L3C’s, B Corps and Social Enterprises
Wikipedia defines a “social enterprise” as “any for-profit or non-profit organization that applies capitalistic strategies to achieving philanthropic goals.” The concept has been getting quite a bit of attention recently–without a doubt, for good reasons. Within the past few years, the Low Profit Limited Liability Company (“L3C”) and the Benefit Corporation (“B Corp.”) have arisen as sort of quasi entity classifications to allow social enterprises to distinguish themselves in a formal manner from their more profit-focused counterparts. We’ve been getting questions about them, so…here’s what they are, and more importantly, what they’re not.
L3Cs
A number of states have enacted L3C statutes, although Ohio is not one of them. L3C entities are similar to LLCs but have certain features which attempt to make them more attractive to private foundations seeking to make an investment. In order to maintain its charitable (tax-free) status, a private foundation must disburse much of its profit each year. But, if a private foundation makes a qualifying investment related to the foundation’s purpose, then the investment will count toward the annual distribution and will not jeopardize the foundation’s charitable purpose. However, the private foundation must bear significant costs to ensure that an investment meets IRS requirements (usually by seeking a private letter ruling from the IRS). The L3C entity is designed to remedy this problem by baking the IRS’s requirements for a qualifying investment directly into the authorizing statute, thereby eliminating the need for a private letter ruling. So, theoretically, an L3C should be more attractive to private foundations because the foundation will have lower investigation costs associated with making the investment.
Unfortunately, the IRS has not formally recognized L3C status as meeting its requirements (and there has been no indication that they will do so in the near future). The concept is great–enabling private foundations to more efficiently invest in social enterprises would certainly enable a number of very noble causes to gain funding. But unless and until the IRS does formally recognize the L3C, the benefits may amount to little more than branding, especially since any associated governance provisions can be included in the Operating Agreement of a normal LLC.
Benefit Corporations
First, a B Corporation is not an entity in its own right (except in Maryland and Vermont, where a company can incorporate as a state-sanctioned entity known as a Benefit Corp). It is a certification offered by a third party—B Lab. To be certified as a B Corporation, your company must agree to take on additional corporate responsibilities. These responsibilities include redefining the best interests of the corporation to include the consideration of employees, consumers, the community, and the environment. The certification process involves several steps and requires that specific language be included in your company’s governing documents. In addition to goodwill in the community, certification may help attract funding from socially conscious investors and may entitle the company to certain tax breaks (for example, in 2009 Philadelphia created a tax break for B Corporations).
For the most part, if you want to put any of these provisions in your governing articles to better define your social enterprise, you can do so without paying for a B Corporation certification. And incorporating as a B-corp in one of the states that allow it may in fact create legal costs down the line as investors and other parties who you’ll do business with will have to get comfortable with the entity. That said, though, a B-corp certification, for the right organization, could be a very important branding tool, both internally and externally.
How to Avoid Tax Penalties on Startup Employee Compensation
Startup and growing companies often use deferred compensation as an effective way to attract and retain important employees. Unfortunately, this process has been complicated by a recent tax change that significantly penalizes a broad range of “non-qualified” deferred compensation plans. Under Section 409A, deferred compensation which does not meet certain requirements is immediately taxable to the recipient and is subject to significant penalties. In order to avoid the penalties associated with this provision, startup companies should ensure that any deferred compensation meets IRS requirements.
Although Section 409A applies to many types of deferred compensation, stock option compensation is the most commonly implicated. Deferred stock option compensation is not subject to Section 409A penalties if the strike price (or exercise price) is greater than, or equal to, the fair market value of the shares on the grant date. Failure to set an appropriate strike price will subject the stock option recipient (employee) to the penalty provisions of 409A. The penalty provisions provide that the recipient of non-compliant stock options will: (1) be taxed at ordinary income tax rates for the value of the deferred compensation, (2) pay an additional twenty percent penalty, and (3) be subject to significant late payment penalties. Employees will, understandably, not be very happy about paying all of these extra taxes. Furthermore, the company may be subject to employee lawsuits for failing to set an appropriate option price.
Since the consequences of setting the strike price below fair market value are severe, you may be wondering how fair market value is calculated for your company’s stock. The IRS has provided several methods for complying with the strict requirements of Section 409A. Although compliance can be achieved through other means, there are three valuation methods that, if followed, create a presumption that the calculated fair market value is reasonable.
Independent Appraisal Presumption
The requirements under the Independent Appraisal Presumption are fairly straightforward. To fall within this presumption, the company must hire a qualified independent appraiser to value the company’s shares. The valuation provided by the independent appraiser is valid for a period of 12 months unless a subsequent event occurs which has a material effect on the company’s stock value. Examples of significant events might include a proposed merger or new equity financing. One downside to this method is the potential cost of hiring an independent appraiser. The upside is that an independent appraisal serves as an insurance policy against a subsequent IRS challenge. When selecting an independent appraiser it is important to ascertain that they are “qualified”. The surest way to do that is to select a professional that has certification credentials from one or more of the four national organizations that provide education and certification credentials for business valuation professionals. They are the National Association of Certified Valuation Analysts (NACVA), the American Institute of Certified Public Accountants (AICPA), the Institute of Business Appraisers (IBI) and the American Association of Appraisers (ASA). Selecting a professional that specializes in 409A valuations is also a good idea and may help keep fees to a minimum.
Formula Valuation Presumption
The Formula Valuation Presumption is only applicable for a narrow range of companies. To use this presumption, the company must already have in place a binding formula for determining the sale price of stock to other parties. For example, if a company’s stock had a permanent limitation which required the holder to sell or offer the stock according to a specific formula (e.g. a buy-sell agreement between the shareholders), that formula could be used to create a presumption of fair market value. These formulas are often based on a multiple of book value or earnings (or a combination of the two). However, if the shares may be sold or transferred in any way other than according to the formula, then this presumption is not available.
Illiquid Startup Presumption
Since startup companies are often difficult to value, the IRS has provided a special presumption for the stock of these illiquid companies. As long as certain requirements are met, the IRS will consider a valuation of startup company stock to be reasonable. However, if the company has any public stock or has been in business for more than 10 years, this presumption is not available. Furthermore, the valuation must be performed by a person with significant experience performing similar valuations and must be evidenced by a written report. But, unlike the Independent Appraisal method, the startup company does not need to hire a third party to perform the valuation (the startup may use in-house personnel as long as the relevant requirements are met). Since in-house personnel may conduct the valuation as long as they are qualified, this method is often cheaper than hiring an independent appraiser. For a full understanding of the requirements pertaining to this presumption, you should consult an attorney.
Deferred compensation in the form of stock option grants can be a powerful and effective tool for motivating and retaining startup employees. However, you must ensure that the strike price is set at, or above, fair market value to avoid significant penalties under Section 409A. By using one of the three presumptive methods for calculating fair market value, you place the burden on the IRS to prove that your valuation is unreasonable. Conversely, if you do not follow one of the above methods, you bear the burden of proving to the IRS that your valuation is reasonable.
An attorney experienced in this area can help you determining the best approach for your company by advising you of the myriad of practical and legal considerations as well as the associated costs and the risks.
How To and Why: Keeping Corporate Records
Small companies and startup businesses might view keeping corporate records as a low priority. Public companies and other large companies can usually have their attorneys keep their minute book up to date, but that can be expensive for small companies who may not have an attorney or law firm that they engage on a regular basis. This post describes what items should be kept in your minute book and why it is important to keep up to date with corporate records.
In general, your company’s minute book should have records for all formal board and shareholder actions as well as a complete record of stock ownership. In addition, your company’s minute book should include a copy of the articles of incorporation and bylaws as well as any amendments to these documents.
You might be wondering why you should keep current with your minute book or even have one at all. Below are a few of the important reasons to keep a minute book for your company.
- The minute book leaves a trail that enables owners and attorneys to look back at the decisions and transactions of a corporation. The minute book is an important audit backup. The minute book can help determine effective dates for tax purposes and establish justification for the accrual of expenses and fixed obligations.
- Up to date records can help you avoid challenges to the corporation’s authority to take certain actions. These challenges might come from minority shareholders, fellow directors, employees or government agencies. Your corporate minutes are important records of the authority granted to the corporate officers and directors to act on behalf of your company.
- The minute book establishes the background record needed by your lawyer to support certain legal opinions. When a corporation undertakes a certain transaction, it is often necessary to obtain a legal opinion regarding the corporation’s history as well as current authority for such a transaction. An example may be something as simple as securing financing from a bank.
- The corporation’s minute book should include stock records. This section needs to be carefully kept current because it is the one true ownership record of the stock of the corporation. Ownership is not officially recorded anywhere else. Your minute book should reflect exactly when and to whom shares of stock have been transferred. It is sometimes a good idea to keep the original stock certificates of the owners with the minute book – this prevents the certificates from becoming lost and prevents shareholders from selling their stock without the corporation’s knowledge.
- Your minute book is extremely important if you ever decide to sell your company. Any potential buyer is going to want to look at your minute book to ensure all actions have been properly taken. This will help the potential buyer evaluate any outstanding liability your company has. For example, if your company merged with a subsidiary in the past, but you do not have the records showing a board resolution approving the merger, a potential buyer might ask to decrease the purchase price based this outstanding liability.
If you can’t remember the last time you updated your minutes, now is a good time to give your attorney a call. Or, if you are just starting a company, you should contact an attorney to help you set up a minute book.
Stay Informed
