Legal Structure

Legal Structure

A social enterprise may be incorporated either as a for-profit or a nonprofit.1 It is however important to recognize that social enterprises are not defined by their legal status: legal status may be arbitrary. A social enterprise’s structure or model is not a definitive determinate of its legal status.

The decision to incorporate the social enterprise separately from the parent, and then to do so as a for-profit or nonprofit is driven by one or more of the following factors:

Legal Environment

The law in many countries does not make provisions or recognize the social enterprise (income-generating nonprofit) as legitimate or legal. Therefore, nonprofit organizations risk losing their nonprofit status and associated privileges by launching a social enterprise or income-generating activity. Some countries have made special provisions in the law and tax codes for social enterprises.

Legal issues are complex and vary widely. The environment is more enabling in some countries than in others; however, there is still work to be done around the world on this issue.

Generally speaking governments regulate social enterprise according to:

  • nature of business activities--related or unrelated to organization's mission;
  • use or destination of earned income--to mission activities or other purposes;
  • source of income--general public, clients, 3rd party payers (insurance, donors), government;
  • the amount of income earned through social enterprise--limits placed on either monetary amount of percentage of budget; or
  • a combination of these.

In any case, the legal situation must be analyzed on a country-by-country and case-by-case basis.

Regulatory Environment in Emerging Market Countries2

While the legal environment varies from country to country, a general lack of clarity in the law about the legality and tax treatment of NGOs engaged in economic and commercial activities in emerging market countries results in a variety of practical and ethical challenges for many NGOs.3

Many social enterprises operate in "legal grey areas," fearing that their commercial activities will jeopardize their NGO status. Attempts to remain "off the radar screen" of local authorities forces social enterprises to remain small and thus unable to maximize their profit potential or achieve scale. In some instances, local authorities or "tax police" take advantage of the ambiguous laws and extort social enterprises, requiring them to pay bribes or exorbitant taxes that can threaten the survival of both the enterprise and the NGO. In other cases, governments have eagerly looked to social enterprises as a new mechanism for building the tax base, and charged high taxes on earned income, crippling social enterprise performance and preventing them from achieving their purpose of funding social activities. Where the laws are clearer, reporting requirements can be burdensome, penalties harsh, or tax incentives nonexistent. Furthermore, the lack of clarity in the law presents an ethical dilemma for NGOs as they struggle to promote and preserve a reputation of transparency and accountability to their constituents, donors, and public-at-large, while also trying to identify the most favorable tax treatment for their social enterprise.

Although the microfinance field has made inroads into creating an enabling environment for NGO financial service businesses and raising awareness about NGO income generated as a means to achieve sustainability, the legal environment for social enterprise development can still be strengthened. Advocacy efforts have the opportunity to dovetail with the work of microfinance, broadening governments' understanding of social enterprises not as a mechanism to build the tax base, but rather as an instrument to replace government funds that draw from taxes. An unambiguous and favorable legal environment, such as tax incentives to social enterprises, would not only foster growth in this field, but would also serve to increase integrity and clarify ethical questions and public misperceptions regarding NGO commercial activities.

Access to Capital

Social enterprises are capitalized through a variety of different instruments: grants, loans, charitable contributions, program-related investments (soft loans, etc.), or a combination thereof. The type of funding a social enterprise is able to obtain depends on its maturity, reputation, availability of funding (nonprofit capital market), and legal structure. On the latter point, an organization may choose a legal structure that is consistent with the funding it seeks. For-profits are often barred from receiving philanthropic funds and soft loans, whereas nonprofits have difficulty obtaining commercial funds--borrowed capital. In this case, legal status may be guided by the requirements for the most suitable type of funding.

Capitalization

Undercapitalization is a problem as common in private business as it is for social enterprises, particularly for capital intensive enterprises such as manufacturing. For-profits have the ability to raise equity investments that, depending on the local laws, are not an option for nonprofits, whose assets are considered publicly owned. Some social enterprises opt to incorporate as a for-profit and many mature nonprofits convert their legal status in order to capitalize the business with private funds in exchange for equity. In the early stage, social enterprise incubation usually occurs within a nonprofit parent, which also serves to capitalize the nascent enterprise.

Leadership Decision

Frequently the board or executive director will opt to incorporate the social enterprise as a separate legal entity simply out of preference. Integrating business practices and income-generation into a nonprofit organization rocks institutional culture and tests capacity, potentially threatening core social service programs of the parent organization and causing internal strife or mission drift. Also, when the business is unrelated to the organization's mission, it can be difficult to gain stakeholder and staff support. In these instances, leadership may prefer to separate the entities both physically and legally.

  • 1In the US this is a 501(c)(3) and in most developing countries a nongovernmental organization (NGO)
  • 2For more information pertaining to social enterprise legal issues in emerging markets see: Etchart, Nicole and Lee Davis, Legal Series: Chile and Columbia, 2002; and Profits For Nonprofits, NESsT, 1999, chapter 3 Legal Issues as well as: International Center for Not-For-Profit Law (ICNL)
  • 3Etchart, Nicole and Lee Davis, Unique and Universal: Lessons from the Emerging Field of Social Enterprise in the Emerging Market Countries, NESsT, 2003.