Taxing social enterprise.

Author:Mayer, Lloyd Hitoshi
Position:Introduction through II. Taxation of For-Profit and Nonprofit Entities A. Current Tax Treatment of For-Profits and Nonprofits 2. Rationales for the Differing Tax Treatment b. Tax-base theory through Conclusion, with footnotes, p. 414-441
  1. Tax-base theory

The tax-base theory approaches the issue of tax exemption by beginning with the assumption that corporate income taxes are rightfully levied on enterprises that exist to produce revenues for private benefit. (131) Under this assumption, entities that are not organized for private profit and whose net income is inherently indeterminate should fall entirely outside the realm of taxable organizations. (132) This explains tax exemption for entities that engage in activities that the government is prohibited from having a hand in, or towards which the government is simply indifferent. (133)

A slight variant of the tax-base theory also solves the paradox presented by the subsidy theory with respect to deductions for charitable contributions. These deductions seem disproportionately to benefit the wealthy and give donors--again, mostly the well-to-do--the ability to direct government subsidies. (134) Tax-base theorists argue, however, that personal income taxes are intended "to reduce private consumption and accumulation in order to free resources for public use." (135) Because donations are put to public use, (136) they should be excluded from the tax base if tax is only to be levied upon personal consumption. (137)

Roughly speaking, the subsidy theory therefore looks on tax benefits as a legislative grace that relieves tax-exempt entities of the taxes that they would otherwise rightfully owe, thereby rewarding them for the public benefit that they provide. The tax-base theory, on the other hand, adjusts tax liability according to a more nuanced consideration of what amount of income is appropriately included in the normative base upon which tax is calculated: earnings of--and donations to--public-benefitting entities are simply not a part of the base. Regardless of the exact rationale that one accepts for the tax benefits provided to nonprofits--and none of the explanations fit the existing scope of these benefits perfectly--the benefits and the continuing distinction between for-profit and nonprofit entities are a firm part of the federal and state tax landscape.

  1. Current Tax Treatment of Hybrids

    Because hybrids are not specifically addressed by existing federal or state tax laws, their current tax treatment must be discerned from the general rules governing for-profit and nonprofit entities discussed above. Since benefit corporations and flexible purpose corporations are formed under existing state corporation laws while L3Cs are formed under existing state limited liability company laws, and since these state law differences generally lead to somewhat different federal tax treatments, it is best to consider them separately.

    1. Benefit corporations and flexible purpose corporations (138)

    Both benefit corporations and flexible purpose corporations are formed under the corporation law of their respective states, although with the special provisions noted previously. Because they have owners with rights to share in the entities' profits, they do not comply with the nondistribution constraint. This means they are not nonprofit corporations and so are not eligible for exemption from federal income tax under any of the currently available categories. As a result, and since they are organized as corporations under state law, federal tax law requires that they be classified either as an S corporation or as a C corporation for federal tax purposes. (139)

    As with other types of state law corporations, whether a benefit corporation or a flexible purpose corporation can choose S corporation status depends on whether it meets the eligibility requirements for that status. Those requirements include: having no more than 100 shareholders; having only shareholders who are U.S. citizens or residents, tax-exempt organizations, or certain trusts; having only a single class of stock such that ownership rights between shareholders vary only based on the number of shares owned; and filing the required IRS form to choose S corporation status. (140) If state law corporations, including benefit corporations and flexible purpose corporations, lack one of the required characteristics, then they will be classified as C corporations. (141) While it is certainly possible for benefit corporations and flexible purpose corporations to meet these requirements in theory, in practice it will not be possible to do so if such entities have different categories of investors with different rights, or if one or more investors are not eligible S corporation shareholders.

    If a benefit corporation or flexible purpose corporation is required to be a C corporation because it does not meet one or more of the S corporation requirements, then the organization will be subject to the federal corporate income tax and its state equivalent, if any. The fact that the organization may have public-benefitting goals as well as profitmaking goals is currently irrelevant for federal and state tax purposes. Such organizations will therefore calculate their taxable income and the tax owed on that income in the same manner as any other C corporation, including with respect to any expenditures for charitable or other public-benefitting purposes.

    If instead a benefit corporation or a flexible purpose corporation is eligible to choose S corporation status and in fact elects to do so, then the income and permissible deductions of the organization pass through the corporation to its shareholders. Taxable shareholders, such as individuals, then include their portion of that income and those deductions on their individual tax returns. If the income exceeds the deductions and the taxable shareholder does not have other deductions that she can use to offset the excess, she pays tax on that net income. Furthermore, shareholders that are themselves tax-exempt organizations also generally owe tax if the income allocated to them exceeds the deductions allocated to them from the organization. This result occurs because when Congress chose to include tax-exempt organizations in the list of eligible S corporation shareholders, it also classified the S corporation income allocated to such shareholders as unrelated business taxable income that is taxed at the corporate income tax rates. (142) This treatment applies regardless of the S corporation activity that generated the income. (143) It also applies to any gains that a tax-exempt shareholder might realize and recognize from the sale of its S corporation stock. (144) Congress's stated rationale for this automatic unrelated business taxable income treatment is that the relatively simple tax rules for S corporations are premised in part on the assumption that all income from an S corporation will be subject to shareholder-level taxation. (145)

    The bottom line is therefore that the net income earned by a benefit corporation or a flexible purpose corporation will be subject to federal income tax, and generally state income tax, either at the corporation level--if the organization is classified as a C corporation--or at the shareholder level--if the organization is classified as an S corporation. This result applies even if the organization is classified as an S corporation and the shareholder at issue is a tax-exempt organization.

    2. Low-profit limited liability companies (146)

    L3Cs are formed under state limited liability company statutes, although with the modifications noted previously. Domestic for-profit entities that are not corporations, including limited liability companies and partnerships of all types, may generally choose either to be classified as a partnership for federal tax purposes (the default option) or as a corporation and, if they choose corporation status, either to be classified as a S corporation (if eligible) or as a C corporation. (147) If such an entity does not choose corporation status and only has a single owner, however, it will be disregarded for federal tax purposes and its activities and income will be attributed to its single owner. If a single individual owns and operates a for-profit enterprise, either directly or through such a disregarded entity, then that enterprise is considered a sole proprietorship, with all of the income and deductions associated with that activity attributed to that individual and included on her individual tax return.

    As with limited liability companies generally, the default federal, and usually state, tax rule is that L3Cs are treated either as partnerships or, if they have a single owner, as disregarded entities for tax purposes. (148) As a result of this treatment the income and permissible deductions pass through the L3Cs to their owners, who then include that income and those deductions on their tax returns and, if net taxable income results that is not offset by other deductions, the owners will owe tax. Unlike S corporations, however, those owners may include any type of individual or entity and the allocation of income and deductions between owners may vary significantly, and may even be different depending on the type of income or the kind of deduction at issue. This attribute of L3Cs may be particularly attractive, since L3C advocates promote L3Cs as being particularly amenable to a tranched finance structure whereby private foundations make high-risk, low-return PRI infusions into the L3C, thereby attracting socially minded and traditional market members who make lower-risk and higher-return investments. (149) L3Cs, like limited liability companies generally, can, however, also choose to be taxed as corporations (C or, if eligible, S), in which case the tax consequences are the same as noted above for benefit corporations and flexible purpose corporations. (150)

    If an L3C is treated as a partnership or disregarded entity and one or more owners are tax-exempt nonprofit organizations, certain special rules apply. First, if the L3C is a disregarded entity with a tax-exempt organization as its sole owner, then the L3C's income...

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