Contemplating “enterprise”: the business and legal challenges of social entrepreneurship

I. INTRODUCTION

(1) It includes such organizations as hospitals, churches, food banks, schools, social clubs, libraries, chambers of commerce, museums, low-income housing developers, legal services providers, disaster relief organizations and cemetery associations. Collectively, nonprofit organizations have a tremendous influence on the quality of life in the United States. (2) They also have a significant impact on the nation’s economy controlling more than $1 trillion in assets and earning nearly $700 billion annually. (3)

This article focuses on social service nonprofit organizations, commonly known as “charitable” organizations. These are the nonprofits that are dedicated to solving America’s most troubling social problems, serving those society deems least deserving, and providing socially important goods that are not adequately provided by government or private enterprise. (4) Like all nonprofit organizations, social service nonprofit organizations are being challenged by the increased competition for revenue resources and financial support with other nonprofits and for-profit entities. They are under heightened pressure for accountability from supporters and the public, while being called on continuously to develop new programs and improve organizational efficiency to meet the increased demand for services. (5)

Social service nonprofit organizations have historically sustained themselves through a portfolio of financial resources such as government and private foundation grants, individual donations and fees for services. (6) Unfortunately, the economic and political forces that have shaped the nonprofit sector over the past two decades have created a fiscal crisis for these organizations that cannot be solved by simply finding additional, like- funding sources. Rather, social service nonprofit organizations need to become “entrepreneurial” to sustain organizational mission in the new millennium.

The words “nonprofit” and “entrepreneur” are not inherently antithetical. Entrepreneurs stimulate economic progress by finding new and better ways to do things. They find opportunity in change, not despair in it. They are innovative, resourceful, and visionary. (7) A nonprofit entrepreneur is someone who responds to the changing environment of that sector by designing new ways to create value for his or her organization. Nonprofit entrepreneurs are social entrepreneurs. They recognize and relentlessly pursue new opportunities that serve their mission. They engage in a process of continuous innovation, adaptation and learning. They act boldly without being limited to resources currently in hand. They also exhibit a heightened sense of accountability to the constituencies served and for the outcomes created. (8)

Adopting an entrepreneurial approach to solve social problems is not novel. In fact, “social entrepreneurship” is a burgeoning area of study supported by dynamic professionals and prolific literature. However, there is some controversy regarding the proper parameters of social entrepreneurship. Some define it narrowly as nonprofit organizations engaged in earned income strategies to bring in additional revenue to support mission. (9) Broader definitions include businesses organized as for-profit entities and hybrid organizations mixing nonprofit and for-profit elements. (10) For purposes of this paper, social entrepreneurship means nonprofit organizations that apply entrepreneurial strategies to sustain themselves financially while having a greater impact on their social mission (i.e., the “double bottom line”). The strategies focused on range from commercialization of existing social service programs to corporate subsidiaries and complex cross-sector affiliations, collectively “Enterprise.” Some are profit-making ventures. Other strategies are capital enhancing. All are revenue-generating in some respect.

A decision to venture into Enterprise is a long-term management strategy. It is not a quick fix for a financially vulnerable nonprofit organization that is experiencing systematic funding problems. In contemplating enterprise strategies, social service nonprofit organizations must consider whether the risk is worth the ultimate financial reward. Much has been written about the organizational and operational risks present when nonprofits pursue entrepreneurial strategies. Less has been written about the legal issues raised by these ventures, specifically the risks of incurring federal tax liability and of losing federal tax-exempt status. (11) What business literature exists tends to treat the law as a technicality. (12) In fact, the legal implications raised by Enterprise should be central to management’s decision making process. (13)

This paper identifies the business and legal challenges associated with entrepreneurial strategies for social service nonprofit organizations. Part II provides background on the current state of affairs for the nonprofit sector in the United States. Part III defines what it means to be a nonprofit organization and how to obtain and maintain federal tax exemption as a charitable organization under the U.S. Tax Code. Part IV highlights a broad range of enterprise strategies available to nonprofit organizations. Part V identifies the business and federal tax challenges associated with those strategies and provides a matrix for use by social service nonprofit organizations in contemplating Enterprise. Additionally, this part proposes a basic framework for analyzing the federal tax implications raised by Enterprise based on the U.S. Tax Court’s decision in Aid to Artisans, Inc. v. Commissioner (14). This framework provides a key reference for social service nonprofit organizations in understanding the significance of tax law to their decision-making process.

II. RECENT ECONOMIC HISTORY

According to nonprofit scholar Lester M. Salamon, the American nonprofit sector faces four distinct challenges: fiscal crisis, economic crisis, accountability crisis, and legitimacy crisis. (15)

The fiscal crisis has been created by the increased demand for social services coupled with decreases in government funding. It has been in the making for decades. In the 1970s, costs skyrocketed as a result of recession and inflation while government funding grew at an astonishing rate. The Reagan presidency reversed this trend by implementing two new government policies: privatization and New Federalism. This New Federalism, also called “devolution”, saw the conversion of federal entitlement and income security programs into block grants that were then allocated to the states. (16) It was part of a bigger movement that directed reform at the nonprofit sector, resulting in a dramatic decrease in nonprofit funding. At the same time, federal spending in education, social services, community development, and international assistance was slashed, adding more demand on the services of nonprofits.

Now with the recent election of a Republican President, there is a high probability that the amount of government funding allocated to social services and government funding of nonprofits will be further reduced. (17) The fiscal crisis will only become more pronounced as the market constricts. With the implosion of the dot-coms, the tragic events of September 11 and the current recession in the U.S., it is likely that private donations will decrease as people become more uncertain about their own economic future. (18) Unfortunately, this will also coincide with increased needs for social services as the economic situation worsens.

The economic crisis facing nonprofit organizations is a result of forced competition with for-profit enterprises in a way that distracts from and harms traditional charitable activity. Partially as a result of the fiscal crisis described above, nonprofit organizations have increasingly turned to charging fees. (19) While this marketization of nonprofits was successful in allowing them to survive the Reagan era, it opened the door to new challenges. (20) Having evidenced that many of these new markets could yield returns, nonprofits have attracted, to their detriment, new for-profit competitors. In this way, nonprofits are victims of their own success. (21)

Salamon’s third challenge concerns nonprofit accountability. By this, Salamon means the effectiveness of nonprofit activities and the need for improved performance measures. Nonprofit organizations do not typically have objective measures to evidence the value added by their social services. This is changing with the development of standards such as a social return on investment (SROI) measure that serves as a corollary to profit measures for for-profit entities. (22) The SROI measure attempts to quantify the impact of social services provided by the nonprofit sector, as a way to both measure the social value created by nonprofits and increase public support for their work. (23) In the meantime, with scandals like the United Way of America and the recent Red Cross embarrassment in New York City, attention has been focused on nonprofit efficiency and accountability. (24)

Finally, the legitimacy crisis is erupting as there are more challenges to nonprofit organizations’ tax-exempt status and the faith of the public in the work of the nonprofit sector. Public attitudes towards nonprofits have suffered in recent years due in part to the financial, economic and accountability crises. Some critics attack nonprofit organizations for fueling the so-called welfare state. (25) Others point to nonprofit commercialization with skepticism, questioning the privileges granted to nonprofits in the first place. (26)

Controversy has been brewing over nonprofits. For-profits and nonprofits are competing with each other in a largely unprecedented way. The “morphing” of the nonprofit and for-profit sectors has both sides accusing the other of unfair competition. (27) While nonprofits are charging fees, producing and marketing typically commercial products, and otherwise looking like for-profits, for-profits are entering the social services arena previously occupied by nonprofits alone. (28) The criticism leveled at nonprofits engaging in commercial activities is that if they can so readily develop or shift into commercial activities, they should not benefit from the privileges associated with federal tax-exempt status. For-profit entrepreneurs are angered that nonprofit organizations capitalize on their successful and trusted reputations to venture into commercial activities. (29) They argue that these nonprofits are unfairly positioned by years of tax breaks. (30) In their defense, nonprofit leaders argue that they have been forced into the positions they are in by the harsh and unforgiving fiscal environment and the need for more capital to stay alive, let alone compete. (31)

The inescapable truth is that entrepreneurial ventures allow nonprofits a way to provide a flow of income to hedge against the vagaries of traditional grant and private donation funding. (32) In the current political and economic environment, the reality for many nonprofit organizations is that sustainability means contemplating some level of commercial enterprise.

III. SOCIAL SERVICE NONPROFIT ORGANIZATIONS

A. The Meaning of Nonprofit Organization

Nonprofit organizations are organized and operated for some benevolent purpose completely unrelated to the economic advancement of its founders and those who support it financially. (33) Like their for-profit sisters, nonprofit organizations are created under and governed by state law. They have a right to sue and be sued, to enter into legal contracts, to produce goods and/or services and to make investments. If organized in the corporate form, as most are, they have centralized management in the form of a board of directors and enjoy perpetual life as a corporation.

Nonprofit organizations can and often do earn a profit, but they are not permitted to distribute those earnings to their directors, officers, members or any other interested party in their private capacity. In other words, the organization’s net earnings may not inure to the benefit of private parties. This restriction is called the “private inurement doctrine.” (34) It is a cornerstone of the law of nonprofit organizations and the substantive dividing line between nonprofits and for-profit organizations. (35)

B. The Meaning and Requirements of Tax Exemption

The terms nonprofit organization and tax-exempt organization are not synonymous. The concept of a nonprofit organization is broader than that of tax-exempt organization. (36) Nonprofit organizations are creatures of state law. Whether a nonprofit organization is also a tax-exempt organization is determined by federal law, namely the Internal Revenue Code (“Code”). A tax-exempt organization under federal law is relieved in certain circumstances from the obligation to pay certain federal taxes such as excise and employment taxes. (37) The principal exemption by statute is Section 501 of the Code, which relieves qualifying organizations from paying federal income taxes. (38)

There are a number of categories of tax-exempt organizations incorporated into Section 501. There are member-serving organizations such as social clubs, business leagues, and labor unions. (39) These organizations primarily exist to provide some benefit to their members rather than the public at large. (40) A second category is referred to as public-serving or charitable organizations. These are organizations defined in Section 501(c)(3) of the Code. (41) They quite broadly include a spectrum of activities designed to improve the quality of life by improving arts, education, social welfare and health. (42) Social service nonprofit organizations are included in this definition. (43)

Section 501 (a) of the Code exempts from federal income taxation any organization that meets the criteria of Section 501 (c). (44) Section 501 (c)(3) provides exemption for:

Corporations, and any community chest, fund or foundation organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, … no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation …, and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office. (45)

The term “charitable” is often used to refer to all the various types of organizations described in Section 501 (c)(3) notwithstanding the fact that it is only one of the descriptive words used to identify qualifying organizations. In fact, the term “charitable” is considered a generic term which is read to include “religious”, “scientific”, “educational” and like purposes. (46)

The Code grants charitable organizations the added privilege of deductions for contributions to such organizations. (47) That is, gifts to or for the use of the organization are tax deductible to the donor. Historically, Congress has granted charitable organizations tax benefits (e.g., exemptions and contribution deductions) because these organizations serve desirable public purposes. (48) The conference of these benefits is “based upon the theory that the Government is compensated for the loss of revenue by its relief from financial burdens which would otherwise have to be met by appropriations from other public funds, and by the benefits resulting from the promotion of the general welfare.” (49)

A social service nonprofit organization seeking exemption from federal income taxation must meet (and continue to meet) the statutory requirements that are outlined in Section 501(c)(3) and the accompanying Treasury Regulations. (50) It must be organized (“organizational test”) and operated (“operational test”) exclusively for one or more charitable purposes. (51) It must not allow any of its assets to inure to the benefit of insiders (“private inurement doctrine”) (52) or confer a private benefit on outsiders (“private benefit doctrine”) (53). It must not participate in any campaign for political office, or engage in any attempts to influence legislation as a substantial part of its activities (together referred to as “political activity”). (54) Finally, as explained more fully below, it must report and pay taxes on any unrelated business income. (55) All of these requirements (except the restriction on political activity) are pertinent to a social service nonprofit organization contemplating Enterprise.

(i) The Organizational Test.

The organizational test looks principally to the organizational documents, which for a corporation (including a nonprofit corporation) will be articles of incorporation and bylaws. (56) Generally, articles of incorporation (“Articles”) contain provisions stating the corporation’s purposes, whether there will be members, the names of the initial board of directors and officers, dissolution and liquidation procedures and references to appropriate tax law requirements. The bylaws are the corporation’s governing rules, including such provisions as the election of directors and officers, procedures for forming committees, the accounting period and any indemnification allowances. Articles are filed with the secretary of state of the state of incorporation. Bylaws typically are not.

An organization is organized exclusively for one or more tax-exempt, charitable purposes only if its Articles limit its purposes to one or more exempt purposes and do not expressly empower it to engage, otherwise than an insubstantial amount, in activities that are not in furtherance of one or more exempt purposes. (57) To that end, the Articles of a social service nonprofit organization seeking exemption from federal income tax should contain a statement of purpose that reflects the charitable purposes identified in Section 501(c)(3) of the Code. (58) Additionally, the Articles must obligate the organization to further such exempt purposes as its primary activity and prohibit the organization from engaging in any meaningful way in activities that are not in furtherance of some exempt purpose. (59)

(ii) The Operational Test.

Generally, the Organizational Test is easily satisfied with properly prepared Articles. In contrast, the Operational Test requires examining the entirety of the corporation’s ongoing operations to determine if it is devoted to purposes that qualify as “exclusively charitable.” (60) The organization will be regarded as operated exclusively for one or more exempt purposes only if it engages substantially in activities that accomplish those purposes. (61) If more than an insubstantial amount of the corporation’s activities are not in furtherance of its exempt purposes, it will not qualify as a charitable organization defined in Section 501(c)(3). (62) Even if the corporation operates to further an exempt purpose, but substantially engages in another activity with a non-exempt (e.g., commercial) purpose, it will fail the Operational Test and be ineligible for (or lose) tax-exempt status. (63) Thus, the Operational Test assesses not only whether an organization’s activities conform to its tax-exempt status, but also whether the organization is engaged in impermissible activities that are in pursuit of a non-exempt purpose. (64) The line is drawn when the activities, permissible or impermissible, become “substantial.”

For example, in Federation Pharmacy v. Commissione (65), the U.S. Tax Court denied tax-exempt status to a nonprofit corporation organized to provide prescription drugs at discount prices to the elderly and handicapped. The organization’s social service mission was to promote health and relieve financial distress for that charitable class. It discounted drugs and even provided a delivery service when necessary. Additionally, the corporation had many characteristics frequently associated with a nonprofit organization. For example, it sought to use volunteer labor to keep costs at a bare minimum. It only sold products associated with its mission

In understanding the Operational Test, it is critical to distinguish between activity and purpose. The fact that an organization’s primary activity itself constitutes a trade or business does not automatically disqualify it from classification as a tax-exempt organization, provided the trade or business accomplishes an exempt purpose. In Federation Pharmacy, the court found that Federation Pharmacy’s commercial operations did not further its stated social purpose. An interesting case for comparison in this regard is Monterey Public Parking Corporation v. United States (68) In that case, the District Court of California had to decide whether the operation of a public parking lot could be in furtherance of a charitable purpose. The Monterey Public Parking Corporation was established by a number of private businesses ostensibly to relieve traffic congestion in downtown Monterey. In connection with this, the Corporation incorporated a business validation stamp system for parking. The IRS claimed the real purpose of the organization was to benefit the founders by encouraging the public to patronage their businesses. The court found that the parking lot lessened the burden on the local government by providing additional parking facilities. (69) In its view, the City of Monterey was the primary beneficiary of the organization’s operations and there were no special benefits accruing to the founders which did not also accrue to the community as a whole. (70)

Reconciling these cases is a difficult task. The U.S. Tax Court’s decision in Aid to Artisans, Inc. v. Commissioner is helpful in this regard. (71) There the U.S. Tax Court emphasized the important distinction between an organization’s activities and its purposes, and held that it is incorrect to focus narrowly on the nature of the organization’s activities without an understanding of its ultimate purpose. (72)

In Aid to Artisans, the organization’s primary activities were the purchase, import and sale of handicrafts from disadvantaged artisans in the United States and in developing societies throughout the world. These activities were undertaken to accomplish a number of objectives, namely achievement of economic stabilization in disadvantaged communities where handicrafts are central to the economy and education of the American public in the artistry, history and cultural significance of handicrafts from such communities. In the court’s view, each qualified as an exempt charitable and/or educational purpose under Section 501(c)(3). (73) The court further found that the organization’s primary activities (the purchase, import and sale of handicrafts), albeit commercial, were not an end unto themselves, but rather were undertaken to accomplish its exempt purposes. (74)

(iii) Private Inurement and Private Benefit.

The Aid to Artisans Court was also faced with the issue of whether Aid to Artisans served private or public interests in violation of Section 501 (c)(3). The IRS argued that Aid to Artisans’ activities provided an illegal private benefit to the artisans whose handicrafts it sold. Recall that Section 501(c)(3) requires that no part of an exempt organization’s net earnings inure to the benefit of a private shareholder or individual. A private shareholder or individual refers to those in a position to control the organization’s affairs to their benefit (e.g., insiders). (75) The government’s argument was not exactly a private inurement argument, but rather an extension of it. Referred to as the private benefit doctrine, it is based on Treasury Regulation 1501(c)(3)-1(d)(1)(ii) which provides that “[a]n organization is not organized or operated exclusively for [exempt purposes] unless it serves a public rather than a private interest.” (76) Unlike private inurement, the private benefit analysis considers the scope of the class served by an organization. (77) The prohibition against private benefit goes well beyond insiders to consider whether a benefit has been conferred on disinterested outsiders, in this case the artisans. (78) When an organization operates for the benefit of private interests, such as a designated group of individuals, the organization’s founder or her family, or persons controlled by such private interests, the organization by definition does not operate exclusively for exempt purposes. (79) The organization will therefore be denied federal tax-exempt status on the basis that it is operated for the substantial non-exempt purpose of benefiting private interests. (80)

In Aid to Artisans, the IRS argued that those disinterested beneficiaries were the individual handicraft artists who received some marginal economic benefit from the organization’s otherwise exempt activities. The U.S. Tax Court was not persuaded that any incidental benefit conferred on them warranted a denial of tax exemption. However, several years later in American Campaign Academy v. Commissioner, that same court applied the private benefit doctrine to affirm the denial of federal tax-exempt status to a professional school whose activities more than incidentally benefited the private interest of Republican party candidates and entities. (81) American Campaign Academy sought tax-exempt status on the basis of its charitable and educational purposes. Its primary activity was the training of individuals for careers as political campaign professionals. Campaign professionals work for candidates in such positions as communications director, finance director, or campaign manager. The school’s founder was former General Counsel to the National Republican Congressional Committee. Funding for the school was provided by the National Republican Congressional Trust and its initial directors had clear ties to the Republican party. The curriculum included such partisan topics as, “How some Republicans have won Black votes” and “Other Republican givers list.” Finally and most importantly, the school’s graduates frequently obtained positions with Republican candidates and entities. In short, the court found that American Campaign Academy conducted its educational activities with the partisan objective of benefiting Republican candidates and entities. (82) If further found that the benefit was not incidental and that more than an insubstantial part of the school’s activities were therefore performed to further a non-exempt purpose. (83)

(iv) Unrelated Business Income.

While a charitable organization is not generally subject to federal income taxation on its income, it will be taxed on any income derived from an “unrelated trade or business.” Such income is referred to as unrelated business income, or “UBI.” Under Section 511 of the Code UBI is taxed at the prevailing corporate rate. (84)

The purpose of imposing a tax on UBI (called the unrelated business income tax, or “UBIT”) is to treat exempt organizations in the same manner as their taxable counterparts when they are regularly engaging in income-producing activities that do not further a charitable purpose. (85) While this type of commercial, revenue-generating activity is permissible if conducted within the limits dictated by the Operational Test, if the organization engages substantially in unrelated business activities, it may ultimately jeopardize its tax exempt status. A social service nonprofit organization that is contemplating Enterprise needs to be cognizant that if the entrepreneurial activity is unrelated to its mission it will be taxed on any income generated (i.e., UBI). Furthermore, if that activity becomes substantial, it may lose its tax exempt status altogether.

(a) “Unrelated Trade or Business”

Any activity selling goods or performing services for the production of income is considered a “trade or business” for purposes of determining how the UBIT applies to an exempt organization. (86) Whether or not profits are made on the sale of these goods or provision of services is irrelevant in determining whether these activities are considered a “trade or business.” (87)

The legislative history of the UBIT provisions evidences congressional intent to prevent unfair competition of nonprofits with for-profit businesses. Section 513 of the Code which defines unrelated business income tax does not mention this explicitly, but judicial interpretation has picked up on this policy concern. (88) In U.S. v. American Bar Endowment, the U.S. Supreme Court held that the “undisputed purpose of the UBIT was to prevent tax-exempt organizations from competing unfairly with business whose earnings were taxed.” (89)

The courts increasingly emphasize the “commercial” activities of nonprofits in their interpretations of UBIT law. The result is the emergence of the “commerciality doctrine,” which is best encapsulated in the case of Living Faith, Inc. v. Commissioner. (90) In Living Faith, a nonprofit organization operated two vegetarian restaurants and health food stores in observance of the tenets of the Seventh-Day Adventists Church. The court looked at many factors in holding that the organization’s primary purpose was commercial rather than religious: 1) the organization’s restaurants directly competed with for-profit restaurants

Many legal commentators have observed that the courts reliance on gross receipts and paid employees is misplaced. (92) It is well-settled that the failure to make a profit is not determinative of commercial purposes. (93) Similarly, the use of volunteers instead of paid employees specifically excludes the income from such activity from UBIT

Despite the criticism surrounding the Living Faith decision, the commerciality doctrine lives on, and social service nonprofit organizations need to be alerted to the courts’ scrutiny on activities that appear to be commercial or are deemed to compete with for-profit organizations, even if their activities are also in furtherance of their exempt purpose. As the court in Living Faith noted, “[c]ompetition with commercial firms is strong evidence of the predominance of nonexempt commercial purposes.” (94) Social service nonprofit organizations should be aware that the commercial nature of certain activities may sometimes trump exempt purposes, at least with respect to an UBIT analysis.

(b) “Regularly Carried On”

In evaluating the second element of whether activities are unrelated business activities, the courts examine whether an activity is considered to be “regularly carried on.” (95) “Regularly carried on” means that the activities are frequently and continuously engaged in by the nonprofit organization, and that the commercial activities are pursued by the nonprofit in a manner that is similar to comparable activities by for-profit organizations. (96) A restaurant that runs year around would be considered regularly carried on, but an annual refreshments booth at the county fair would not be. In general, even if there are activities that happen annually, but only annually, they will not necessarily be considered to be regularly carried on. For example, a nonprofit organization that has an annual fundraising ball every sprang would not be deemed to have an unrelated business that is regularly carried on because it is an intermittent activity. (97) However, paying employees to sell advertising over a four-month period and to publish programs over an eight-month period for a tax-exempt symphony is not intermittent and is regularly carried on. (98)

(c) “Substantially Related”

The third and final component of unrelated taxable income is that it is not causally related to the organization’s exempt purposes, nor does it contribute importantly to those purposes. (99) The size and extent of the activity is considered in relation to the nature and extent to which the exempt purpose is being furthered. (100) This is a hazy fact specific test, and the IRS tends to look at its own rulings instead of judicial interpretation. It examines factors such as the amount of the employees’ time spent on the activity, the purpose for and manner in which the activity is conducted, the percentage of the organization’s revenue that the activity generates, and any accumulated reserves, (101) Fortunately, the Treasury Regulations have made a few clarifications of the substantial relationship test. For example, if an activity is partially related to the organization’s exempt purpose but is done on a larger scale than is necessary to meet the exempt purposes, the portion of the income attributable to the excess activity will be taxable. (102) However, if the activity itself constitutes an exempt function, it will be considered substantially related.

Since the substantially related test is so fact specific, it requires examples to understand the nebulous spectrum of “substantially related.” Examples of activities that have been held to be unrelated activities include: a school using its tennis facilities as a public tennis club during the summer

In addition, the Code sets forth specific exceptions to UBI, such as selling donated merchandise, distribution of low cost items, and the exchange of member mailing lists. (109) The exception applied most often is the exception for trade or business performed substantially by volunteers. (110) To qualify for this exception, nonprofit organizations must make sure that any benefits provided to volunteers are de minimis. (111) In addition there are exclusions from UBI including the exclusion for rents and royalties (like licensing fees for the use of a name). (112)

IV. STRATEGIES FOR ENTERPRISE

A social service nonprofit organization must account for unique organizational considerations in deciding whether it needs an entrepreneurial strategy to sustain its mission and, if so, exactly what type of enterprise in which to engage. It must make commercial decisions in the context of its greater social service mission. For-profit organizations do not have this challenge. (113)

Nonprofit consultant and scholar Edward Skloot identifies four questions for social service nonprofit organizations to ask in contemplating Enterprise. (114) First, what are the risks and can the organization afford them? (115) Skloot references financial, organizational and reputational risks associated with commercial ventures. (116) Each may be alleviated to an extent with appropriate legal structuring. For example, a separate for-profit or nonprofit entity such as a subsidiary may be financed and staffed independently of the parent organization. (117) Employee morale may be less at stake when the venture has a separate, albeit related existence. Furthermore, in separating the new commercial venture, the mission of the parent remains “pure” and untainted. If it fails, the injured reputation will be that of the subsidiary, not the parent.

The second question is, what are the resources, skills and knowledge required for the enterprise and can the organization supply them? (118) Skloot recommends calibrating the level of effort and size of the enterprise to available resources. (119) This may be accomplished with the completion of first a feasibility study and then a business plan. (120) In light of the admitted risks associated with nonprofit organizations engaging in Enterprise, a social service nonprofit organization may wisely decide to embark on a small scale pilot program initially before implementing a larger scale, more risky business plan.

Skloot’s third question is, how do the social service nonprofit organization’s values, goals and attitudes differ from those required to support the enterprise, and can the organization adapt? (121) This is a principal concern for many social service nonprofit organizations that value service and public participation over the bottom line. To many nonprofit staff, “earning money” is offensive. (122) In recent years, resistance to the idea of entrepreneurship in nonprofits has diminished due to increased familiarity with the opportunities and immediate financial pressures. If there is a willingness to discuss Enterprise, Skloot suggests a number of pragmatic approaches that might be useful. For example, he suggests those in favor of an enterprise strategy build support for the idea with a small group, like a board committee. (123) He also suggests consulting with and visiting like enterprises, and keeping financial expectations at a modest level. (124) If the corporate culture is completely unyielding, or the attitude toward risk and Enterprise is strongly negative, the social service nonprofit organization may simply have to decline the commercial opportunity for a more traditional solution to sustainability. (125)

Finally, Skoot asks, what are the timing requirements for launching the venture and can the organization meet them? (126) This requires an understanding of the marketplace and the organizational resources at hand. In other words, it requires good planning. (127) Obviously, hasty decision making and inadequate planning lay the groundwork for failure in any venture. (128)

Skloot’s strategic framework for contemplating Enterprise is useful as a starting point. However, social service nonprofit organizations vary dramatically both in their objectives and in how they achieve those objectives in their day-to-day operations. This makes it very difficult to identify one or more entrepreneurial strategies that are uniformly appropriate. (129) Consider the following two examples.

Pioneer Human Services, Inc. is a nonprofit corporation operating in the state of Washington since 1962. Its mission is to create opportunities for recovering alcohol and drug-dependent persons, convicts and work release participants to realize personal, economic and social development through participating in an integrated array of training, employment, housing, and rehabilitation services. (130) Pioneer Human Services serves approximately 6,000 clients a year, employs over 1,000 staff and operates on an annual budget of approximately $55 million. (131) It is a model entrepreneurial nonprofit organization, a classic example of social enterprise, integrating self-supporting businesses with an array of client services. (132)

Compare Pioneer Human Services with the Northwest Women’s Law Center, also a nonprofit corporation organized in the state of Washington. The Law Center’s mission is to advance legal rights for women through public impact litigation, legislative and administrative advocacy, legal rights education, and by providing legal information and referral services. It provides broad-based legal advocacy services on virtually every issue that affects women. (133)

The Law Center differs from Pioneer Human Services in two very important respects. First, it does not have clients in the traditional sense. Rather, it represents a small number of individuals in cases that will impact the larger charitable class of women. Second, the Law Center relies heavily on grants and individual and corporate donations to sustain its mission. Pioneer Human Services, on the other hand, has a number of self-supporting businesses that further its rehabilitative mission. The same client that receives counseling and housing services may also be working in the corporation’s retail food or construction business. At Pioneer Human Services, clients are rehabilitated by participation in its enterprise.

Both the Law Center and Pioneer Human Services are social service nonprofit organizations

A. Commercialization of Core Programs

The most direct way for an existing social service nonprofit organization to increase revenue is program addition or extension. Program addition or extension is defined as revenue-generating enterprise that is established as a related program of the sponsoring organization. (134) While this is typically accomplished within the existing organization’s structure, additional programs can also be housed in an independent business enterprise.

There are a number of advantages to embarking on a new program while retaining it within the existing nonprofit organization. When a new program is operated in-house, its management is direct. This results in shorter lines of authority and faster resolution of policy conflicts. Keeping programs together under one umbrella may also allow for a flexible use of staff and resources. Finally and most obviously, there are expenses saved by not forming a new entity and avoiding the duplication of administrative and managerial costs. (135)

On the other hand, there are distinct advantages to separating out a new program. The most apparent is that in doing so there will be more direct focus on program activities with fewer distractions. In turn, less distractions mean more efficient operations. A separate organization may also help protect the nonprofit’s tax-exempt status, particularly if the new activities are commercial in nature and participation might otherwise result in violation of the Operational Test or the Commerciality doctrine. (136) If separation of programs is deemed the best route for the new venture, this can be accomplished by an independent business enterprise as described below.

B. Independent Business Enterprise

An independent business enterprise is a separate legal entity established exclusively for the purpose of expanding economic opportunity for a given target population. (137) It involves forming a new entity to separate activities. Separation allows for the pursuit of both types of activities while protecting each company from the liabilities of the other. Although housing a new program within an existing organization can often be the simplest method for expansion

(i) Nonprofit Subsidiaries

The most common way to set up an independent business entity is to form a second nonprofit corporation. Typical reasons for selecting the nonprofit form include providing a vehicle to engage in different activities or possibly under another category of tax exemption. It is not uncommon, for example, for a charitable organization under Section 501(c)(3) to widen the scope of its activities or to want to engage in unpermitted activities for a 501(c)(3) organization such as lobbying. In that case, the 501(c)(3) organization might form a second nonprofit corporation and apply for federal tax exemption as a social welfare organization under Section 501(c)(4). (138) Common reasons for choosing a nonprofit subsidiary that are more relevant to Enterprise include: to segregate property into a separate entity in order to maximize income, to separate net income to avoid reductions in grant money, and to set up a foundation in order to establish a long-term endowment. (139)

(ii) For-Profit Subsidiaries

When a social service nonprofit organization is contemplating Enterprise, it will likely consider forming a for-profit subsidiary that can safely carry on revenue generating activities unrelated to its tax-exempt purpose. Carefully planned corporate structuring can be an effective tool to avoid loss of tax-exempt status, to strengthen the organization, to protect existing resources and possibly tap into new resources, and to facilitate collaboration with other organizations. (140)

A nonprofit parent typically owns all of the new for-profit corporate subsidiary’s stock. (141) Since it owns all of the stock, the nonprofit organization controls the subsidiary’s board of directors. The nonprofit and the for-profit can have different boards of directors, or overlapping boards of directors. For corporate liability reasons, the boards should not be identical, even if a few members overlap. (142) On an annual basis, the for-profit subsidiary can dividend any profits to the nonprofit organization (although this will be income to the nonprofit). The for-profit subsidiary can also get money back to the parent by paying part of an employee’s salary for the percentage of work performed for the subsidiary, or leasing some space from the parent and paying market value rents.

An overriding reason for forming a for-profit subsidiary is in order that the social service nonprofit organization can dispel any accusation that it is taking unfair advantage of its for-profit competitors. With a tax-paying subsidiary, the social service nonprofit organization can rightfully claim its new programs and services are being provided in the same way and under the same tax conditions as its competitors. (143)

Final advantages to this structure include facilitating commercial funding from third parties or institutional lenders who understand the for-profit model better than they understand the nonprofit model. Also, a for-profit subsidiary can allow for a joint venture or a partnership with an entity or person who has needed resources or expertise. Perhaps most importantly, if the proper corporate formalities are recognized so that the subsidiary will not be aggregated with the parent company, a subsidiary can be an excellent way to protect the social service nonprofit organization by splitting off the risky commercial activities into another company. These activities may be risky because they jeopardize tax-exempt status, or simply because they increase the general legal liability associated with increased business operations. (144)

C. Nonprofit Consortia

The term consortium means an agreement, combination or group of companies formed to undertake an enterprise beyond the resources of any one member. (145) Consortia are attractive options for social service nonprofit organizations because participation can effect economies of scale in their own charitable operations. Consider for example a social service nonprofit organization that has an opportunity to acquire real estate, but cannot fill the space. The organization may approach other nonprofit organizations that have similar space needs for administration or service provision. This collective can take advantage of their similar needs by forming a partnership to own and operate the real estate. (146)

Consortia are inherently entrepreneurial. One of the principal reasons for establishing a consortium is efficiency of operation. Often the enterprise that is jointly created performs functions for its members that they would otherwise have to undertake for themselves. When tax-exempt entities work as a collective to maximize their individual resources, they create value for themselves and the communities they serve. They are better able to impact their mission with the resources that are saved as a result of their collaboration. (147)

There are a number of legal choices available for social service nonprofit organizations interested in pursuing a consortium. A common choice is the cooperative venture. Cooperatives are attractive because they are egalitarian in nature. While distribution of profits reflects percentage of investment, each member has equal managerial control regardless of its capital contribution. (148)

Historically, cooperative ventures were treated favorably by the IRS, which routinely granted exempt status to these collaborations even when their operations were not inherently charitable. (149) The rationale seemed to be that even if performance of a particular activity was not inherently charitable (e.g., owning and occupying real estate in the example above), it could nonetheless serve a charitable purpose. (150) Unfortunately, a U.S. Tax Court decision in 1980 turned the tides. (151) Today, the state of the law regarding cooperative ventures established by tax-exempt entities is not clear, even where the venture is controlled by and performs a function for its members that each exempt institution would otherwise have to do for itself, without incidence of tax. (152) If the consortium is itself conducting substantive programs that are charitable in nature, it will be granted exempt status. This is the case where, for example, one or more organizations form a coalition to provide a comprehensive approach to a social problem. Typically, however, the utility of a consortium is in overhead savings. If a social service nonprofit organization can benefit from the use of a tax-exempt consortium to lower its operating costs, it can devote more resources to improvement and expansion of its existing charitable programs.

The ultimate form of consortia is the strategic merger or consolidation. In a merger, one corporation liquidates into another. The transferor’s existence ceases to exist. The transferee acquires its assets and liabilities and survives. By contrast, in a consolidation, two or more corporations liquidate into a third, new corporation. The old ones cease to exist. Merger and consolidation are legally distinct, but the end result is the same. That is, two or more corporations become one. (153)

Nonprofit mergers and consolidations are distinct from their for profit counterparts principally because there are no stockholders to contend with. That fact would seemingly make these enterprise options attractive from a logistical standpoint. However, neither is a popular choice in the nonprofit sector because of the fact that one or both of the participating organizations cease to exist, at least technically. The issue for nonprofit organizations is defined as loss of identity

According to attorney Gary W. Jenkins, merger or consolidation decisions, in the nonprofit sector may be the best strategies for impacting mission. (155) This type of collaboration can provide two social service nonprofit organizations an opportunity to take advantage of economies of scale or economies of integration, or both. (156) It may assist the organizations in accessing new resources, integrating services, reaching new clients and developing new programs. In other words, a combined entity can do better than what each organization would have achieved on its own. (157)

An important advantage of this type of enterprise strategy worth noting is that, when structured properly, there should be few cultural conflicts. The participants are all in the nonprofit sector. They speak the same language when it comes to value-based operations and organizational goals. If the organizations can overcome the fear of identity loss, merger or consolidation may be the best solution for furthering mission.(158) The focus needs to shift from survival of the individual organizations to survival of the mission.

D. Cross-Sector Alliances

Cross-sector alliances are long-term strategic collaborations between the business and nonprofit sectors. They reflect recognition by business and social service organizations that their needs can be met by working toward a common, ultimately charitable goal. These partnerships reflect “a new paradigm for innovation,” (159) producing profitable and sustainable change for both private enterprise and public interest. (160)

The earliest forms of cross-sector alliances addressed education reform, cultural opportunities and environmental issues in the communities where businesses operated. For example, a company looking to attract employees to an area by improving the schools would partner with those schools to improve student achievement. (161) Today, cross-sector alliances are proliferating in areas such as minority representation, promotion of the arts, hunger relief, breast health and technological literacy. (162)

A well-known cross-sector alliance is the Ben & Jerry’s Partnershop Program. (163) This program grants franchises of Ben & Jerry’s retail outlets for the sale of ice cream to community-based social service nonprofit organizations. The social service nonprofit organizations gain the knowledge and experience of managing a business and an opportunity to provide meaningful employment and job skills to their clients. Ben & Jerry’s waives its normal franchise fee and provides training to selected participants. However, participants are required to arrange financing, provide management and staffing, and handle day-to-day operations. (164) An effective cross-sector alliance does just this

Cross-sector alliances are attractive to businesses that want to move beyond philanthropic donation to find more significant and active ways to contribute to the community. In fact, private enterprise can benefit tremendously from the business development that results from participation in these partnerships. (165) To continue with the earlier example, better school districts not only attract today’s employees to a region, they also produce better workers and possibly more affluent consumers. For nonprofits, the interest in participation reflects an entrepreneurial approach to sustaining mission. In short, these alliances pair visionary companies that see how the social context in which they operate affects their bottom line with social entrepreneurs who understand the value of business discipline in promoting social mission. (166)

The most important components of a successful cross-sector alliance are the strategic fit between the participating organizations, the level of cultural fit, and the degree to which the separate organizations perceive the alliance as mutually beneficial. (167) Strategic fit is the degree to which an organization augments or compliments the other organization’s strategy and thus makes identifiable contributions to financial and non-financial goals. (168) This is something that can be researched in advance by a social service nonprofit organization in selecting a business sector partner. For example, if senior management is enthusiastic about the proposed venture and seems willing to be connected to the social service nonprofit organization on multiple levels, there would be an implication of a good strategic fit. Other factors to consider are the time and capital commitments a business sector organization is willing to make. (169)

Cultural fit, also called organizational fit, concerns the degree to which the organizations can create common understanding and common goals. This requires communication as the organizations must be aware of each other’s management and administrative practices. (170) Finally, to succeed cross-sector alliances must benefit both organizations.

A social service nonprofit organization can clearly gain much by allying with a business sector organization

V. COMPLICATIONS OF COMMERCIALIZATION

Social service nonprofit organizations need to contemplate a range of enterprise strategies in the context of business and legal challenges. Many of these challenges have already been identified in the context of the specific commercialization strategies highlighted in Section IV. The following discussion is intended to augment that information.

In general, both the business and legal challenges increase with the level of enterprise complexity. So, for example, the challenges are less ominous for a social service nonprofit organization contemplating program extension than one contemplating a cross-sector alliance. The following Enterprise Risk Identification Matrix presents a summary. The left column lists the principal business and legal challenges for social service nonprofit organizations to consider in evaluating each of the four enterprise strategies

A. Business Challenges

The culture of social service nonprofit organizations is remarkably distinct from that of most for-profit entities. For-profits are motivated principally by the bottom-line. In sharp contrast, social service nonprofit organizations are driven by their charitable mission. (174) Theirs is not a culture of commerce, but a culture of public service. (175)

A social service nonprofit organization that over-commercializes risks undermining its legitimacy. That is, if it focuses more on its bottom line than its mission, the public, the organization’s volunteers and donors may become discouraged and withdraw their support. Without that support, those most in need of the organization’s social services suffer. (176) A related challenge for social service nonprofit organizations in becoming more entrepreneurial is that they risk losing sight of their mission. (177) Because mission and organizational identity are equivalent in the nonprofit world, losing site of mission means losing identity.

While there are certainly organizational risks a social service nonprofit organization faces in moving toward social enterprise, it is incorrect to assume that these risks are fatal for mission survival. In New Social Entrepreneurs: The Success, Challenge and Lessons of Non-Profit Enterprise Creation, Jed Emerson and Fay Twesky identify a number of factors that are present in those organizations that have successfully moved toward a social enterprise culture from that of a strictly nonprofit, social services one. (178) These factors are: entrepreneurial management

The successful establishment of a social enterprise culture requires an entrepreneurial orientation. In short, what is required is a “world view filtered through the lens of market opportunity.” (179) A social service nonprofit organization cannot obtain an entrepreneurial orientation simply by completing a retreat or by hiring a consultant to transform its culture. Entrepreneurial spirit must be cultivated as part of a larger process of organizational development. (180) The executive director is the principal leader in this respect, buffered by a supportive board of directors. Without board endorsement, the process of transitioning to an entrepreneurial orientation will fail. Similarly, it is critical to obtain the support of staff. If the staff equates entrepreneurial activity with a “tainted” culture, employee morale will suffer and have serious consequences for the success of any commercial venture.

Enterprise development also requires a participatory culture, or a willingness to integrate the assistance of others external to the organization. The assistance of program participants (i.e., clients) can be extremely helpful in this respect. Program participants provide the social service nonprofit organization with direct feedback on the appropriateness of Enterprise. They also keep the process honest and relevant to their lives, and in this way help maintain cultural values. (181)

Whereas the organizational factors highlighted by Emerson and Twesky relate well to the cultural challenges identified on the Enterprise Risk Identification Matrix, the remaining factors seem to correspond to the operational challenges. Openness to organizational change means the organization is willing to examine established values and beliefs and move beyond them to better accommodate its enterprise strategy. It also means living with the chaos that exists during the transformation, including a sometimes overburdened management and staff and loss of managerial control. (182)

Organizational capacity refers to the availability of middle management to guide the enterprise supported by appropriate resources. While some enterprise strategies can allow for a flexible use of resources particularly during the start-up phase, if not properly managed, there can be an erosion or depletion of resources that could affect performance of both new and existing programs. This may be most obvious where a social service nonprofit organization commercializes an existing, in-house program but may also present a risk for cross-sector alliances. For example, assume the Northwest Women’s Law Center introduced in Section IV offers a sexual harassment education program free of charge to community centers in Seattle, Washington. If the Law Center decides to transform this program into a fee-for-service training program for local business firms, it might use existing staff and educational materials at least during the start-up phase. In fact, the Law Center would be wise to make such a flexible use of its staff and resources. Now assume that instead of offering such a program on its own, the Law Center decides to partner with a business sector firm to offer sexual harassment prevention programs throughout the Northwest (i.e., a cross-sector alliance). A program of this scale might move the business sector partner beyond philanthropy while helping relieve a social problem of significance to the Law Center’s multi-state constituency. Again, the Law Center would be in a position to take advantage of its existing resources in this field. However, in both instances the organization must be careful to prevent the new opportunity from draining resources to the disadvantage of its other traditional social service and legal assistance programs.

Finally, Emerson and Twesky identify external financial and professional resources to complement the feedback of program participants. (183) This goes hand in hand with accessing business, nonprofit capital and other networks. (184) Social service nonprofit organizations must be able to identify and use all available resources in securing a successful transition to social entrepreneurship. There can be significant administrative costs associated with this process including staff allocation and professional fees such as attorneys’ and accountants’ fees.

B. Legal Challenges

While there are a number of legal challenges associated with entrepreneurial strategies for businesses in general, the one that is unique to social service nonprofit organizations is maintaining federal tax-exempt status. Relief from the obligation to pay federal income tax is the seminal privilege of supplying social services to the public. In exchange for that benefit, an organization must meet (and continue to meet) the statutory requirements outlined in Section 501(c)(3) of the Code and the accompanying Treasury Regulations as more fully discussed in Section III of this paper. Unfortunately, these requirements are subject to varying interpretations by the IRS and the federal courts. (185) With that in mind, what might be useful to social service nonprofit organizations contemplating Enterprise is to have at least an initial framework for analyzing whether an opportunity presents immediate tax status problems. The analysis laid out by the Aid to Artisans Court provides such a framework. First, identify the organization’s primary activities. Second, identify the purposes for which the organization is operated. Third, decide whether such purposes are exempt purposes. Fourth, decide whether the primary activities further one or more exempt purposes. Fifth, determine whether a substantial part of the organization’s activities further nonexempt purposes. Sixth, determine whether the organization serves private or public interests. (186)

Recall that in Aid to Artisans, the organization’s primary activities were the purchase, import and sale of handicrafts from disadvantaged artisans in the United States and in developing countries throughout the world. The organizational purposes included achievement of economic stabilization in communities where handicrafts are central to the economy and education of the American public in the history and cultural significance of these handicrafts. (187) The court was convinced that each such purpose qualified as an exempt purpose under Section 501(c)(3). (188) It found that the very commercial activity engaged in by the organization (the import and sale of goods) in fact helped achieve those exempt purposes, and that this activity constituted a substantial part of the organization’s overall activities. (189) Finally, the court stated that although there was an incidental benefit conferred on the individual artisans whose art was purchased, the organization principally served a public interest by providing economic assistance to disadvantaged communities. (190)

In Aid to Artisans, the organization was appealing the IRS’ initial negative determination that it did not qualify as a tax-exempt entity. In other words, Aid to Artisans was not an existing nonprofit firm contemplating entrepreneurial strategies to complement traditional social service programs. Its business model was inherently entrepreneurial. In applying the Aid to Artisans analysis to an existing social service organization contemplating Enterprise, the most important factors for consideration will therefore be the fourth, fifth and sixth. These factors relate to the connection between primary activities and exempt purposes, the level of activity that furthers a non-exempt purpose and any private benefit that the activity confers, respectively. For example, consider the Northwest Women’s Law Center’s hypothetical sexual harassment prevention program as implemented by a cross-sector alliance. The Law Center’s primary activities of engaging in public impact litigation, legal rights education and legal referral services should not be affected by its participation in this alliance. Its purpose, advocating women’s rights, will not change and should continue to be recognized as an exempt charitable purpose under Section 501(c)(3) of the Code. Unless the activities related to the cross-sector alliance become “substantial”, there should continue to be a direct and measurable connection between the Law Center’s primary activities and its success in furthering its mission. If these activities do become substantial, there will then be an issue under the fifth factor in the Aid to Artisans analysis of whether the activities further a permissible exempt purpose, or a non-exempt, unrelated one.

The danger to a social service nonprofit organization of having too much unrelated business activity is that it risks losing its tax-exempt status altogether. (191) In that event, it will be obligated to pay corporate taxes. In practical terms, the organization becomes like a for-profit corporation, subject to any restrictions that the nonprofit statute in the state of the organization’s formation might include.

Managers of social service nonprofit organizations need to take into consideration that this may be a risk they do not want to take, and be aware that no bright line has been drawn determining how much unrelated activity is too much. To be safe, the social service nonprofit organization should presume that any more than fifty percent of its total activities will cause it to lose its exemption. (192) Yet social service nonprofit organizations should not assume that less than fifty percent is a safe threshold. The rulings vary so widely that it is not predictable how the IRS will rule and if it will revoke an organization’s tax-exempt status. Some legal commentators suggest that organizations keep their unrelated activities under thirty percent. (193) Others suggest a lower threshold of fifteen percent of unrelated activities. (194)

Fortunately for the Law Center, it is likely that its involvement in a cross-sector alliance that promotes sexual harassment prevention will be designated activity that is directly related to its exempt purpose of advancing women’s rights. Social service nonprofit organizations are generally permitted to participate in a substantial amount of business activity so long as that activity is in furtherance of its exempt purposes. However, there is an important historical limitation to this rule called the commerciality doctrine. (195) Recall from Section III that this doctrine is applied to deny or revoke tax exemption where the organization’s activities, even related activities, become “too commercial.” (196) This muddies the water for any social service nonprofit organization contemplating enterprise strategies, even where the enterprise is directly in pursuit of its mission. As noted by tax scholar Bruce Hopkins, “[there are tax court cases that go] a long way toward establishing the principle that efforts to be efficient, productive, and successful will be equated with substantial commercialism, and that tax exemption is fostered by volunteers struggling to keep an organization afloat in a sea of red ink.” (197) Fortunately this perspective has been largely rejected by the federal courts that refuse to revoke tax-exempt status from social service nonprofit enterprises that experience financial success, so long as they remain true to their charitable goals. (198) As stated by one such court, “the pertinent inquiry is whether the [organization’s] exempt purpose transcends the profit motive rather than the other way around.” (199)

The sixth factor in the Aid to Artisan’s analysis speaks to the private inurement doctrine and its sister, the private benefit doctrine. As explained in Section III, both doctrines are intended to prevent tax-exempt organizations from serving private rather than public interests. Organizations granted the privilege of tax-exempt status under Section 501(c)(3) of the Code are public charities. If a tax-exempt organization serves the financial interest of either insider beneficiaries (founders, directors, officers, etc.) or disinterested outsider beneficiaries, it will be denied tax-exempt status on the basis that it is operated for the substantial non-exempt purpose of benefiting private interests. (200) Therefore, even if the Law Center avoids the commerciality doctrine, it may risk losing its tax-exempt status if its participation in the cross-sector alliance confers an illegal private benefit on its business sector partner. The private inurement and private benefit doctrines have presented particular problems for charitable organizations engaged in alliances with for-profit entities that take the form of a partnership (i.e., cross-sector partnerships). (201)

A partnership is simply a type of business entity recognized under state law. The Uniform Partnership Act defines partnership as an association of two or more persons to carry on as co-owners a business for profit. (202) Under the Code, partnership entities do not pay income taxes. (203) Rather, they are treated as pass-through entities transferring net revenue to the individual partners who are then responsible for paying tax on the net income. (204) A cross-sector partnership can take the form of a general partnership, a limited partnership or a limited liability company. A general partnership is simply an arrangement in which the parties carry on a trade or business for the joint benefit and profit of all concerned. (205) Unless otherwise agreed, all the partners are equally responsible for management of partnership business. (206) They are also equally liable for its debts. (207) By contrast, a limited partnership is a partnership comprised of one or more general partners who manage the business of the partnership and are personally liable for its debts, and one or more limited partners who contribute capital and share in profits, but who take no part in management and are not responsible for its liabilities. (208) Limited liability companies, or LLCs, may be organized in similar fashion to either a general partnership or a limited partnership. (209) The partners, called members, may elect a form of decentralized management, in which case each member has an equal right to manage the affairs of the company. (210) This form is referred to as a member-managed LLC and is very similar to the general partnership form, at least with respect to day-to-day management of the company’s affairs. If the members desire centralized management in one or more members, they will opt to organize as a manager-managed LLC. This type of LLC is more like a limited partnership with regard to management responsibility. However, for both the member-managed and the manager-managed LLC, the members bear no personal liability for company debts and obligations. (211)

The IRS has historically resisted granting tax-exempt organizations approval for participation in cross-sector partnerships with for-profit entities, concluding that such participation was incompatible with maintaining tax-exempt status. (212) The IRS has reasoned that this type of commercial activity may ultimately confer on the for-profit partner substantial financial benefits in violation of the private inurement doctrine. (213) It has also focused on the conflict of interest that is present when the tax-exempt organization has a legal duty to operate the partnership so as to maximize profits for its private partners while simultaneously conducting its operations in furtherance of its own charitable purposes. (214) This risk is particularly prevalent in the case of a limited partnership where the tax-exempt organization serves as the general partner and the private for-profit partner or partners serve as limited partners. (215)

For example, in Housing Pioneers, Inc. v. Commissioner, (216) the IRS denied tax-exempt status under Section 501(c)(3) of the Code to Housing Pioneers, a nonprofit organization created to provide affordable housing to low-income and handicapped persons, and pre- and post-incarcerated persons. (217) The organization participated as a co-general partner in a number of limited partnerships formed to develop housing that could be rented at reduced rates due to the Housing Pioneer’s presumed exempt status. The U.S. Tax Court held, and the Ninth Circuit Court of Appeals affirmed, that Housing Pioneers did not qualify for exemption because it had a non-exempt purpose that was substantial, and because private investors benefited from the partnership. (218) The non-exempt purpose was to provide the benefit of state property tax exemption and federal low income housing tax credit to private investors. Essentially the private investors would realize a benefit from the ability to reduce rents because of Housing Pioneer’s tax exemption without having to depend on partnership assets to cover expenses.

Most of the recent federal tax law in this area has developed as a result of innovative financing techniques by, or for the benefit of, nonprofit healthcare organizations suffering from a lack of adequate funding. (219) The financing model generating much of the activity by the IRS and the courts is the “whole hospital joint venture,” which involves a nonprofit hospital transferring its assets to a joint venture ultimately controlled by a for-profit firm. In 1998, the IRS issued Revenue Ruling 98-15, which addressed the issue of whether a nonprofit hospital participating in such a joint venture could continue to qualify for tax-exempt status under Section 501(c)(3) of the Code. The Ruling speaks directly to tax-exempt hospitals seeking to participate in a whole hospital joint venture to sustain their healthcare mission. However, the analysis in the Ruling has been lauded as having broad application in the analysis of tax-exempt entity/taxable entity partnerships. (220) In the Ruling, the IRS held that an organization may participate in an alliance with a for-profit partner without risking its tax-exempt status if “participation in the partnership furthers a charitable purpose, and the partnership arrangement permits the exempt organization to act exclusively in furtherance of exempt purposes and only incidentally for the benefit of the for-profit partners.” (221)

If a social service nonprofit organization, like the Law Center, seeks to engage in a cross-sector alliance, it would be wise to comply with the requirements of Revenue Ruling 98-15. (222) It should structure the alliance in such a way as to ensure that the venture furthers a charitable purpose, and any financial benefit conferred on the for-profit partner or partners is purely incidental to achieving that purpose. Unfortunately, there is no blueprint for satisfying these two somewhat obscure requirements. (223) The IRS will look at the facts and circumstances of each alliance in determining whether in a particular case the social service nonprofit organization can maintain its tax-exempt status. The Ruling does identify the following as significant factors for the nonprofit organization in retaining its exempt status: management control of the alliance (i.e., voting control of the board of directors)

VI. CONCLUSION

The current political and economic environment has many social service nonprofit organizations in a crisis. Traditional revenue sources are rapidly dwindling. Recent controversies have the public crying for nonprofit accountability and outcome measurement. All the while the need for basic social services has never been more apparent.

Social service nonprofit organizations that adopt an entrepreneurial approach to sustaining social mission may have the solution. These social entrepreneurs strive for a “double bottom line

A decision to venture into Enterprise is a long-term management solution that requires contemplating both the business and legal challenges that arise when nonprofit organizations pursue entrepreneurial strategies. Risks will be specific to each social service nonprofit organization. This paper identifies and reviews those that must be considered at the outset of management’s planning process. It suggests proven business tools for addressing cultural and operational issues and provides an initial analytical framework for contemplating the federal tax implications of Enterprise.

APPENDIX A

Internal Revenue Code [section] 501 Exemption from tax on corporations, certain trusts, etc.

(a) Exemption from taxation.

An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.

(b) Tax on unrelated business income and certain other activities.

An organization exempt from taxation under subsection (a) shall be subject to tax to the extent provided in parts II, III, and VI of this subchapter, but (notwithstanding parts II, III, and VI of this subchapter) shall be considered an organization exempt from income taxes for the purpose of any law which refers to organizations exempt from income taxes.

(c) List of exempt organizations.

The following organizations are referred to in subsection (a)

(1) Any corporation organized under Act of Congress which is an instrumentality of the United States but only if such corporation–

(A) is exempt from Federal income taxes

(i) under such Act as amended and supplemented before July 18, 1984, or

(ii) under this title without regard to any provision of law which is not contained in this title and which is not contained in a revenue Act, or

(B) is described in subsection (l).

(2) Corporations organized for the exclusive purpose of holding title to property, collecting income therefrom, and turning over the entire amount thereof, less expenses, to an organization which itself is exempt under this section. Rules similar to the rules of subparagraph (G) of paragraph (25) shall apply for purposes of this paragraph.

(3) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

(4)

(A) Civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare, or local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes.

(B) Subparagraph (A) shall not apply to an entity unless no part of the net earnings of such entity inures to the benefit of any private shareholder or individual. (5)-(28) Intentionally Deleted.

ENTERPRISE RISK IDENTIFICATION MATRIX

Commercialization Independent Nonprofit Cross-

of Core Programs Business Consortia Sector

Enterprise Alliances

Business

Challenges

Cultural

* Maintaining Yes No No Yes

Organizational

Legitimacy

* Maintaining Yes No No Yes

Clarity

of Mision

* Cultural Fit No No No Yes

* Employee Morale Yes No No Yes

Operational

* Overburdened Yes No Yes Yes

Management and

Staff

* Loss of No Yes Yes Yes

Managerial

Control

* Complications Yes No No Yes

with Resource

Allocation

* Increased No Yes No Yes

Administrative

Costs

* Conflict No No Yes Yes

Resolution

Legal

Challenges

* Maintaining Tax Yes Yes Yes Yes

Exempt Status

(1) See Gary W. Jenkins, The Powerful Possibilities of Nonprofit Mergers: Supporting Strategic Consolidation Through Law and Public Policy, 74 S. CAL. L. REV. 1089, 1094 (May 2001).

(2) See id.

(3) See id. For information on employment statistics in the nonprofit sector see MICHAEL O’NEILL, THE THIRD AMERICA: THE EMERGENCE OF THE NONPROFIT SECTOR IN THE UNITED STATES 1 (1989). Nonprofit organizations also rely significantly on volunteer efforts to supplement employee contributions. In fact, one in two adult Americans volunteers time for nonprofit causes. Jenkins, supra note 1, at 1095.

(4) J. GREGORY DEES, SOCIAL ENTERPRISE: PRIVATE INITIATIVE FOR THE COMMON GOOD 1 (HARV. BUS. SCH. PUB. 1994) [hereinafter DEES, SOCIAL ENTERPRISE].

(5) See id. at 9-11

(6) See e.g., Dees, Enterprising Nonprofit, supra note 5

(7) See J. Gregory Dees, The Meaning of Social Entrepreneurship (Oct. 31, 1998), at Stanford Graduate School of Business Website http://www.gsb.stanford.edu/CSI/SEDefinition.html (last visited Nov. 2, 2002) [hereinafter Dees, Social Entrepreneurship].

(8) See id. Outcome measurement is a complex issue for nonprofit organizations. Much has been written of late on this topic. See e.g., ROBERTS ENTERPRISE DEVELOPMENT FUND, SOCIAL RETURN ON INVESTMENT COLLECTION (2001), at http://www.redf.org/pub_sroi.htm (last visited Sept. 25, 2003).

(9) See generally, THE NONPROFIT ENTREPRENEUR, CREATING VENTURES TO EARN INCOME (Edward Skloot ed., 1988) [hereinafter THE NONPROFIT ENTREPRENEUR].

(10) See Dees, Social Entrepreneurship, supra note 7

(11) But see Rita Marie Cain, Marketing Activities in the Non-Profit Sector–Recent Lessons Regarding Tax Implications, 36 AM. BUS. L.J. 349 (1999)

(12) See, e.g., PETTER C. BRINCKERHOFF, SOCIAL ENTREPRENEURSHIP: THE ART OF MISSION-BASED VENTURE DEVELOPMENT 175-199 (2000)

(13) Interview with Larry Fehr, Senior Vice President, Pioneer Human Services, in Seattle, Wa. (July 23, 2001).

(14) 71 T.C. 202, 209-10 (1978).

(15) See Salamon, supra note 6.

(16) See Jennifer Alexander, The Impact of Devolution on Non Profits: A Multiphase Study of Social Service Organizations, 10 NONPROFIT MGMT. & LEADERSHIP 57 (Fall 1999).

(17) But see Laura Meckler, Bush Administration Rewriting Regulations Handing Out Dollars to Boost Religious Groups, THE ASSOCIATED PRESS, Sept. 4, 2002

(18) See Alan Clendenning, Lean times thinning charities’ coffers us service needs grow, CHI. TRIB., Oct. 6, 2002, at B8

(19) Nonprofits are looking for ways to rely less on donations and grants and more on fees and contracts. For example, some nonprofits are accepting contracts from government agencies to run social service and job training programs. Others are charging corporations or other beneficiaries fees for services that used to be provided free of charge. See Dees, Enterprising Nonprofits, supra note 5, at 6-7

(20) See Salamon, supra note 6.

(21) See id.

(22) See Jed Emerson et al., Social Return on Investment: Exploring Aspects of Value Creation in the Nonprofit Sector, in 2 SOCIAL PURPOSES ENTERPRISES AND VENTURE PHILANTHROPY IN THEN NEW MILLENNIUM 132-73 (1999), available at http://www.redf.org/download/boxset/REDF_Vol2_8.pdf

(23) One model employed by the Roberts Enterprise Development Fund attempts to capture three types of return generated by nonprofits: economic value (e.g., product and service offerings)

(24) See Salamon, supra note 6.

(25) See id.

(26) See id.

(27) Shirley Sagawa & Eli Segal, Common Interest, Common Good: Creating Value Through Business and Social Sector Partnerships, 42 CAL. MGMT. REV. 105, 112 (Winter 2000)

(28) See Sagawa & Segal, supra note 27, at 112.

(29) See Gottry, supra note 11, at 255-59.

(30) See id.

(31) See Dees, Enterprising Nonprofits, supra note 5, at 5.

(32) See Diane Brady, When Nonprofits Go After Profit, BUS. WK., Jun. 26, 2000, at 173.

(33) See BRUCE R. HOPKINS, THE LAW OF TAX-EXEMPT ORGANIZATIONS 3-7 (7th ed. 1998) [hereinafter HOPKINS, TREATISE].

(34) Henry Hansmann, The Role of Nonprofit Enterprise, 89 YALE L.J. 835 (1980).

(35) See HOPKINS, TREATISE, supra note 33, at 5.

(36) See Bruce R. Hopkins, The Legal Context of Nonprofit Enterprise, in THE NONPROFIT ENTREPRENEUR 12 (Edward Skloot ed., 1988) [hereinafter Hopkins, Legal Context of NP Enterprise].

(37) See HOPKINS, TREATISE, supra note 33, at 7. At the state level, there are exemptions for state income, sales, use, excise and property taxes. Id.

(38) I.R.C. [section] 501 (2002). See appendix A for select provision of Section 501 of the Code.

(39) See I.R.C. [section] 501 (c)(7) (social clubs)

(40) See John G. Simon, The Tax Treatment of Nonprofit Organizations: A Review of Federal and State Policies, in THE NONPROFIT SECTOR: A RESEARCH HANDBOOK 60, 67 (W. Powell ed., 1987) (comparing charitable and noncharitable nonprofit organizations).

(41) Organizations that are exempt from federal income tax under I.R.C. [section] 501 (c)(3) include: [C] orporations, and any community chest, fund or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals….

(42) See HOPKINS, TREATISE, supra note 33, at 85-96

(43) See HOPKINS, TREATISE, supra note 33, at 88-96.

(44) See I.R.C. [section] 501 (a) (available in Appendix A). Section 501 (a) also exempts from income taxation organizations described in sections 501(d) (concerning certain religious organizations) and 401(a) (concerning employee benefit trusts). These sections are not at issue in this paper.

(45) See I.R.C. [section] 501 (c)(3) (available in Appendix A). Section 501 (c)(3) organizations include both public charities and private foundations.

(46) HOPKINS, TREATISE, supra note 33, at 69.

(47) I.R.C. [section] 170 (2002).

(48) Bob Jones Univ. v. U.S., 461 U.S. 574, 589 (1983).

(49) Id. at 590 (quoting Congressional hearings in the enactment of Revenue Act of 1938. H.R. Rep. 75-1860, at 19 (1938)).

(50) Aid to Artisans, Inc. v. Commissioner, 71 T.C. 202, 209-10 (1978).

(51) I.R.C. [section] 501(c)(3).

(52) See generally Hansmann, supra note 34.

(53) See Treas. Reg. [section] 1.501 (c)(3)- 1(d)(1)(ii)

(54) I.R.C. [section] 501(c)(3)

(55) I.R.C. [section] 511 (2002).

(56) See HOPKINS, TREATISE, supra note 33, at 54.

(57) See Treas. Reg. [section] 1.501(c)(3)-1(b)

(58) See HOPKINS, TREATISE, supra note 33, at 55.

(59) See id. at 56.

(60) See Aid to Artisans, 71 T.C. at 210-11.

(61) See Treas. Reg. [section] 1.501(c)(3)-1(c).

(62) See id.

(63) See Marni Hussong, Protecting the Tax Exempt Status of Housing Developers Participating in Low-Income Housing Tax Credit Partnerships, 76 WASH. L. REV. 243,250 (2001). Engaging in commercial activity, on an insubstantial basis will not prevent the organization from obtaining tax-exempt status, but it may result in unrelated business income tax (UBIT). See the discussion on UBIT, infra pages 16-21.

(64) See Hopkins, Brief Guide supra, note 12.

(65) 72 T.C. 687 (1979).

(66) Id. at 692.

(67) Id.

(68) 321 F. Supp. 972 (N.D. Cal. 1970), aff’d, 481 F.2d 175 (9th Cir. 1973).

(69) See id. at 976.

(70) See id. at 977.

(71) T.C. at 202.

(72) See id. at 211-14.

(73) See id. at 214.

(74) See id.

(75) See Treas. Reg. [section] 1.501(a)-1(c)

(76) Treas. Reg. [section] 1.501(c)(3)-1(d)(1)(ii)

(77) See Hopkins, Brief Guide, supra note 12, at 301.

(78) See id.

(79) Am. Campaign Acad., 92 T.C. at 1065.

(80) See id.

(81) See id. at 1053

(82) Am. Campaign Acad., 92 T.C. at 1070.

(83) See id. at 1075.

(84) I.R.C. [section] 511.

(85) See Gottry, supra note 11, at 267

(86) See I.R.C. [section] 513(a) (2002).

(87) I.R.C. [section] 511.

(88) See I.R.C. [section] 513.

(89) 477 U.S. 105, 114 (1986).

(90) 950 F.2d 365 (7th Cir. 1991), aff’d, 60 T.C. MEM. (CCH) 710 (1990).

(91) See id. at 372-74.

(92) See e.g., Steven D. Simpson, Tax Exempt Organizations: Organizational and Operational Requirements, 869 TAX. MGMT. (BNA) at A-197 (2000).

(93) Golden Rule Church Ass’n v. Commissioner, 41 T.C. 719, 731 (1964).

(94) Living Faith, 950 F.2d at 373 (citing B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352, 358 (1978)).

(95) See Cain, supra note 11, at 355-59.

(96) See I.R.C. [section] 512 (2002).

(97) See Suffolk County Patrolmen’s Benevolent Ass’n Inc. v. Commissioner, 77 T.C. 1314 (1981).

(98) See Rev. Rul. 75-200, 1975-1 C.B. 163.

(99) See Treas. Reg. [section] 1.513-1(d)(2).

(100) See Treas. Reg. [section] 1.513-1(d)(3).

(101) See Simpson, supra note 92, at A-197.

(102) Treas. Reg. [section] 1.513-1(d)(3) (as amended in 2001).

(103) See Rev. Rul. 76-402, 1976-2 C.B. 177.

(104) See Carle Found. v. U.S., 611 F.2d 1192 (7th Cir. 1979), cert. denied, 449 U.S. 824 (1980).

(105) See Rev. Rul. 73-105, 1973-1 C.B. 264.

(106) See Rev. Rul. 80-295, 1980-2 C.B. 194.

(107) See Rev. Rul. 78-435, 1978-2 C.B. 181.

(108) See Rev. Rul. 73-104, 1973-1 C.B. 263.

(109) See, e.g., I.R.C. [subsections] 513(a)(3), 513(h)(1)(A), 513(h)(1)(B), respectively.

(110) See I.R.C. [section] 513(a)(1)

(111) See HOPKINS, TREATISE, supra note 33 at 742.

(112) See id. at 723-53.

(113) See Gottry, supra note 11, at 258-60 (providing an overview of factors distinguishing nonprofit operations).

(114) See Edward Skloot, How to Think About Enterprise, in THE NONPROFIT ENTREPRENEUR 27, 30-34 (Edward Skloot ed., 1988) [hereinafter Skloot, Enterprise].

(115) See id. at 31.

(116) See id.

(117) See Wim Wiewel, Organizing for Business: The Organizational Context of Income-Generating Activities, in THE NONPROFIT ENTREPRENEUR 121 (Edward Skloot ed., 1988).

(118) See Skloot, Enterprise, supra note 114, at 32.

(119) Id.

(120) See Edward Skloot, The Venture Planning Process, in THE NONPROFIT ENTREPRENEUR 37 (Edward Skloot ed., 1988)

(121) See Skloot, Enterprise, supra note 114, at 32.

(122) Id. at 32-33.

(123) See id. at 33.

(124) Id.

(125) See id.

(126) See id.

(127) It should be noted that in connection with the business planning process the organization will need to complete legal due diligence. It will need to review its organizational documents and make appropriate changes to allow for commercial activity. This may involve amending the articles of incorporation, bylaws and tax exemption application.

(128) See Skloot, Enterprise, supra note 114, at 34.

(129) Cf. Alexander, supra note 16 (discussing throughout how particular types of nonprofits are better positioned to commercialize than others).

(130) See http://www.pioneerhumanserv.com (last visited Sept. 25, 2003).

(131) Id.

(132) See id.

(133) See http://www.nwwlc.org (last visited Sept. 25, 2003).

(134) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 331.

(135) See Wiewel, supra note 117, at 127-28.

(136) See id. at 126-27.

(137) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 331.

(138) See infra Appendix A.

(139) See Brinckerhoff, supra note 12, at 192.

(140) See id. at 185.

(141) There are tax and legal implications unique to a nonprofit parent, for-profit subsidiary structure. If the subsidiary is controlled (meaning the nonprofit owns eighty percent or more of the for-profit subsidiary) the dividends from the subsidiary to the parent will not result in taxes for the nonprofit parent

(142) See id. at 192

(143) See Brinckerhoff, supra note 12, at 192.

(144) See Hopkins, Legal Context of NP Enterprise, supra note 36, at 24.

(145) See MERRIAM-WEBSTER ONLINE, at http://www.m-w.com(last visited Sept. 25,2003).

(146) See Brinckerhoff, supra note 12, at 197.

(147) See Jenkins, supra note 1, at 1107.

(148) See Brinckerhoff. supra note 12, at 196. The group is not limited to the partnership form in this regard. They may also establish a separate nonprofit corporation to own and operate the real estate or form a limited liability company for that purpose.

(149) See HOPKINS. TREATISE, supra note 33, at 150 (citing Rev. Rul. 67-4, 1967-1 C.B. 121).

(150) See id.

(151) See Associated Hosp. Serv., Inc. v. Commissioner, 74 T.C. 213 (1980).

(152) See HOPKINS, TREATISE, supra note 33, at 150

(153) See Jenkins, supra note 1, at 1114-22 (discussing state law requirements associated with this strategy).

(154) See id. at 1122.

(155) See id. at 1104.

(156) See id. at 1109-12.

(157) See id at 1108.

(158) See id. at 1105-06.

(159) Rosabeth Moss Kanter, From Spare Change to Real Change: The Social Sector as Beta Site for Business Innovation, HARV. BUS. REV., May-June 1999, at 124.

(160) See id.

(161) See Sagawa & Segal, supra note 27, at 111.

(162) See id.

(163) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 314, 316-21

(164) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 315-16.

(165) See Kanter, supra note 159, at 124.

(166) See Sagawa & Segal, supra note 27, at 105.

(167) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 314

(168) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 314.

(169) See Andreasen, supra note 162, at 58-59.

(170) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 319.

(171) See Andreasen, supra note 162, at 50.

(172) See id. at 50-55.

(173) See id. at 58-59.

(174) For an interesting discussion regarding what private enterprise can learn from nonprofits’ focus on mission, see Peter E. Drucker, What Business Can Learn from Nonprofits, HARV. BUS. REV., July-Aug. 1989, at 88.

(175) See Dees, Enterprising Nonprofits, supra note 5, at 6-7.

(176) See Sagawa & Segal, supra note 27, at 113-14.

(177) See William P. Ryan, The New Landscape for Nonprofits, HARV. BUS. REV., Jan.-Feb. 1999, at 127 (discussing how nonprofits can adapt without compromising the qualities that distinguish them from for-profits)

(178) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 333.

(179) Id. at 334.

(180) See id. at 335.

(181) See id. at 336.

(182) See id. at 337.

(183) See id. at 338.

(184) See William P. Ryan, Nonprofit Capital, A Review of Problems and Strategies (2001), at The Rockefeller Foundation Website, http://www.rockfound.org/publications (last visited Sept. 25, 2003) (presenting a detailed discussion of funding sources and strategies for nonprofit organizations).

(185) See e.g., Federation Pharmacy, 72 T.C. at 687

(186) Aid to Artisans, 71 T.C. at 211.

(187) See id. at 204.

(188) See id. at 216.

(189) See id. at 214.

(190) See id. at 216.

(191) Federal tax-exempt stares can be revoked in several ways: 1) a notice to the organization by the IRS

(192) There are several different ways to measure these activities: receipts from activities, expenses attributable to activities, or amount of employee time spent on the activities.

(193) See Simpson, supra note 92, at A-206.

(194) See NEW SOCIAL ENTREPRENEURS, supra note 10, at 326.

(195) See Living Faith, 950 F.2d at 365.

(196) Id.

(197) HOPKINS, TREATISE, supra note 33, at 79-80 (citing Presbyterian & Reformed Pub. Co. v. Commissioner, 70 T.C. 1070 (1982), rev’d, 743 F.2d 148 (1984)).

(198) See id. at 80-82.

(199) Id. at 82.

(200) See infra notes 52-53, 75-83, and accompanying text.

(201) Cross-sector partnerships are just one form of cross-sector affiliations. See infra Section III

(202) UNIF. PARTNERSHIP ACT [section] 6(1) (1989).

(203) I.R.C. [section] 701 (2002).

(204) See I.R.C. [section] 7701(a)(2) for the Code’s definition of partnership.

(205) See CONSTANCE E. BAGLEY & CRAIG E. DAUCHY, THE ENTREPRENEUR’S GUIDE TO BUSINESS LAW 55-59 (2nd ed. 2003).

(206) See id. at 55.

(207) See id.

(208) See id. at 56.

(209) LLCs are often referred to as hybrid entities because they are treated like partnerships for tax purposes and like corporations for liability purposes. They are often attractive vehicles for start-up entities that expect a significant amount of losses in the early years and want to pass those losses on to the individual members. See id. at 59-62.

(210) See id. at 61.

(211) See id.

(212) For a discussion of the evolution of tax law in this area, see HOPKINS, TREATISE, supra note 33, at 826-33.

(213) See id. at 832-33.

(211) See David M. Flynn, Tax Court’s Derision in Redlands Provides Limited Endorsement for IRS Position on Joint Ventures, 91 J. TAX’N 241 (1999).

(215) See id. In contrast, joint venture arrangements have received less scrutiny from the IRS so long as the exempt organization’s participation furthers its exempt purpose and the joint venture agreement does not prevent it from acting exclusively to further those purposes. See HOPKINS, TREATISE, supra note 33, at 833.

(216) 65 T.C.M. (CCH) 2191 (1993), aff’d, 58 F.3d 401 (9th Cir. 1995).

(217) Cf. Plumstead Theatre Soc., Inc. v. Commissioner, 74 T.C. 1324 (1980).

(218) Housing Pioneers, 58 F.3d at 402

(219) See HOPKINS, TREATISE, supra note 33, at 831.

(220) See Flynn, supra note 214, at 244.

(221) Rev. Rul. 98-15, 1998-12 I.R.B. 6, 9

(222) This analysis would likely be the same for a cross-sector alliance formed as a limited liability company (LLC) where the social service nonprofit organization assumes the role of managing member. On the contrary, if the LLC is formed as a member-managed entity, the social service nonprofit organization’s role would be more analogous to its role as a limited partner in a limited partnership. In other words, it would likely be responsible for paying tax on any unrelated income (UBIT), but the organization’s tax-exempt status would not be jeopardized. See Flynn, supra note 214, at 250.

(223) But see St. David’s Health Care System, Inc., 2002 U.S. Dist. LEXIS 10453.

(224) See Rev. Rul. 98-15, 1998-121 I.R.B. 6.

Gail A. Lasprogata *

Marya N. Cotten **

* Assistant Professor, Seattle University.

** Weil, Gotshal & Manges LLP.