For Profit or Non-Profit or Hybrid?
Competitive practices between organisations have been amplified by the online market squeeze for the all important consumer traffic. That is why companies of all pedigrees are innovating to incorporate a non-profit 'hydrid' organisational structure in order to gain meaningful market distinction. This article examines the pros and cons of using such a diversified and broad-minded approach.
Historically, there was a clear distinction between for-profit and non-profit organizations: the former engaged in income generation, while the latter focused on philanthropic activities to address social issues and mostly avoided revenue generation. However, that divide has become less and less evident in recent years due to the growth of social companies. By focusing on economically viable business models, social entrepreneurs are challenging conventional wisdom about for-profit corporations and nonprofit organizations (by focusing on solving social issues).
You must choose whether you want to create your company as a for-profit or nonprofit organization, or possibly some kind of combination of the two, before you go on your quest to improve the world. Your best judgment as to the source of financing and your activity will primarily determine the answer.
The Classic Case
In order to manage the rapid expansion of the Firefox Web browser, the charity Mozilla Foundation established a for-profit subsidiary, Mozilla Corporation, in 2005. Currently, the for-profit organization earns around $104 million a year via revenue-sharing contracts with its search partners, which include businesses like Google and Yahoo. The open-source software is developed by the Mozilla Foundation, the company's only shareholder and recipient of just over $222,000 in philanthropic contributions each year.
Some for-profit businesses are establishing their own charities and foundations to oversee humanitarian endeavors as corporate responsibility initiatives have increased in popularity. A nonprofit and a for-profit are connected in the hybrid model. One may be a subsidiary of the other in some situations, while in others, the two parties may be tied together by long-term agreements wherein one party provides a fundamental requirement for the other and vice versa. Each entity is taxed separately from the others. As long as their tax-exempt status is recognized, nonprofits are still exempt from federal income tax as well as taxes in the states and municipalities where they operate. According to their corporate arrangements, for-profits are taxed.
Here are the pros, cons, and how they were formed for each.
Overview of Benefits
You can have your cake and save the whales at the same time. The organization maintains its eligibility for foundation grants and tax exemption. Angel investors and venture capitalists can provide the for-profit with unconstrained funding, and it can also give its nonprofit partner tax-deductible gifts. For-profit subsidiaries frequently have more flexibility than the revenue-generating divisions of NGOs because they are legally distinct companies. Additionally, they are not required to pay talent more than they feel is appropriate.
Option 1: Just For-Profit Businesses
For-profit organizations can be set up as ordinary C-Corporations, S-Corporations, Limited Liability Companies, Benefit Corporations, or Flexible Purpose Corporations (CA only).
The capacity to accept investments A for-profit business can have private owners, unlike a nonprofit. A company's equity, or ownership, may be divided and distributed among many people. Because of this, having a for-profit business may give you the opportunity to attract investors, including everyone from friends and family to angel investors and venture capitalists. A C-Corporation is the ideal legal form for receiving investments. S-Corps place limitations on who is permitted to own the company's stock. It's uncertain how having a Benefit Corporation as your legal form may affect your capacity to attract venture capital and angel investors.
Effect investors are drawn to triple-bottom-line companies because of their focus on social impact, even if some investors are extremely unfamiliar with this new entity form and have concerns about the exposure to risk due to the company's social commitment.
No restrictions on generating revenue. There are no restrictions on a for-profit company's ability to make money by offering goods and services, unlike a nonprofit. This may be a crucial consideration for businesses with a sizable anticipated stream of income, as too much income may jeopardize your nonprofit status (see below).
No capacity to accept grants or provide donors with a tax deduction.
One significant disadvantage of a for-profit business is that, in contrast to a charity, it is typically ineligible for foundation and government funds (one exception is Program Related Investments). A for-profit business is also not permitted to give donors tax deductions. This effectively excludes significant donors because they almost always want a tax deduction as a condition for gift, even though some people may still give regardless of the tax deduction.
Taxes. Taxes are another issue with for-profit companies (see Fees/Costs below). Although slightly relevant, this element shouldn't be the deciding reason for your entity type because choosing a nonprofit could result in the loss of some business prospects.
Fees/Costs. A little bit over $100 may be required to register a for-profit firm with the US government. This cost only applies once. A business must also pay a minimum amount of franchise taxes in each state where it conducts business ($800 in California and $350 in Delaware). This fee is yearly.
Formation. You must take the following actions in order to establish a for-profit company:
- Choose the state in which you want to incorporate your firm. Here are some details on the variables that affect that choice.
- To formally register as a corporation, LLC, or other entity, submit your organizational paperwork to the Secretary of State.
- Adopt all other required paperwork. Depending on the sort of entity, they could consist of bylaws,
- a secrecy and invention assignment agreement, an operating agreement, stock issuances, director consents, indemnification agreements, and others.
- Complete any additional required paperwork (such as a Statement of Information in California).
- Be eligible to conduct business in any state where you operate.
Option 2: Just Non-profit Organizations
A nonprofit can exist as other kinds of entities, but it typically still exists as a corporation (a nonprofit company). It differs significantly from a typical for-profit organization, though. There are many various kinds of nonprofits, and each one can accomplish a different goal, but the 501(c)(3) nonprofit is the most prevalent.
Possibility of obtaining grants and providing donors with a tax deduction. A 501(c)(3) nonprofit organization enables you to get donations from the government and foundations and to give donors tax deductions. Although they are theoretically tax exempt, other nonprofit organizations (such 501(c)(4) social welfare organizations) do not have this capability. This may be a crucial consideration for companies that work in industries where grants are frequently awarded (such as education) and where it is uncertain whether the company will be able to produce enough income to survive without them.
Limit on the production of income. The constraints on revenue generation that a charity for social entrepreneurs has may be its largest flaw. Here is a previous piece we wrote about how nonprofits can sell products and services.
In conclusion, a nonprofit is capable of selling goods or services. However, those portions of the organization's operations will be taxed if such sales are unrelated to its exempt purposes (as stated to the IRS in its tax-exempt application).
Additionally, the nonprofit runs the danger of losing its tax-exempt status if the unrelated revenue represents an excessively large amount of the organization's income. Unfortunately, there isn't a consensus on what constitutes "significant" for this analysis. Depending on the specifics of each case, the permissible amount may range from 5% to 75% of income, though it's best to keep it around 20%. For more details, consult the IRS regulations.
If at all possible, planning your IRS tax-exempt application in a way that anticipates the activity as part of your exempt purpose is the best way to avoid the issue of generating large revenue. However, if the IRS wants to inquire about your plan to make a sizable amount of revenue, telling them could cause a delay in processing your application.
Lack of Investment Capability. A nonprofit has no owners, hence there is no equity to distribute. This implies that you would be unable to recruit equity investors like angels and venture capitalists (although loans are still available).
Fees/Costs. Although a nonprofit does not pay taxes, the IRS application's government filing fee is close to $1,000. (this is a one-time fee).
Formation. You need to picture a two-step process in order to think of nonprofits accurately. The organization is first established as a nonprofit organization with the state. Second, the organization submits an IRS application for tax exemption. The group is not a tax-exempt organization and cannot solicit donations or provide tax deductions to donors until it actually receives a determination letter from the IRS. A non-profit would be created by:
- Submit your organizational papers to the Secretary of State for official nonprofit corporation registration.
- File a tax exemption application with the IRS (Form 1023), which can take a few months at the low end and a year or more at the high end (especially if the IRS has questions about revenue generating activities).
- Pass the bylaws.
- File a complaint with the Attorney General of California.
- Comply with continuous reporting obligations.
Option 3: A For-profit and a Non-profit Organization (Hybrid Structure)
Possibility of accepting investments, receiving grants, and providing donors with a tax deduction. As a result, you will be able to carry out both the organization's paid and pro bono services under the auspices of the for-profit company.
Grants and donations will be available to the nonprofit, and the for-profit can recruit investors, opening up a wider range of funding options.
No restrictions on activities that generate income. There is also no restriction on producing revenue as long as the activities are carried out for profit.
Complex Architecture. These hybrid structures' structure is what makes them challenging. There are two choices:
- Parent-Subsidiary. Make the for-profit a subsidiary owned by the nonprofit, with the nonprofit serving as the parent organization. To accomplish this, the non-profit would need to meet the criteria to become a "public charity," which requires that the majority of its funds come from public sources in order to meet the public-support requirement.
- Brother-Sister. Run the nonprofit and for-profit organizations separately.
Money can go from the for-profit to the nonprofit under either form, but not the other way around. The for-profit organization may make a financial contribution to the nonprofit (and reduce its tax obligation by up to 10% of net income). However, a nonprofit could not donate its finances to the for-profit because all of its assets had to be permanently committed to philanthropic purposes. However, the charity can pay fair prices to the for-profit to supply it with goods and services. Due of this, the business must keep meticulous records of all interactions between the two entities.
The main disadvantage of this hybrid strategy is that you would effectively need to manage two separate organizations, each with its own board of directors. This could be difficult administratively because it is better to avoid too much board overlap. (At Badaboost however we provide an option under French non-profit law which can obviate the need for yearly meetings regarding your non-profit should you elect to do so.)
Costs/Fees. You would be required to pay tax on the for-profit company's operations, and filing costs would include both of the charges mentioned in choices 1 and 2.
The typical course of action for an entity that isn't sure whether it should take the nonprofit, for-profit, or hybrid approach is to start with the nonprofit entity (as described in option 2 above) and wait to form the for-profit entity (as described in option 1 above), when it becomes possible or necessary to generate significant unrelated income or attract investors. Conversely however, should you see the benefits that a non-profit arm in your business can bring 'beneficially' then we always advice that you get more information in order to make the appropriate decision for your business.
To discuss the ideal strategy to set up your social enterprise as a hybrid structure, get in touch with us at Badaboost Ltd or outline your business aims on our Badaboost Intake Form here and get a tailored proposal from us within 24 hours.
DISCLAIMER: The material in this article is being provided for informative purposes only and should not be interpreted as, or used as a substitute for, professional legal advice. Under the applicable state legislation, this article can be considered attorney advertising.