)(3) organization or governmental unit).
198. Tax Exempt Bonds Training Materials,
199. Hansmann, supra note 77, at 72-75.
200. Id. at 75.
201. See, e.g., I.R.C. § 45D (offering a tax credit for investments that assist "low-income communities or low-income persons"); id. § 1202 (offering a "[p]artial exclusion for gain from certain small business stock," which is very restricted in availability).
202. While there are public reporting requirements in place for benefit corporations, there are no corresponding requirements for L3Cs, compare, e.g., VT.
203.
204. See
205.
206. See generally
207. See supra notes 68, 72 and accompanying text.
208. See supra note 23 and accompanying text.
209.
210.
211. See generally
212.
213. Even if investors are aware that profit is not the name of the game, it is unlikely that they and the directors collectively will have complete unanimity of opinion as to just how much other interests will prevail over the goal of generating revenues, if only to make the enterprise sustainable and forestall a constant need of new capital. As one student note commented: "While the benefit corporation legislation to date provides a strong, basic framework for social enterprise, it may not do enough to encourage mission fulfillment, to guide directors and officers, or to assist prospective investors." Munch, supra note 187, at 188.
214.
215. See MELVIN ARON EISENBERG &
216.
217. Id. at 155.
218. Id.
219. Id. at 152.
220. For investors who are not so relaxed, there are numerous ways for them to ensure that their investments have sufficient positive social and environmental impact. See, e.g., MONITOR INST., INVESTING FOR SOCIAL & ENVIRONMENTAL IMPACT: A DESIGN FOR CATALYZING AN EMERGING INDUSTRY (2009), available at http://www.monitorinstitute.com/ downloads/what-we-think/impact-investing/Impact_Investing.pdf.
221. The Attorney General of
222.
223. See id. at 156-57 (noting that the "agency responsible for charities enforcement could have a different [interpretation] than the attorney general's office that pursues ultra vires acts" and suggesting that the two functions be consolidated).
224.
225. Obviously, this solution is subject to the caveat that it would require finding new enforcement resources or diverting them from existing enforcement regimes. Considering that there has been little push to strengthen the oversight of nonprofits in spite of widespread agreement that the sector is prone to abuse, see supra note 224 and accompanying text, it is even less likely that there is sufficient political will to come up with resources to support a new regime.
226. See supra notes 68-69 and accompanying text. Indeed, the British CIC is subject to regulatory oversight in spite of the fact that it does not receive preferential tax treatment. See U.K. DEP'T FOR BUS. INNOVATION & SKILLS, COMMUNITY INTEREST COMPANIES INFORMATION PACK 47-48 (2010), available at http://www.bis.gov.uk/assets/cicregulator/ docs/leaflets/10-1387-community-interest-companies-information-pack.pdf.
227. As it is, even if tax benefits are not granted, one scholar warns that there will be a strong "temptation to regulate" the L3C form if only to "protect investors, customers, and . . . the L3C brand itself from misuse." Schmidt, supra note 210, at 196.
228. The CIC Regulator is expected to engage in "light touch" regulation,
229.
subjecting L3Cs to unduly restrictive approaches that undermine the ability to earn and distribute profits and allow values to appreciate could impose artificial burdens on L3Cs. These burdens may discourage investors, create confusion for creditors, cause ambiguity among managers about fiduciary obligations, or otherwise interfere with the ability of legitimate L3C enterprises to succeed . . . .
Tyler, supra note 29, at 153.
230.
231. See id. at 94.
232. For example, it has been shown that the choice of medical services offered by nonprofit hospitals moves toward the mix of services more commonly offered by for-profit hospitals when the two types of hospitals share the same market.
233. E.g., Kelley, supra note 26, at 364; Reiser, supra note 25, at 2453.
234. See, e.g.,
235.
236.
237. The Nobel Peace Prize 2006, NOBELPRIZE.ORG, http://www.nobelprize.org/ nobel_prizes/peace/laureates/2006 (last visited
238. See, e.g.,
239. See, e.g.,
240. Malkin, supra note 238 (noting that some "are vilifying [the founders of Compartamos and their lending and collection tactics] as 'pawnbrokers' and 'money lenders'" ). The picture has not improved since.
241.
242. See, e.g., Lang & Minnigh, supra note 28, at 17 (stating that in seeking a name the creators of the L3C "wanted branding," and calling the L3C "the for-profit with the nonprofit soul"); Business FAQ's, BENEFIT CORP INFO. CENTER, http://benefitcorp.net/ business/business-faqs (last visited
243. See, e.g., Malani & Posner, supra note 164, at 2019 ("[I]f the charity raises
244.
245. Reiser, supra note 60, at 3-4.
246. There is also a very real danger that pressure from weakly regulated, newly exempt hybrids could push some traditional charities out of business altogether. Program-related investing, currently of limited interest due to strict expenditure responsibility rules, might become significantly more attractive to private foundations if tax-exempt L3Cs were able to offer artificially high rates of return, and especially if those rates of return came bundled with automatic PRI status.
247.
248. Compare id. § 170(b)(1)(A), with id. § 170(b)(2)(A). The limit on the deductibility of charitable transfers for corporations was fixed at five percent from the time it was introduced in 1935 until it was increased to the current ten percent limit in 1981.
249. This would include C corporation-like benefit corporations and other similar forms. L3Cs and other partnership-like forms-including S corporations-are not limited by the ten percent cap, but their owners may run into other difficulties that are addressed below. See infra Part III.B.2.
250. In 2005, there were efforts generally to raise the ceiling on the deductibility of corporate charitable giving to as high as twenty percent. See Charitable Giving Act of 2005, H.R. 3908, 109th Cong. § 103(b) (2005).
251. See supra notes 96-99 and accompanying text.
252. Cf. Rev. Rul. 72-314, 1972-1 C.B. 44 (noting that the ordinary test for determining whether a payment falls under § 162 or § 170 is "whether such payments are completely gratuitous or whether they bear a direct relationship to the taxpayers' business").
253. See supra note 104 and accompanying text. This could be accomplished either through a modification of § 179 or an expansion of § 168.
254. See supra notes 142-44 and accompanying text.
255. See supra note 155 and accompanying text.
256. Reiser, supra note 76, at 55. Reiser does not argue for an elimination of UBIT or existing property taxes on charitable property, only for the elimination of the threat of loss of existing exemptions. Id.
257. Id.
258. See, e.g., I.R.C. § 42 (offering a tax credit for the provision of low-income housing); id. § 45 (offering a tax credit for "electricity produced from certain renewable sources"); id. § 45C (offering a tax credit for drug testing for "rare diseases or conditions"); id. § 45D (offering a tax credit for investments that assist "low-income communities or low-income persons").
* Associate Dean and Professor of Law,
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