Nonprofit social enterprises are businesses whose primary purpose is the common good operated within a nonprofit or as a wholly-owned subsidiary of nonprofit. Utilizing the definition of a "social enterprise" developed by the Social Enterprise Alliance, a nonprofit social enterprise has 3 characteristics that distinguish it from other types of businesses, nonprofits and government agencies:
- It directly addresses an intractable social need and serves the common good, either through its products and services or through the number of disadvantaged people it employs.
- Its commercial activity is a strong revenue driver, whether a significant earned income stream within a nonprofit’s mixed revenue portfolio, or a for profit enterprise.
- The common good is its primary purpose, literally “baked into” the organization’s DNA, and trumping all others.
For a charity, there are 3 principal structural options for creating and operating a social enterprise:
1. Nonprofit social enterprise housed within a nonprofit
A business may be run within an existing nonprofit. This option requires the least structural change, but the business activity must either (a) be substantially related to advancing the organization's charitable purpose (without regard to how the profits are to be used) or (b) be insubstantial in relation to the overall activities of the charity.
For example, a charity may operate a school as a business in which tuition generates substantially all of its revenues because it's related to advancing its charitable/educational purposes, but it may not operate a gas station for commercial purposes (even if all the profits are to be used to fund the school) if the gas station is a substantial activity in relation to the overall activities of the charity. Whether an unrelated business activity is substantial depends on all the facts and circumstances and is not simply based on the amount of revenues generated by the activity.
Net revenues generated by an unrelated business operated within a charity will likely be subject the unrelated business income tax (UBIT). We'll discuss UBIT in more depth in a follow-up post.
2. Nonprofit social enterprise housed in a separate nonprofit (tax-exempt) entity
A business may be run within a newly created nonprofit, tax-exempt subsidiary. While the creation and operation of a new nonprofit entity may involve considerable costs and administrative burdens, this option may be appropriate where the parent organization wants to protect itself against potential liabilities of the new enterprise. For example, if a nonprofit with significant assets whose sole activity is publishing educational content wants to run a summer camp for kids, it may consider operating the camp (which has a greater risk profile) in a nonprofit subsidiary.
There may be other reasons for housing the enterprise in a subsidiary, including (a) different missions; (b) incompatible staffing structures; and (c) new fundraising opportunities. Also, if funding for the new enterprise might tip a charity into private foundation status, housing it in a subsidiary may be the appropriate strategy.
3. Nonprofit social enterprise housed in a separate for-profit (taxable) entity
A business may be run within a newly created for-profit, taxable subsidiary. If the enterprise's activities do not substantially further a 501(c)(3) exempt purpose (without regard to how any profits are deployed), this may be the best option. It would protect the nonprofit from jeopardizing its tax-exempt status by engaging in too much unrelated business activity, immediately or over time as the enterprise grows in size and scope.
Dropping the enterprise in a for-profit subsidiary may also serve to isolate liabilities, address different staffing needs, prevent a clashing of nonprofit and for-profit cultures within a single entity, and mitigate against public/donor/grantor relations issues that might arise from running the enterprise within the nonprofit.