5 Hybrid Business Models

Turning a profit and contributing to the good of society have not always been aligned. For example, traditional corporations require those who run them to maximize profits. This profit-seeking “duty” is so central to the corporate identity that those who make decisions that end up hurting the bottom line can be held responsible. Luckily, entrepreneurs are no longer forced to choose between a for-profit and non-profit model; they can now take advantage of emerging hybrid business entities:

  1. Benefit Corporation;
  2. Social Purpose Corporation;
  3. L3Cs;
  4. Nonprofit with UBIT;
  5. Nonprofit with a for-profit subsidiary.

We call these organizations hybrid business entities because they allow companies to pursue both a profit and a social purpose. California’s two main hybrid entities are the Benefit Corporation and the Social Purpose Corporation.

The Benefit Corporation

A benefit corporation is a business with two purposes—to generate revenue and to pursue a social mission. Benefit corporations are for-profit and non-tax exempt entities and generally operate as a traditional C corporation. However, C Corporations solely seek to maximize shareholder profit—benefit corporations, on the other hand, must pursue a “general public benefit.” In short, a benefit corporation combines features of a for-profit and nonprofit entity and seeks to positively impact society and the environment, even if it sacrifices a profit to do so.

We’ve dedicated an entire article to benefit corporations, which you can read here.

Certified B Corporations

Although similar in name, a “benefit corporation” and a “Certified B Corporation” are very different concepts. A Certified B Corporation is a voluntary certification businesses may pursue to brand themselves as a socially conscious company. The certification initiative was created by the B Lab—a nonprofit organization dedicated to building a global community of certified B corporations who meet overall high standards of verified, social and environmental performance, public transparency, and legal accountability.  Thus, as described above, a benefit corporation is a type of business entity, whereas a “Certified B Corporation” must meet rigorous standards of social and environmental performance, accountability, and transparency to receive a “certified” stamp of approval, which can be used for marketing purposes.

The Social Purpose Corporation (SPC)

For those who dislike the benefit corporation because they consider the independent third party standard too “rigorous” a requirement, the Social Purpose Corporation is an alternative hybrid entity. Like the benefit corporation, the SPC allows companies to pursue social responsibility rather than mere shareholder economic value. The SPC offers a more flexible approach when it comes to balancing profitability and the pursuit of a social purpose because it creates its own annual report, without being subject to a third-party standard. In short, the SPC is similar to a benefit corporation, but with less bite. Here are some key distinctions and comparisons between the two entities to note.

Benefit vs. Social Purpose Corporations

Public benefit: A benefit corporation must pursue a “general” public benefit, which is a benefit that significantly and positively impacts society or the environment, as determined by an independent third-party standard. A social purpose corporation, on the other hand, must pursue a “special purpose,” which means any public purpose activity that a nonprofit pursues or any purpose that positively effects its employees, suppliers, customers, or even its creditors, the community, society, or the environment.

Annual reports for shareholders: Both benefit corporations and SPCs must prepare annual reports on how effective they are in achieving their purpose, but the standard used to measure success for both entities differs. An independent, third-party standard measures a benefit corporation’s success, whereas  SPCs may conduct their own assessment internally.

Directors Fiduciary Duties.  In traditional corporations, directors owe special duties to a corporation, known as fiduciary duties. As such, corporate shareholders may sue directors for breach of fiduciary duties if directors act contrary to maximizing shareholders’ profit. Benefit corporation directors also owe fiduciary duties, but such duties are subject to the corporation’s public benefit as well. This means that a benefit corporate shareholder may not sue a director for breach of fiduciary duty if the director acted towards pursuing the corporation’s public benefit at the expense of shareholder profit. SPC directors must act with the shareholder interests, the SPC’s special purposes, and its overall best interests in mind.  Unlike benefit corporation directors, SPC directors are not required to consider any particular public benefit related factors when addressing proposed actions.

Low profit limited liability company (L3C):

*Note the L3C is not a California entity option

In 2005, Robert Lang developed the low-profit liability company (the “L3C”), a hybrid business entity, which allows companies to “do well” and also “do good.” An L3C can pursue profit-oriented objectives, as long as those objectives are secondary to the L3C’s social goals.

Lang created the L3C as a win-win for private foundations and for-profit entities. In order to maintain tax-exempt status, private foundations must make “qualified distributions,” yet avoid high-risk investments. A “program-related investment” (PRI) is an investment for a purely charitable, nonpolitical purpose, which also counts as a “qualified distribution,” but not a high-risk investment.

This is where L3Cs come into play. Foundations and other tax-exempt organizations can more confidently invest in an L3C because the IRS will more likely consider these distributions as non-taxable PRIs.

Nine states recognize the L3C business entity: Vermont, Utah, Louisiana, Michigan, Illinois, Maine, Wyoming, North Carolina, and Rhode Island. Although California has yet to get on board, its benefit corporation and social purpose corporation provide similar hybrid forms.

Nonprofit with UBIT

Did you know nonprofits can actually make a profit? With a few caveats of course. By definition, the IRS will not tax a nonprofit’s income if generated from activities substantially related to the nonprofit’s exempt purpose. Additionally, a nonprofit can generate profit from activities not substantially related to the nonprofit’s exempt purpose, as long as it pays income tax on this profit. This Unrelated Business Income is known as “UBI” and the applicable tax is known as Unrelated Business Income Tax, or “UBIT.”  However, organizations generating too much UBI may lose their tax-exempt status since the IRS will view these entities as no longer being operated primarily for a non-exempt purpose.

What qualifies as UBI?

As mentioned above, nonprofits making profits will be taxed if their earned income is “unrelated” (earned income is any money brought in other than from donations or grants). A nonprofit’s earned income is “unrelated” when the income is not “substantially related to the organization’s exempt purpose.” What qualifies as an activity “substantially related” to your exempt purpose? Learn more here.

How much is too much?

Nonprofits must meet one of two tests in order to keep their tax-exempt status. First, a nonprofit may generate income without losing its tax-exempt status as long as one-third of its total revenue comes from public contributions. Moreover, an organization that receives less than one-third (33.33%) but more than 10% of its contributions from the public can still qualify as a public charity as long as it can establish that it normally receives a substantial part of its support from governmental units or the general public. For more information, here are links to the IRS’ two tests, the Public Support Test and the “Facts and Circumstances” Public Support Test.

Nonprofit with For-Profit Subsidiary

One way a non-profit organization may earn profits without jeopardizing its tax-exempt status is by creating a separate for-profit entity. The nonprofit would essentially own and somewhat control the subsidiary and, if properly structured, all distributions from the subsidiary to the parent nonprofit would be treated as exempt passive income. On the flip side, if these organizations are not properly structured and managed, then the IRS will treat all income distributed from the subsidiary to the nonprofit as “UBI” attributable to the nonprofit.

To qualify as passive income and not UBI, the parent-subsidiary must meet the IRS’ two-prong test:

  1. Bona Fide Purpose The subsidiary must be organized for some bona fide purpose of its own and not be a mere sham or instrumentality of the parent.
  2. Not an Instrumentality of ParentThe non-profit parent cannot so greatly control the subsidiary’s day-to-day activities that the subsidiary appears to merely act as the parent’s instrument.

The parent should not directly manage the subsidiary and both entities should maintain separate governance schemes, since the tax-exempt parent must take care not to create a subsidiary as its mere alter ego.

As you can see, this model creates a complex framework and requires ongoing diligence to maintain the separate entities. Failure to do so will change the income’s character from passive into UBI, and thus defeat the purpose of creating a subsidiary in the first place.

The emerging trend of social welfare combined with commercial enterprise has spun off new business models that pursue both social and financial goals. Hybrid organizations are relatively new in California, so stay tuned for further developments.

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