Taxing Social Enterprise

By Mayer, Lloyd Hitoshi; Ganahl, Joseph R. | Stanford Law Review, February 2014 | Go to article overview

Taxing Social Enterprise


Mayer, Lloyd Hitoshi, Ganahl, Joseph R., Stanford Law Review


b. 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.

B. 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. …

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