Preventing Private Inurement in Tranched Social Enterprises

Abstract

Social Enterprises are organizations that are operated for the dual purpose of engaging in profit-making activity and furthering a social good. Because of their “hybrid” nature, social enterprises are perceived to be stymied by a legal system that is overly devoted to defining organizations as either businesses or nonprofits. Legal academics and legislatures have been hard at work trying to make room for social enterprises by experimenting with modifications the laws that constrain both businesses and nonprofits. One significant sector of this reform movement is devoted to making it easier for social enterprises to receive funding from both for-profit investors and charitable non-profits. They argue that social enterprises will not flourish until charitable non-profits are permitted make below-market investments in social enterprises for the purpose of subsidizing the return expected by for-profit investors. This combination of below-market charitable investments and market-rate for-profit investments is generally called a “tranched investment structure.” It is not impossible under current law, but reformers argue that it is unnecessarily difficult, primarily because of federal laws restricting nonprofit activities.

This article addresses the specific legal issues raised by a tranched investment structure. Previous scholarship (and legislative reform) has focused on specific rules that apply only to “private foundations,” a subcategory of §501(c)(3) organizations, the general federal classification of charities. But, surprisingly, commentators have largely ignored the laws that apply to tranched investment structures involving any 501(c)(3) organization. This article fills that gap.

This article argues that the IRS should issue guidance clarifying that the "private inurement regime" prevents a charity's insiders from investing in a for-profit social enterprise in which the charity is also an investor. At the same time, it should issue guidance clarifying that a fully independent charity investing in a for-profit social enterprise is not at risk of losing its tax exemption because of the "private benefit regime." Emphasizing the importance of independence as a check on abuses of the tranched structure will enable social entrepreneurs to innovate while the law continues to protect the interests of charitable contributors, the federal government and the charitable sector.

Keywords: nonprofit, social enterprise, social entrepreneurship, charity, tranched investment, not-for-profit