Allen Bromberger does some great pro bono work for the field by answering questions on the npEnterprise list, which is the official list of the Social Enterprise Alliance (where I am proudly a founding board member and am in my last term).
After the question of where to find capital, the question of structure is the next most frequently asked question posed to me by aspiring social entrepreneurs. The question is not an easy one to answer, and involves both legal/tax and style/moral aspects. Allen does a fine job of covering the legal/tax angle and references at the end of his post a good paper from REDF that touches on the style/moral aspects.
FOR-PROFIT OR NONPROFIT?
From Allen Bromberger
(When considering how to structure your social enterprise) The two most important issues for you are liability and taxes. If you run the business inside your nonprofit, rather than a subsidiary, the nonprofit will be responsible for any financial and legal liabilities that flow from the business. That means increased insurance costs at the very least. If you don't want the nonprofit subjected to that risk, run the business through a sub (you'll still need the insurance, but your nonprofit will be protected.) Also, if the business is going to represent a significant part of the nonprofit's activity, you should consider using a subsidiary to avoid jeopardizing the nonprofit's tax exemption. Remember, the nonprofit has to be operated primarily for exempt purposes. If the business is run in a way that furthers your exempt purpose in an important way - other than through the production of income - (i.e., you employ at risk youth), the business will be treated as "related" and you won't have a problem. Otherwise, a sub would be strongly indicated.
With respect to taxes, the scenario is a bit different depending on whether you do the business within your nonprofit or you use a sub.
1. Within the nonprofit: If the business is "related," you won't have to pay unrelated business income tax (UBIT) on the profits from the business. Otherwise you may have to pay a tax on profits equal to the normal corporate tax rate. Nonprofits with unrelated business income have to file Form 990-T instead of the "regular" 990.
2. Subsidiary option #1 "C Corp": The net income of the business will be taxed at the corporate level and after-tax profits will be paid to the nonprofit in the form of dividends, which are not taxable to the nonprofit. The rules on what you can count as expense are more generous if you run the business in a C Corps than they are if you run the business within the charity, so you could end up with more money in the nonprofit's pocket at the end of the day, but without knowing more I couldn't say whether the difference would be significant.
3. Subsidiary option #2 LLC: An LLC is a pass-through entity for tax purposes, so profits would not be taxed at the corporate level; they would be passed down to the nonprofit and taxed as if they had been earned there directly. But you get the liability protection of a sub.
The Roberts Enterprise Development Fund published a booklet on choice of entity a while ago. I think it was called, "If the Shoe Fits." Basic, but very thorough. It certainly discusses all the points I have raised. Grab a free copy here: If the Shoe Fits.
(List Moderators' note: Check out the "Tax & Legal" FAQ at http://www.npenterprise.net/FAQ-Archive/tax.htm for more comments from Allen and other subscribers.)