Legal Structures 101
Below is the information from my workshop for social entrepreneurs about how to pick your legal structure and the differences/similarities between them. The resources are mostly for the SF Bay Area.
Disclaimer: I am not an attorney and you should consult a qualified attorney to incorporate your social enterprise. Everything is provided for informational purposes only.
A nonprofit organization is one that is not formed solely for a profit, but instead of a societal good. Nonprofits can make money, but they must re-invest all surplus revenues to further their purpose, rather than pay out dividends to their board. Nonprofit is a tax status, and nonprofits do not have to pay business taxes, although sales tax and payroll taxes still need to be paid.
Nonprofits must:
· be organized for some kind of social good (language must be in articles of incorporation)
· be operated for that social good (not do substantial other business)
· not have any inurement (excess benefit transactions of over $100,000 to a disqualified person)
· not substantially perform lobbying (less than 5%)
· never electioneer (advocate for someone in an election)
· have a board of directors who govern the organization
· file IRS form 990 annually
501(c) is the nonprofit section of the IRS tax code. There are 29 different types of nonprofits. The previous information only applies to 501(c)(3) since they are the vast majority of nonprofit organizations. Main types of nonprofits:
501(c)(3): Religious, Educational, Charitable, Scientific, Literary, Testing for Public Safety, to Foster National or International Amateur Sports Competition, or Prevention of Cruelty to Children or Animals Organizations Classic nonprofit, including churches, colleges, museums, foundations, and most charitable organizations. 501(c)(3)’s are divided into private foundations and public charities (509a1/107b1Ai-vi).
501(c)(4): Civic Leagues, Social Welfare Organizations, and Local Associations of Employees. Most lobbying entities fall into this category.
501(c)(5): Labor, Agricultural and Horicultural Organizations
501(c)(6): Business Leagues, Chambers of Commerce, Real Estate Boards, etc.
501(c)(7): Social and Recreational Clubs
All 501(c) organizations do not have to pay business taxes, however, only in 501(c)3 orgs and certain specific exceptions can the donations to the orgs be deducted on personal income taxes
Fiscal Sponsorship is a great way to try out your new nonprofit idea without having to go through the whole nonprofit application process. You basically borrow another nonprofit’s 501(c)3 status and they vouch for you in exchange for a typical 5–15% cut of all your income (I know some fiscal sponsorships with 0% and some with 20+%). The fiscal sponsor (nonprofit) will start a line item in their financials for your organization and all your grants and donations will go through them. If a fiscally sponsored initiative ends up breaking IRS law, the nonprofit that is sponsoring them might be in jeopardy of losing their status. Therefore, there has to be a high level of trust on both the nonprofit as well as the new initiative’s part. Certain organizations make it a business to fiscally sponsor other organizations. They charge a higher fiscal sponsorship rate, but they also have staff to help and support new organizations and initiatives. For instance, Community Initiatives in SF will charge around 20%, but they also help you find and write grants for your org. My recommendation is to find an organization that has a similar mission to what you want to start and see if they would be willing to fiscally sponsor you.
· Choose your nonprofit name and mission. Check to make sure no other organization has your company’s name: http://kepler.sos.ca.gov/
· Recruit at least 3 non-related people to your board of directors
· Create a set of bylaws that the nonprofit needs to follow. This basically states how the organization can function, how many board members you need, what voting means, etc. This document does not have to be filed with the state.
· File articles of incorporation with the Secretary of State: 1–2 page doc with very specific language.
· Hold your first meeting of the board of directors: approve the bylaw and articles of incorporation, elect and appoint officers (you have to have a president, secretary and treasurer), set accounting period and tax year, and any initial transactions such as opening a bank account. Make sure to take minutes. Minutes of all nonprofits should be available to the public upon request.
· Fill in IRS Form 1023 within 27 months of incorporation (and the nonprofit status is retroactively applied.
· File for California state tax exemptions via the Franchise Tax Board: https://www.ftb.ca.gov/. This can include exemptions from income, property, sales and other state taxes.
· Obtain any licenses or permits you may need: http://www.calgold.ca.gov/
L3C’s, also known as Low-profit Limited Liability Companies, combine the legal and tax flexibility of LLC’s with the social benefits of nonprofits, and the branding and market advantages of a social enterprise.
They must be mission driven. Mission first, profits second.
L3C status makes it easier for socially oriented businesses to attract investments from foundations and private investors through Program-Related Investments (PRIs).
L3C is a new legal structure and only available in certain states: Illinois (only for certain orgs), Kansas, Louisiana, Maine, Michigan, North Carolina (repealed), North Dakota, Rhode Island, Utah, Vermont, Wyoming, and 2 Indian tribes. Each state has different requirements on how to incorporate as an L3C. A total of 1326 social enterprises have incorporated as L3Cs.
Benefit Corporations is a legal structure that is only awarded to organizations that show that they have a positive impact on society and the environment. This legal structure differs from normal for-profit legal structures in purpose, accountability and transparency, but not in taxation (still taxed as an S or C Corp). They must publish, on their website, their annual benefit reports of social and environmental performance using a comprehensive, credible, independent and transparent third party standard. They must include a purpose in their articles of incorporation and their share certificates must specifically state the benefit nature of the corporation.
Benefit Corporation status is allowed in these states: Maryland, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Illinois, Louisiana, Maryland, Massachusetts, Minnesota, Nebraska, Nevada, New Hampshire, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, South Carolina, Utah, Vermont, Virginia, Washington, Washington DC, West Virginia
Benefit Corps are NOT B Corps. B Corp is a certification by B Lab that the organization meets all rigorous standards of social and environmental performance, accountability and transparency. B Corp is not a legal status.
Famous Benefit Corps: Method, Kickstarter, Patagonia
To apply, you can amend just your articles of incorporation to include the specific language needed
FPC, aka SPC (social purpose corporation) organizations must define “special purpose” in their articles of incorporation. These special purposes include having a positive effect on its employees, suppliers, customers, creditors, the community, society or the environment. This legal status is created for Corporate Social Responsibility for For-Profit Companies to provide them a “safe harbor”. Boards and management are protected from shareholder liability. Regular reports are required. FPC’s have more freedom in how they pursue their purpose and do not need a third party measurement, as compared to Benefit Corps.
SPC Status is only available in California (since 2011), Washington State (2012) and Florida (2014). You can convert an organization into a SPC with 2/3 vote of each class of voting shares, with dissenter’s rights
Sole proprietorships are basically an extension of a person. One person is solely in charge and liable for everything the business does. They are easy to incorporate and very easy to start. The business’s taxes go on to the proprietor’s taxes. In fact, if you freelance, you already have a sole proprietorship. A sole proprietorship is classified as an unincorporated business. The debts of the company are the debts of the owner and the income of the company are the income of the owner.
It is sometimes difficult to get financing from banks as a sole proprietorship. However, there are certain government grants for stimulating the economy.
You don’t need to do anything to form a sole proprietorship, as long as you are the only owner of your business activities. When you do your income taxes, you report any income/losses with your Schedule C and Form 1040. It’s your responsibility to pay all income taxes, including self employment and estimated taxes.
However, like all other businesses, you need to obtain the necessary licenses and permits. Those depend on your industry and location. Check this website for a list: http://www.calgold.ca.gov/. Also, if you operate under a different name than your own, you will have to file a DBA (doing business as).
A partnership is a business where two or more people share all aspects of the organization, including ownership, finances, property, work and time. This is also an unincorporated business status and the taxes passes through to the partners on their individual taxes. Partners are personally liable for business debts and also for decisions made by other partners.
It’s best practice to have a legal partnership agreement since more than one person is involved in decisions. This might include the division of profits, dispute resolutions, how decisions will be made and how to change ownership.
Partnerships can be divided into Limited Partnerships, General Partnerships and Limited Liability Partnerships. LP’s must have at least one general partner who is in control (and more liable) and one limited partner. GP’s must have two or more people engaged in a business, and jointly liable. LLP’s are only for public accountants, lawyers, architecture firms, engineering firms, land surveyors, or organizations who provide services or facilities to other LLP’s.
To form a partnership, register your business with the Secretary of State, establish your business name (fill out a DBA), apply for the specific partnership you want to be with the Secretary of State, and apply for any permits and licenses you might need. You will need to file an annual information return to report the income, deductions, gains and losses, but do not pay business tax. The partnership must send all partners Form 1065 (Schedule K-1) instead of W-2’s.
LLC’s provides limited liability features of a corporation with the tax efficiencies and operational flexibility of a partnership. Owners are known as members. Members can be one single owner, multiple owners, corporations or other LLCs. Business taxes are still passed through to each member of an LLC to be reported on their personal tax returns. Members are protected from personal liability for business decisions of actions, including debt or litigation.
There is less paperwork to do in an LLC than in an S Corp and there are few restrictions on profit sharing within the LLC. However, LLC’s are easily dissolved if any member leaves the business.
To incorporate an LLC, you must choose a business name with the letters LLC in the name, file Articles of Organization with the Secretary of State, and create an operating agreement among the members, and obtain all the licenses and permits necessary. LLC’s are not recognized as a separate tax entity and you might have to file as a single member LLC, a partnership, or a corporation.
S Corporations are usually closely held smaller businesses and they pass through their taxes. They don’t pay any federal income taxes, and instead, income and loses are divided among and passed through the shareholders for them to report on their own income tax returns. However, California still taxes corporation profits before distribution at a 1.5% rate (C corps get taxed 8.84%). S Corps can only have one form of stock and can never have over 100 shareholders. The shareholders must be US citizens or resident aliens, and are generally individuals. They have complicated accounting rules. An S Corp can lose their S Corp status if it ceases to meet all the requirements. A C Corp can file anytime to change into an S Corp.
To incorporate as an S Corp, do everything for a C Corp and file a Form 2553 with the IRS within 2 months and 15 days of filing Articles of Incorporation. S Corps also have to pay the $800 franchise tax.
C Corps are the typical businesses. C Corps are independent legal entities owned by shareholders. Corporations are treated as people and are held legally liable for its actions and debts.
They have costly admin fees and complex tax and legal requirements, so it’s suggested that you start with another corporate form and change into a C Corp. Corporations are taxed twice, first when the company makes a profit on the business taxes and then again when dividends are paid to shareholders on their own personal tax returns. Use IRS Form 1120 or 1120A to report revenue. C Corps are the only type of business entity that can go public with an IPO.
To incorporate a C Corp, choose a business name, appoint at least one director, file Articles of Incorporation with California Secretary of State, create a set of bylaws that sets internal rules and procedures, file a Statement of Information form with the Secretary of State within 90 days of incorporation, hold an organizational meeting, issue stock to initial owners, and file other tax and regulatory forms. C Corps also have to pay an $800 minimum franchise tax. This can include a EIN request from the IRS, California employer account number through the Employment Development Department.
Adler and Colvin, an SF law firm specializing in nonprofit law, has a listing of great legal resources for nonprofits: https://www.adlercolvin.com/resources/index.php
Blue Avocado is an amazing nonprofit governance magazine/newsletter. Always packed with great information: http://www.blueavocado.org/
Foundation Center: Great resource library for all things nonprofit, especially fundraising. They also have an amazing free database of millions of grants/funders: http://foundationcenter.org/
Young Nonprofit Professionals Network: Great resource for events and job openings in the social sector: http://www.ynpnsfba.org/
Impact Hub: Coworking/event space centered around social enterprises: https://bayarea.impacthub.net/
Business Search (to make sure no one else has the name you want to use: http://kepler.sos.ca.gov/
In depth info on what kinds of permits you might need depending on location of operations and industry: http://www.calgold.ca.gov/
Apply for California state tax exemptions via the Franchise Tax Board: https://www.ftb.ca.gov/
SF Small Business Development Center: http://sfsbdc.org
SCORE: https://www.score.org
Small Business Association: https://www.sba.gov/
Legal Structures 101
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