Formerly Staff Attorney, Lawyers Alliance for New York
Legal Issues in Structuring Relationships Between For-Profit and Nonprofit Entities
Historically, in the United States, a corporation or other legal entity could only be created as either a nonprofit—whose purpose is exclusively to create social value—or as a “regular” entity that exists to maximize economic profit. In recent years, some jurisdictions have created new vehicles (such as the low-profit limited liability company “L3C” and the benefit corporation) in attempts to make room under one roof for both goals. Although the new vehicles are useful, engineering a bespoke structure using the traditional nonprofit and for-profit corporate forms can often better suit an organization’s goals.
A nonprofit and a for-profit entity can relate to each other in three principal ways:
- Ownership (i.e. a nonprofit entity can own a for-profit entity, although not the other way around)
- Board composition (i.e. having corporate directors or trustees in common)
- Contracts between them
All three methods can be deployed alone or in combination, and each has distinct advantages and disadvantages. The choice of methods will depend on your situation and goals, and you should confer with an attorney when (re)structuring your enterprise.
Ownership: A tax-exempt nonprofit endeavor may create and own a for-profit entity without necessarily jeopardizing the nonprofit’s tax-exempt status. For example, a nonprofit that sees an opportunity to engage in “commercial” activity to generate revenues to support the non-profit’s mission may elect to create a separate entity, which it (the nonprofit) will own, to pursue the commercial activity. The advantage of the ownership route is that it allows the sponsoring nonprofit to maintain a fairly high degree of control over the for-profit subsidiary. The disadvantages of the ownership route are, first, that it is only available when a nonprofit will own a for-profit: the reverse is not possible, as a nonprofit, by its nature, cannot be owned. Second, there can be unintended consequences for the nonprofit owner entity if plans are not reviewed in detail with an attorney prior to implementation.
Board Composition: In theory, there is no reason why a nonprofit and a for-profit entity, that will not do business together, could not have 100% of the same individuals on each of their respective Boards. If, however, the two entities will be entering into contracts with each other, there need to be Directors on the nonprofit Board who are not also on the for-profit Board. Those “non-conflicted” Directors will be crucial for approving transactions between the two entities and managing potential conflicts of interests that may arise for Directors who are on both Boards. The consequences for the nonprofit may differ depending on whether the “overlapping” Directors are in the majority or in the minority on the nonprofit Board. The prudent course for an entrepreneur considering “Board overlap” between a nonprofit and a for-profit would be to consult an attorney.
Contracts: Needless to say, nonprofits enter into contracts with for-profit companies all the time. There have been cases, however, where a court has held that a for-profit entity has restricted the activities of a nonprofit contracting partner so heavily that the for-profit entity actually controls the nonprofit, resulting in impermissible private benefit to the for-profit from the nonprofit’s activities. In a situation where the relationship between a nonprofit and a for-profit has other features of a close relationship—such as ownership or Board overlap, as discussed above—the goals and expected results of contracts between the two entities should be discussed with an attorney.
In conclusion, a social enterprise can make use of a separate nonprofit and for-profit entity by choosing a combination of ownership, board composition, and contractual relationships between the two entities to tailor a structure that will maximize the goals of the social enterprise to the extent possible. However, consultation with an attorney is essential if the benefits of the available choices are to be realized.
Lawyers Alliance for New York is the leading provider of business and transactional legal services for nonprofit organizations and social enterprises that are improving the quality of life in New York City neighborhoods. Their network of pro bono lawyers from law firms and corporations and staff of experienced attorneys collaborate to deliver expert corporate, tax, real estate, employment, intellectual property, and other legal services to community organizations.