How to Build a Successful (And Lawsuit-Proof) Benefit Corporation
By Cliff Ennico
“Some friends and I are thinking about setting up a benefit corporation or ‘B Corp.’ for our business, which has a strong social mission. We realize these are very new, and don’t want to do anything that will cause trouble for us or our investors down the road. What should be doing to make sure things go smoothly and we actually have the positive impact on society that we plan?”
The benefit Corporation or “B Corp” is becoming an extremely popular vehicle for “social enterprise” startups (http://en.wikipedia.org/wiki/Benefit_Corporation). Basically a hybrid between a “for profit” corporation and a nonprofit organization, the dual purpose of a benefit corporation is (1) to create general public benefit, defined as a material positive impact on society and the environment, and (2) to generate a return for its shareholders. A benefit corporation’s directors and officers operate the business with the same authority as in a “for profit” Corporation but are required to consider the impact of their decisions not only on shareholders but also on society and the environment. Benefit Corporations, being “for profit,” have no exemption from federal and state taxes, and people cannot make tax-deductible donations to them.
As you can see, there is a built-in tension between these dual purposes. When making a specific decision, how will management weigh the Corporation’s social purpose against its “profit motive”?
The reality is that most investors in a startup benefit corporation won’t be too concerned about realizing a return on their investment. They will share the founding entrepreneurs’ zeal to accomplish the B Corp’s social purpose, and will view any return on their investment as “icing on the cake”.
At least they will in the beginning, when the corporation has no money, there’s nothing to fight about, and the investors can write off the corporation’s operating losses on their tax returns.
But once the benefit corporation grows and generates millions of dollars in profit, it’s likely these socially-motivated investors will want to see some money coming back their way, and later investors in these successful companies may balk at seeing all of the profits being plowed back into the corporation’s social purpose. That will put the corporation’s officers and directors in an extremely uncomfortable position if they don’t take several actions early on. Here are some things I’m telling my B Corp clients to do.
Don’t Take the “S” Election. I think a B Corp should be taxed as a regular or “C” Corporation rather than an “S Corporation, even if it legally qualifies for the S election. Since shareholders in an S Corporation are required to pay taxes on their percentage share of the Corporation’s income regardless of the amount actually distributed to them, successful B Corps that take the “S” election will generate a huge amount of “phantom income” for their owners if they devote all their profits to their social purposes. If a B Corp is established as an “S” Corporation, the by-laws should clearly require an annual distribution of cash to the shareholders in an amount at least sufficient to cover their tax liabilities.
Look at Your State’s “B Corp” Statute. B Corps are recognized in only about 28 states, so it’s possible your state doesn’t allow B Corps yet. That needs to be looked into. Also, while Section 301 of the model B Corp statute (www.benefitCorp.net/storage/documents/Model_Benefit_Corporation_Legislation.pdf) exonerates directors from any liability to shareholders for the decisions they make, some states have made significant changes to the model statute. If your state has watered down or qualified Section 301, you need to know exactly how.
Get Signed Affidavits from Your Shareholders. Until B Corps are more recognized in the marketplace, I recommend that shareholders be required to sign a sworn affidavit saying (at least):
- That they recognize a B Corp, although legally “for profit,” has a social and environmental purpose that may take precedence over its obligations to shareholders;
- That decisions regarding dividends and other distributions to shareholders are in the sole discretion of the Corporation’s directors and officers;
- That it is possible the shareholder will never receive a return on his or her investment if the B Corp’s directors and officers view its social/environmental purpose as paramount;
- That any return on the shareholders’ investment will be subject to federal and state income taxes;
- That the shareholder will not sue the Corporation, or any director or officer, because of any decision made by the Corporation’s management (except for criminal activity and “willful misconduct”); and
- That any person to whom the shareholder transfers his/her shares will be required to sign a similar affidavit.
Let People Know You Are Not a Nonprofit. To the untrained eye, a B Corp looks an awful lot like a nonprofit or charity. When putting together a B Corp’s marketing materials and website, it is important to state (using all capital letters and boldfaced type) that the Corporation is not exempt from federal and state taxes, that investments in the Corporation are not tax-deductible, and that investors should consult their legal and tax advisors before making an investment in a B Corp.
Cliff Ennico (www.succeedinginyourbusiness.com), a leading expert on small business law and taxes, is the author of Small Business Survival Guide, The eBay Seller’s Tax and Legal Answer Book and 15 other books. Follow him at @cliffennico.