The recent Arizona Supreme Court case, Zubia v. Shapiro, 243 Ariz. 412 (2018), reminds homeowners to obtain early legal counsel when facing foreclosure, while bolstering lenders’ affirmative waiver defenses. Particularly, the Supreme Court ruled that borrowers waive claims to damages concerning the validity of a trustee’s sale when they first fail to obtain injunctive relief to prevent the trustee’s sale.
Many people work as an employee before they launch their own business. Before you act to build your company, you should understand your legal obligations to your current employer.
Societies have conceived new business structures since time immemorial. Fundamentally, joining together with business partners spreads the demands of capital and limits risk.
Italians made family firms, compagnia, where fathers, brothers, and sons would pool their labor and capital. Fittingly, the name compagnia derives from the Latin phrase for the act of sharing bread, cum panis. Then, companies granted by royal charter arrived, like the East India Company, an import-export business who received special privilege from the Crown to pursue a monopoly on trade between London and Asia, with offerings varying from pepper to textiles to tea. The East India Company, the mother of the modern multinational corporation, pioneered the joint stock mechanism. That innovation allowed for separation of investors and managers, broadening the pool of capital; it also spread risk and provided limited liability, and it allowed the enterprise to trade on its own account, rather than in the names of the individual owners.
Now, with a few clicks and an electronic signature, anyone can form a business entity, securing the same limited liability separation between an entity and its owners as employed by corporate giants across America.
But which form of entity is right for your business?
For many business owners, the choice-of-entity decision is driven purely by tax considerations. But the two most prevalent forms, the corporation and the limited liability company (LLC), also offer sought-after advantages of: (i) limited personal liability, (ii) easy transfer of ownership, and (iii) management separation from ownership.
Certainly, the tax benefits are relevant, like the incentive to avoid double taxation or the substantial restrictions on entities under subchapter S of the tax code — but don’t miss the legal distinctions and historical context. The LLC is structurally different than a corporation. Today, many owners form LLCs, almost by default, without considering their unique attributes, such as: (1) the primacy of the operating agreement, and (2) the application of fiduciary duties.
First, owners should consider that the LLC is as much a creature of contract as of statute. As a result, once an LLC comes into existence and has a member, the LLC necessarily has an operating agreement, whether written, oral, or implied by law. The operating agreement plays a vital role, as it establishes the fundamental rules for the relationships between the LLC, its members, and any manager.
Even so, many business owners select the LLC form but never draft an operating agreement — or perhaps worse, draft one, but neglect to sign it.
On the other hand, a corporation is not driven by private contract between individuals. Rather, there is a body of statutory and common law that, in some ways, cannot be displaced. A corporation has been judicially defined as “an artificial being, existing only in contemplation of the law; a legal entity, a fictitious person, vested by law with the capacity of taking and granting property and transacting business as an individual. It is composed of a number of individuals, authorized to act as if they were one person. The individual stockholders are the constituents or component parts, through whose intelligence, judgment, and discretion the corporation acts.”
Second, the owners should consider the obligations they intend to impress on themselves and management; for example, owners should consider whether they can limit their fiduciary duties to simultaneously pursue other ventures.
Granted, the topic of fiduciary duties raises many of the most complex questions in the law of business organizations.
For the LLC, the primary issue is to what extent the members can privately agree in the operating agreement to vary or eliminate those duties. Although a contract cannot completely transform an inherently fiduciary relationship into a merely arm’s length association, the operating agreement has substantial power to “reshape, limit, and eliminate fiduciary and other managerial duties.” For example, the classic fiduciary “duty of loyalty” means: (i) not “usurping” company opportunities or otherwise wrongly benefiting from the company’s operations or property; (ii) avoiding conflict of interests in dealing with the company (whether directly or on behalf of another); and (iii) refraining from competing with the company. Members can agree, however, to tailor those limitations and allow a member or manager to engage in other business or compete with the company. On the other hand, corporate directors and officers are not free to contract out of their duties to shareholders.
The law of business organizations has continually modernized, providing us with accessible tools to limit personal liability. But, whether your company is in real estate or technology, simply holds investments or engages in long-distance trade voyages around the Cape of Good Hope, building upon the right legal structure is critical to its long-term success. If you or someone you know has questions about how to structure their business or investments, please call our office today to schedule a consultation with Andy Anderson.
Andy Anderson is an Attorney with Provident Law®. He serves businesses and individuals, counseling them as they form, operate, and protect their companies. He is a member of the State Bar of Arizona Subcommittee tasked with revising the Arizona Limited Liability Company Act. He also serves on the Board of Directors of the Christian Legal Society and he is a graduate of the James E. Rogers College of Law at the University of Arizona and the W.P. Carey School of Business at Arizona State University. Andy can be reached at email@example.com or 480-388-3343.
I read two tales of franchise terminations. In both cases, the franchisee had been caught with their hand in the convenience store cash register, using different iterations of register-opening keys to misrepresent sales, from “no sale” and “safe drop,” “cancel age verification,” to “beer non-tax.” Lots of different tricks. The franchisees booked thousands of transactions with unreported or underreported income. In fact, one of the franchisees admitted under oath that he used the cancel age verification modus on as many as 4,000 sales of cigarettes over an 18-month period. But in both cases, the franchisor caught on, by way of detailed audits and surveillance, and notices of franchise termination were served.
In these cases, 7-Eleven v. Kapoor Bros  and 7-Eleven v. Grewal , the franchisor 7-Eleven filed a lawsuit, seeking an immediate order from the court to prevent the franchisees from continuing to infringe its federally registered trademarks and service marks: 7-Eleven®, Slurpee®, and Big Gulp®, as well as to prevent continued operation of the stores in violation of non-competition provisions. The results were surprising. 7-Eleven, a sophisticated franchisor with a well-crafted franchise agreement, achieved an order granting in full a preliminary injunction against the franchisee in Florida — and a lesser result on the same facts in Massachusetts.
These cases teach us that franchisors and franchisees should see their favorably-negotiated agreement as the baseline, the bare minimum. Even more, business owners should plan ahead and know the law of their jurisdiction in connection with pivotal events like termination and renewal.
THE KAPOOR BROS. AND GREWAL CASES
In Kapoor Bros., the Middle District of Florida granted injunctive relief for the franchisor, prohibiting both trademark infringement and operating a competing business. Differently, in Grewal, the District Court of Massachusetts granted injunctive relief, prohibiting trademark infringement, but denying injunctive relief to enforce the non-compete clause. Thus, both courts agreed that franchisor was entitled to preliminary injunction to stop trademark infringement, to prevent harm and preserve status quo through trial. But in Kapoor Bros, the court found that the franchisor would suffer irreparable harm if the franchisee operated a competing business until a trial on the merits could be held, while the court in Grewal found no irreparable harm or balance of harms in favor of the franchisor, denying a preliminary injunction to shut down the franchisee’s operations.
You find at least three key distinctions between these opinions, namely the courts’ consideration of:  the franchisees’ continued trademark infringement,  the franchisees’ hardship and whether it can be considered in connection with the preliminary injunction, and  the economic gap between a large franchisor and an individual franchisee.
First, the Florida court assumed that the franchisee would continue to illegally employ the 7-Eleven trademarks, while the Massachusetts court took as given that the franchisee’s continued competition would be without the use of those marks, assuming that the franchisee would comply with the injunction on trademark infringement. Specifically, the Florida court emphasized that the franchisee was, “operating stores under 7–Eleven’s brand without its permission,” and was “pirating the goodwill associated with 7–Eleven and causing it immeasurable damage.” While the Massachusetts court said that 7-Eleven’s brand would not lose any goodwill in the community because, “Customers would have no reason to associate [franchisee’s] convenience store with the 7–Eleven brand after 7–Eleven’s marks are removed from the premises, assuming [franchisee’s] convenience store continues to operate in accord with this order.” This assumption certainly changes the nature and magnitude of possible harm to the franchisor.
Second, both courts considered a Florida statute, Section 542.335(1)(j), which provides for a presumption of irreparable harm for the violation of an enforceable restrictive covenant. Citing that statute, the Florida court said that a preliminary injunction is, “the common and preferred remedy.” Differently, citing the Kapoor Bros. case, the Massachusetts court found that this Florida law further “prohibits the court from considering individualized economic or other hardship that might be caused to the person against whom enforcement is sought” when determining the enforceability of a restrictive covenant. Massachusetts does not have a similar statute. And so, the Massachusetts court reasoned that the Florida court did not look at the hardship to the franchisee, which was central to the Grewal analysis in Massachusetts.
Third, the courts treated differently the disparate economic strength between a large franchisor and an individual franchisee. The Massachusetts court saw 7-Eleven, who had 50,000 stores, as big enough to absorb any harm that the franchisee could inflict. And the court sympathized with the franchisee, who used “a very significant portion of her personal capital,” testified to be $100,000, to fund the initial franchise fee. Specifically, the Massachusetts court stated:
“[W]hen the value of one (or even two) year(s) of lost profit from one of 7–Eleven’s 50,000 worldwide franchise establishments is viewed in proportion to the company’s total annual profit, the losses would likely be miniscule. Additionally, denying this portion of 7–Eleven’s preliminary injunction certainly would not cause it to lose its indisputably competitive position in the market.”
On the other hand, the Florida court reviewed other facets of harm to the franchisor that the Massachusetts court didn’t consider — recognizing that 7–Eleven “will have difficulty entering the market served by the former franchisees” and also that other 7-Eleven franchisees will take a lack of enforcement as a concession to the breach.
All in all, Florida and Massachusetts law produced two different results on essentially the same facts, with the same franchisor and same franchise agreement. Certainly, 7-Eleven would have sought a premium on its business with franchisees in Massachusetts, had it known that the local court would likely not grant a preliminary injunction to enforce its non-competition provision.
With that context, let’s look at a couple drafting points for franchise agreements.
APPLICATION: FRANCHISE AGREEMENT NUTS & BOLTS
Fundamentally, the first step is to negotiate favorable restrictive covenants in the Franchise Agreement. Generally, franchisors aim to restrict the franchisee, preventing them from competing with the franchisor during the franchise term, plus a period of time after expiration or termination of the franchise agreement. The franchisor will also restrict the franchisee from soliciting employees of the franchisor or other franchisees. Franchisees, on the other hand, try to resist or limit the duration of any competition restrictions, seeking a narrow and precise definition of the restricted activities, as well as the geographic scope of the restriction.
In Kapoor Bros. and Grewal, the 7-Eleven covenant not-to-compete provision prohibited the franchisee for one year after termination from “maintain[ing], operat[ing], engage[ing] in, or hav[ing] any financial or beneficial interest in, adverts[ing], assist[ing], mak[ing] loans to, or leas[ing] a Competitive Business” located at the leased premises or at the site of any former 7-Eleven store within two years of it being operated as a 7-Eleven store. The term “Competitive Business” was defined as, “any business that is the same as or similar to a 7-Eleven Store…, including a convenience store or other store not designated as a convenience store in which the product mix is fifty percent (50%) or more of goods or services substantially similar to those then-currently offered by a 7-Eleven Store.”
Further, the 7-Eleven agreement stated that, “[A]ny breach of any of the terms of the [non-compete provision] will result in irreparable injury to us and that we are entitled to injunctive relief to prevent any such breach.” And the franchisees agreed that the restriction, “contains reasonable limitations as to time, geographical area and scope of activity to be restrained and does not impose a greater restraint than is necessary to protect our goodwill or other business interests.” And the franchisees agreed that its claims against 7-Eleven would not be a defense to enforcement of the non-compete clause.
All of those terms favored 7-Eleven, the franchisor, and those terms are commonly found in franchise agreements.
Therefore, Kapoor Bros. and Grewal demonstrate that, even with the right contract language, whether and how a court grants immediate relief for injunction against franchisee could turn on specific state statutes and body of common law.
What’s at stake?
In the context of restrictive covenants and injunctive relief, it is the franchisor’s ability to immediately shut down franchisee operations and use of its trademarks, post-termination of the franchise agreement. Without it, litigation could stretch out for years before the franchisor receives a judgment, and the franchisor could be exposed to significant harm in the meantime. Overall, business owners should consider how relevant state laws will apply in critical situations. A comprehensive franchise agreement might not be enough. If the law in your jurisdiction is unclear or unfavorable, you might seek additional protection or compensation to bear the legal risk. 7-Eleven, Inc. v. Kapoor Bros. Inc., 977 F. Supp. 2d 1211 (M.D. Fla. 2013).  7-Eleven, Inc. v. Grewal, 60 F. Supp. 3d 272 (D. Mass. 2014).
I have a soft spot for freebies – giveaways, handouts, complimentary gifts, whatever you prefer to call them.
Since 2013, I’ve participated in a medley of musical “crowdsourcing” projects, which have netted me quite the bounty, including, but not limited to: pre-release digital downloads, vinyl (which, according to the Journal, will outsell CDs this year), coffee mugs, autographed posters, VIP parties and private shows, and something one artist named “The Musical Kitchen Sink,” a collection that included his entire discography.
And a majority of the population would say that I’ve been a part of “crowdfunding.” But this isn’t the case. And there is a big difference in the law between what I described as “crowdsourcing” and “crowdfunding.”
While crowdsourcing is about donations in exchange for small tokens or perks, crowdfunding, on the other hand, is all about harnessing the capital of crowds as investment, issuing an equity stake in your company. Starting a Kickstarter or Indiegogo crowdsourcing fundraiser is a relatively simple endeavor that you can launch over the weekend. Crowdfunding, on the other hand, is a technical project that needs legal acumen. If you aim to raise money through crowdfunding, get good advice from your attorney and avoid the risks of that project, including civil and criminal penalties.
Brief Background on Arizona’s Crowdfunding Law
Generally, accepting investment dollars from strangers is a highly regulated area of law. It is also a complex area, considering that both federal law and state law may apply. And so, companies need to determine whether they have complied with both.
The JOBS Act is the federal law intended to relieve regulatory burden of Dodd Frank and Sarbanes Oxley, two gargantuan regulatory schemes that overburdened small business, pushing them out of the capital markets.
But the federal government has been unable to successfully implement the JOBS Act. And in the meantime, twenty-two states, including Arizona, have tackled the problem themselves. Specifically, Arizona enacted ARS § 44-1844(D), declaring “crowdfunding” to be a transaction exempt from registration with the Arizona Corporation Commission, if transacted under certain parameters. Examples of other exempt transactions under Arizona law include private placements, stock dividends, and statutory or judicially approved reorganizations.
How Much Money Can I Raise under the Arizona Crowdfunding Law?
In simple terms, the issuer can raise up to $1 million every twelve months, without audited financial statements. That amount increases to $2.5 million every twelve months with GAAP audited financial statements. The legal analysis is more complicated, however, as sales to officers, directors or 10% shareholders do not count towards the total. And, generally, multiple offerings made within the same six-month window are integrated, that is, counted as one offering.
This $1 to $2.5 million cap makes crowdfunding unworkable for companies with high capital requirements. But for a single-owner or micro-business, it may be adequate, considering a study done by the Kauffman Foundation in 2009, estimating that the average start-up cost was approximately $30,000. And according to U.S. Census data, more than 40 percent of all small businesses started up for under $5,000. Those “average start-ups” are home-based businesses with low upfront investment.
Considering the relatively small amount that can be raised through Arizona’s crowdfunding law, there is slim margin for error in your cost-benefit analysis.
Practically, companies should raise enough capital to justify the cost of hiring professionals, namely, an accountant and attorney, along with the cost of ongoing legal compliance. Obtaining an audit for a small or midsize private company might cost between $7,000 and $50,000, depending on the audit firm, geographic location and complexity of the business. And the legal fee could be of similar magnitude. And so, crowdfunding will likely be uneconomical for the “average start-up” mentioned above that aims to raise its initial $30,000.
Limitations of the Arizona Crowdfunding Law
The Arizona crowdfunding law is an intrastate exemption. That means that the company and the investors must be located, generally, in Arizona.
To be intrastate, companies issuing the securities must be formed in Arizona. All investors must be Arizona residents. And at least: (a) 80% of the issuer’s revenues must come from business within Arizona, (b) 80% of the issuer’s assets must be located in Arizona, and (c) 80% of the proceeds raised in the offering must be used in Arizona. And the investors can only resell their shares to Arizona residents within the first nine months after the end of the offering.
Additionally, beyond ARS § 44-1844(D), companies must comply with Section 3(a)(11) of the 1933 Act and SEC Rule 147 in connection with intrastate offerings.
Further, each non-accredited investor — someone who has a net worth of less than $1 million (including spouse) and who earned less than $200,000 annually ($300,000 with spouse) in the last two years — may only contribute no more than $10,000. That comes to 100 non-accredited investors, at $10,000 each, to reach the $1,000,000 cap for companies without audited financials and 250 non-accredited investors, at $10,000 each, to reach the $2,500,000 cap for companies with GAAP audited financials.
Anecdotally, there are logistical challenges that have stalled many companies who are interested in crowdfunding. For instance, a web portal and website operator are needed; and the proceeds raised must be deposited into a single escrow account maintained by a bank, credit union or other depository financial institution in Arizona.
Disclosure is the touchstone of securities law, assuring that competent investors have full and timely information for their investment decisions. In short, companies must disclose all material information to the Arizona Corporation Commission and all potential investors. Crowdfunding is no exemption from full disclosure.
All investors must receive a Disclosure Document comprised of specified topics for mandatory disclosure. And investors receive additional protection through anti-fraud requirements under SEC Rule 10b-5 and Arizona’s counterpart.
Also, companies must file certain items with the Arizona Corporation Commission at least ten days before its crowdfunding offering. Importantly, companies must inform the Commission your Target Offering Amount and the Offering Deadline. They must also provide notice of the offering, a disclosure document, and a copy of their escrow agreement.
Moving forward, companies must provide quarterly reports throughout the offering period and while securities are outstanding. Additionally, companies have an ongoing obligation to preserve books and records prescribed by Arizona Corporation Commission for three years.
Arizona crowdfunding is not one-size-fits-all. The legal exemption under ARS § 44-1844(D) is just one of many ways to raise capital, and your business attorney can determine whether crowdfunding is the proper tool for you.
Our clients serve as the hands and feet of Jesus, all over the world. It is true, you find life by giving your life away. Abundant life, in fact. As Luke records it: “It is more blessed to give than to receive.” (Acts 20:35 ESV).
The first-century church set into motion a world-wide movement on that cornerstone, the good news that through Jesus people find abundant life. (John 10:10 ESV). Unschooled, ordinary men like Peter and John became champions, raising boldness above lesser ideals of comfort and safety. (Acts 4:23–31 ESV).
And abundant joy naturally overflows in a wealth of giving. (2 Corinthians 8:1-2 ESV).
That tradition of generosity and community persists today.
Granted, the modern-day generous giver faces different obstacles, like regulation, taxation, and legal fees. And for many nonprofit organizations, a primary step is to acquire a helpful tool — the federal income tax exemption under the subsections of 501(c). What follows is an analysis toward a successful 501(c)(3) application.
Enjoy the article and feel welcome to contact me if you need a hand, as you pursue an abundant life.
Qualified to be 501(c)(3)?
While popular, tax code section 501(c)(3) does not cover all categories of exempt organizations. But we will limit our discussion to that section.
First, identify your purpose. The text of section 501(c)(3) sets forth a list of exempt purposes, including those religious, charitable, scientific, or educational. The others are: testing for public safety, literary, amateur sports competition, or prevention of cruelty to children or animals.
Here’s the quick test: is your organization both  organized and  operated for an exempt purpose?
Second, to be organized for an exempt purpose, the nonprofit should be formed as a separate legal entity, normally either a corporation, trust, or unincorporated association, with organizational documents limiting its operations exclusively to its exempt purpose.
And third, to be operated for an exempt purpose, the organization must limit certain activities:  it must restrict political campaigning,  its earnings and assets cannot unjustly enrich insiders,  it cannot benefit someone’s private interest more than insubstantially,  it cannot operate outside its exempt purpose,  it must not engage in illegal acts or violate public policy, and  it must restrict legislative activities.
Do You Need to File An Application?
Certain types of organizations, by their nature, may be considered tax exempt under section 501(c)(3) — without any application to the IRS. Namely, those are:
- Churches, including synagogues, temples, and mosques;
- Integrated auxiliaries of churches and conventions or associations of churches; and
- Any organization that has gross receipts in each taxable year of normally not more than $5,000.
And so, it is wise to ascertain whether you fit within that list, before spending your time and resources on the 501(c)(3) application. On the other hand, even those organizations, such as churches, may decide to apply to receive the IRS determination letter of exemption, in order to make their tax status certain.
Smaller-scale organizations are eligible to complete a truncated application, an application that requires substantially less information and disclosure to the IRS. That short application is the Form 1023-EZ. To be sure, an organization should examine the IRS Form 1023-EZ Eligibility Worksheet.
But, generally, those organizations eligible to use the Form 1023-EZ are those with annual gross receipts less than $50,000 and total assets less than $250,000.
Otherwise, organizations need to complete the in-depth Form 1023.
Public Charities and Private Foundations
Within the universe of 501(c)(3) organizations, there are two main categories:  public charities, and  private foundations. The IRS asks the applicant to identify as one or the other. Both are 501(c)(3) organizations, but with different tax rules. And, broadly speaking, public charity status is a more favorable tax status than private foundation status.
Specifically, tax deductions for donors are more generous for contributions to public charities. And private foundations are subject to tighter restrictions, enforced with excise taxes in the case of a violation. Namely, among others, there are restrictions on self-dealing between private foundations and certain related, “disqualified,” persons, and the IRS imposes a requirement for annual distribution of income for charitable purposes. Additionally, private foundations are subject to excise taxes on net investment income that are not imposed on public charities.
As a rule of thumb, the IRS sorts organizations into one or another based upon the organization’s sources of financial support. Public charities have a broad base of support, while private foundations receive funds from fewer sources.
By definition, the following types of organizations are public charities:
- Hospitals and medical
Additionally, so are organizations that receive “substantial support” from government funding or the general public.
The IRS defines the term “substantial support” through two tests, the “public support test” and the “facts and circumstances test.” The “public support test” looks to whether the organization receives at least 33% of its revenue from general public contributions or government or other public charities. And the “facts and circumstances test” looks at the complete picture, including sources of financial support — both now and projected — as well as other characteristics, such as the public nature of the organization’s governing body and the public nature of its operations.
There are two other predefined categories of public charities:
- Organizations that normally receive more than one-third of their support from contributions, membership fees, and gross receipts from activities related to their exempt functions, and not more than one-third of their support from gross investment income and net unrelated business income; and
- Organizations that support other public charities.
Again, organizations within these bounds are able to receive the most beneficial tax status under section 501(c)(3).
The remaining organizations are deemed to be private foundations. Under that umbrella, the most common is the grant-making (non-operating) foundation, and the other is the private operating foundation, one that actively engages in its exempt activities.
Private operating foundations hold certain tax advantages, such as higher charitable deduction limits for donors.
The legal rule: a private operating foundation is any private foundation that meets the “assets test,” the “support test,” or the “endowment test” — and it must distribute substantially all (85% or more) of the lesser of its adjusted net income or minimum investment return.
In brief, the “asset test” considers whether the foundation directly devotes substantially more than half (65% or more) of its assets to its exempt activity or owning stock to control a corporation that does. The textbook example is museums and libraries. Next, the “support test” measures the portion of capital received from the general public and other exempt organizations, versus the foundation’s gross investment income. And last, the “endowment test” requires the foundation to distribute, directly for the active conduct of its exempt function, at least two-thirds of its minimum investment return.
Another Solution: Affiliate with an Existing Organization
An organization that lacks the resources to become a stand-alone 501(c)(3) organization can also consider affiliating with an existing 501(c)(3) organization. There, the organization would piggyback on the tax-exempt status of the other, receiving many of the same benefits. One drawback, however, is that the organization looking to obtain exempt status must grant full control to the existing organization.
Time Required for the Application and Professionals
If you choose to complete the application yourself, be prepared to devote a substantial amount of time.
In its instructions, the IRS estimates according to its Paperwork Reduction Act Notice that Form 1023-EZ may require a total of 19 hours, 10 minutes to complete, and the longer Form 1023 could require 201 hours, 27 minutes. Tasks included in that estimate are: record-keeping, learning about the law and the form, preparing the form, and copying, assembling, and sending the form to the IRS.
Therefore, most organizations should team-up with legal counsel and a tax adviser, who can reduce the time and money spent on this project.
Why Obtain a 501(c)(3) Tax Exemption?
Why endure this process? In the end, a 501(c)(3) exemption is a key advantage for any nonprofit organization. Once the organization successfully navigates the maze of legal tests, categorizations, and information we’ve discussed, it adds to its credit:
- Exemption from federal income tax;
- Eligibility to receive tax-deductible charitable contributions; and
- Possible exemption from social security taxes for pastors.
The organization also may receive other intangible rewards, like the chance of increased donations, as individual and corporate donors are more likely to support organizations with 501(c)(3) status. Additionally, state and local officials may grant exemption from income, sales, or property taxes.
All things considered, the time and money to obtain a 501(c)(3) exemption is widely considered to be a worthwhile and worthy investment. And it’s one that will enable your organization to better steward the generous gifts entrusted to it.
Arizona law requires directors and officers of B-Corporations to look out for non-owner stakeholders, in addition to the company’s shareholders. This is an extraordinary fiduciary duty. But although B-Corporations raise the bar — as compared to corporations, generally — Arizona law does not provide a robust mechanism to enforce violations.
As a general definition: a fiduciary duty is a standard of good faith, care, and loyalty owed in managing someone’s money or property. A fiduciary acts for another’s benefit on matters within the scope of their relationship. Fiduciary duties are about accountability.
The big idea of the B-Corporation movement is that B-Corporations are accountable to stakeholders, persons affected by the company’s operations, not just shareholders. Thus, Arizona law on B-Corporations gives directors and officers the discretion to widely consider the interests of persons outside the company. Specifically, directors and officers of B-Corporations are required by statute to “consider the effects of any action or inaction” on its shareholders, as well as others who do not hold an economic interest:
- the “employees and workforce” of not only the company but also of its subsidiaries and suppliers,
- its customers, and
- its community where its own offices — and the offices of its subsidiaries and suppliers — are located.
They also must consider the local and global environment, the company’s short and long term interests including its continued independence, and the ability of the B-Corporation to accomplish its general public benefit purpose and any specific public benefit purpose. A.R.S. §§ 10-2431 (directors); 10-2432(A) (officers). And Arizona law expressly provides a safe harbor, stating that those considerations are not violations of the officers and directors’ fiduciary duties. A.R.S. §§ 10-2431(B) (directors), 10-2432(B) (officers), referring to A.R.S. §§ 10-830 (directors) and 10-842 (officers).
A few observations.
The B-Corporation must affirmatively advance to meet threats of harm to its stakeholders. It takes responsibility for both its “action and inaction.” Further, the phrase “employees and workforce” suggests that the company’s independent contractors are on the same plane as its employees. There is no distinction. Also, the B-Corporation shepherds the organizations under its control, including its subsidiaries, as well. It does not use creative legal structures to carve out certain assets or operations from its heightened responsibilities. Even more, its suppliers are within its care, even though the B-Corporation does not have direct control over them. In sum, the law of B-Corporations expands the field-of-view of corporate directors and officers. Within a B-Corporation, officers and directors promise to consider others.
This ideology is markedly different than the bare-bones legal requirement for officers and directors of corporations to maximize profit.
Although Arizona law imposes heightened obligations on B-Corporation directors and officers, there is little means to enforce them. The B-Corporation itself, along with its directors and officers, are generally protected from claims by both shareholders and third-party stakeholders. In fact, the sole remedy belongs to shareholders, who can seek an injunction to compel the officers and directors to follow the B-Corporation’s stated mission.
More specifically, the fiduciary duties to consider others are duties owed to shareholders, not the outsiders to whom they benefit. The relevant Arizona law plainly states that no duties are owed directly to the third-party stakeholders. A.R.S. §§ 10-2431(D) and 10-2432(D). The law also clarifies that these third parties have no legal right of action. A.R.S. §§ 10-2433(C) and 10-2402(2).
Further, shareholders and third-party stakeholders, alike, cannot pursue a claim for money damages.
Additionally, there is a statutory business judgment rule to protect B-Corporation officers. An officer who makes a business judgment in good faith fulfills the duty, if:
- The officer is not interested in the subject of the business judgment;
- The officer is informed with respect to the subject of the business judgment to the extent the officer reasonably believes to be appropriate under the circumstances; and
- The officer rationally believes that the business judgment is in the best interests of the benefit corporation.
A.R.S. § 10-2432(E).
And so, any potential claim for an injunction would need to allege that officers failed to consider B-Corporation purposes, at all — not that the officers made a poor decision. But, as an aside, notice that while officers have a safe harbor, directors do not. And so, directors would not possess the same legal presumption in litigation.
And Arizona law provides that B-Corporation directors and officers are not personally liable for any failure to pursue the public benefits promised. A.R.S. §§ 10-2431(C), (E)(directors), and 10-2432(C)(officers). Neither is the B-Corporation. A.R.S. § 10-2433 (B-Corporation). The only exception appears to be that directors can be liable in transaction where they improperly act upon a conflict of interest.
Application / Conclusion
In total, corporate life as a B-Corporation adds a measure of risk that shareholders might sue the company, asking the court for an injunction, compelling the company to adhere to its stated benevolent mission.
To mitigate that risk, here are two thoughts.
First, your B-Corporation might add a “Benefit Director” to oversee your stated mission and reporting to confirm your performance. Second, your board of directors ought to record in their meeting minutes an entry showing that they considered the company’s declared general and specific benefits for all stakeholders.
These two practices would allow the company to create a record to support its compliance with Arizona law on B-Corporations.
In many markets, consumers and employees, alike, hunger for purpose-driven companies committed to socially and environmentally responsible business practices.
Prior to this year, however, Arizona did not offer a form of business entity that could fully accomplish a dual mission, producing both profit and social good. But now, the Benefit Corporation, or “B-Corporation,” exists as another option for Arizona entrepreneurs, enacted under A.R.S. § 10-2401, et seq.
B-Corporations are uncommon but up-and-coming. For example, in Fort Collins, Colorado, New Belgium Brewing Company, a one-hundred percent employee-owned B-Corporation, serves up an award-winning beverage, while making smart sourcing decisions and charitable partnership initiatives, including a strategy to purchase 10% of all hops from Salmon Safe Certified farms, ensuring healthy watersheds for native salmon. New Belgium also holds accountable the companies in its supply chain on issues such as manufacturing, transportation, waste, and company culture — and likewise, the beer-maker tracks its own statistics to reduce mega joules of energy, water, and greenhouse gas used in production. With these ingredients, this B-Corporation has disrupted the craft beer market.
Fundamentally, the question is whether the underlying state law that governs the company supports the entrepreneur’s mission-driven direction.
If not, then the company faces significant legal risk. The problem arises when one camp wants to use company assets to prosper a non-owner stakeholder, opposed by another group unwilling to subsidize that effort. These disagreements often surface when socially-conscious for-profit companies attempt to scale.
Consider an equity investment, a merger, or a liquidity event. In a larger corporate operation, governance and economic rights are spread out, allocated across tens or thousands of persons, including officers, directors, and shareholders. Historically, managers lean toward their traditional fiduciary responsibility to maximize returns to shareholders. The risk of litigation looms over their planned acts of generosity.
And so, the company’s social agenda will be trimmed back or cut.
On the other hand, the laws for the B-Corporation entity augment certain fiduciary duties, allowing or even requiring managers to pursue shared and enduring prosperity for all stakeholders. Further, tactically, B-Corporations offer market differentiation, broad legal protection to directors and officers, and expanded shareholder rights. Commitment to B-Corporation standards can also attract and retain talented employees.
At New Belgium Brewery, Jenn Vervier, Director of Strategy and Sustainability, agrees that the company’s legal commitments have, “signal[ed] to our stakeholders (coworkers, customers, suppliers, and community) that our values are truly at the core of our business.”
In upcoming articles, I’ll guide you through a few important topics, including fiduciary duties, corporate structure, and the logistics of operating a B-Corporation.
A B-Corporation could nicely fit within the overall corporate structure of a tax-exempt organization, maintaining the tax exemption by limiting unrelated business income and, at the same time, aligning with the organization’s mission-driven standards.
For example, many churches are currently considering revenue-producing mixed-use real estate development projects. Those projects might include administrative and programming spaces for the congregation, along with retail space and condominiums or leasing to other commercial ventures. All in all, churches have pursued these opportunities to acquire better real estate and improve cash flow, allowing them to create spaces in expensive urban areas. Others simply need a way to save a distressed property from foreclosure.
Let’s review some fundamental concepts in connection with exempt organizations. Then, we can think about how the B-Corporation might be used.
Exempt Organizations and Unrelated Business Income Tax
The Internal Revenue Code specifies certain types of organizations that are exempt from federal income tax. The most common types are charitable, religious, and educational organizations. Others include: civic associations, labor organizations, business leagues, social clubs, fraternal organizations, and veterans’ organizations. The main benefit of exempt status is that the organization does not pay federal income tax on income related to its exempt purpose. More particularly, a 501(c)(3) organization must engage in activities that further its exempt purposes or it jeopardizes its tax-exempt status and its eligibility to receive tax-deductible contributions.
Nonetheless, a 501(c)(3) tax-exempt organization may engage in income-producing activities unrelated to its tax-exempt purposes as long as the unrelated activities are not a substantial part of the organization’s overall activities. Yet, the net income from such activities will be subject to the Unrelated Business Income Tax if three conditions are met:
- The activity constitutes a trade or business.
- The trade or business is regularly carried on.
- The trade or business is not substantially related to the exercise or performance of the organization’s exempt purpose.
In addition to tax liability on unrelated business income, a 501(c)(3) organization with substantial unrelated trade or business income jeopardizes its exempt status. There is no bright line test to define how much unrelated business income is “substantial,” but anecdotally, the generally held position is that it should not exceed 10-20% of the organization’s income.
Now, consider an Arizona nonprofit corporation, who received 501(c)(3) tax-exempt status, a corporation whose exempt purpose is to stimulate and foster public interest in the fine arts by promoting art exhibits, sponsoring cultural events, and furnishing information about fine arts. Suppose that this organization leases studio apartments to artist tenants and operates a dining hall primarily for these tenants. Under the current tax law, these two activities do not contribute importantly to accomplishing the organization’s exempt purpose. Therefore, they are unrelated trades or businesses.
This does not necessarily mean, however, that the organization should discard its idea to provide studio apartments and a dining hall. But it must thoughtfully plan how to implement the project without risking its hard-earned tax-exempt status.
Generally, a separate business entity might be formed to operate the new venture.
Then, the question is how the income received by the exempt organization, from the operation of the separate entity, will be characterized. The income could be unrelated business income. The answer will turn on the tax characterization of separate entity.
B-Corporation Subsidiary as a Solution
One strategy would be to form a subsidiary, a company that is partly or completely owned by the exempt organization, and have the exempt organization hold a controlling interest in the subsidiary company. They key is that dividends are excluded when computing an exempt organization’s unrelated business income.
Briefly, dividends are generally excluded from unrelated business income for two reasons. First, the exempt organization as shareholder is acting, generally, as an investor, not engaged in a trade or business, negating the first element of unrelated business income. Second, the subsidiary corporation who earned the income pays tax. And so, in this scenario, the IRS is ultimately able to receive its share.
Let’s return to our fine arts organization, from our example above. Applied there, the exempt organization could retain control of the studio apartment and dining hall project and receive dividends from its subsidiary who operates that project, without garnering any unrelated business income tax. As an aside, the subsidiary in this case would operate for-profit and pay income tax to the federal government, and the exempt organization would not pay tax in connection with dividends received. As a result, the primary goals would be met:  preserving the exempt organization’s tax-exempt status and  minimizing tax liability.
This strategy could be implemented with either a B-Corporation or a C-Corporation. On the other hand, an entity with partnership tax treatment such as certain limited liability companies, would not be a proper choice of entity for the subsidiary, as the unrelated business income would pass through from that company to the exempt organization, causing a tax liability and jeopardizing its exempt status.
The exempt organization may consider using a B-Corporation to convey the message that the subsidiary is transparent and accountable — and that it will produce benevolence for the community, just as the exempt organization does. And legally, the directors and officers of the B-Corporation subsidiary would owe fiduciary duties to pursue those benefits.
Both corporate forms can achieve the tax-minimization goal. But a B-Corporation might better align with the exempt organization’s story and values.