Nonprofit Organizations Incubating Worker Cooperatives

Why Incubate?

Many nonprofit organizations are increasingly focusing on worker-owned business development as a powerful tool for community economic development. This is because worker-owned businesses and cooperatives align with the mission of nonprofit organizations that are seeking to build economic empowerment and opportunity in low-income and marginalized communities.

However, nonprofits should be aware of the risks that come with business development in general, and worker-owned business development in particular. The most important legal risks from the nonprofit’s perspective include jeopardizing the organization’s tax-exempt status and becoming liable for the actions of the cooperative.

It is important to consider that a worker-owned cooperative is primarily organized for the benefit of its members, who are private individuals. Cooperatives generally have a purpose of benefiting their members, whereas nonprofit public benefit corporations are required to focus on public benefit, and 501(c)(3) nonprofits generally must focus on achieving very specific charitable, educational, religious, and/or scientific purposes. Thus, a nonprofit seeking to incubate cooperatives will have to show that the ultimate beneficiaries of the cooperative’s operation are the public and/or a “charitable class” of people or a community in particular need of economic revitalization. Below, we will provide detail about what all of these things mean.

It’s very important for a nonprofit considering starting a new business to consult with an attorney who specializes in nonprofits. This will prevent the nonprofit from getting into activities that may jeopardize its tax exempt status.

An Example: Green Landscaping Cooperative

Green Landscaping Cooperative is a new worker cooperative that has been incubated by Jobs Now!, a community-based nonprofit. The nonprofit’s mission is to bring employment opportunities to low-income, minority and disadvantaged people in the East Bay, by providing business development services to low-income people and businesses that serve low-income people. Green Landscaping will employ low-income day laborers who have trouble finding work and do not have the resources to start their own business. Green Landscaping will ultimately be owned by the day laborers as a worker cooperative. Jobs Now! is providing the cooperative a start-up loan and business development services including helping them to organize, providing business training, assistance with maintaining financial and accounting records, and providing an office space. As Green becomes profitable, it will repay the nonprofit for services received through reduced rent and reduced fees.

The next sections of the manual analyze whether Jobs Now!’s assistance to incubate Green fits within the nonprofit’s tax exempt purpose.

What Is A Nonprofit?

A nonprofit organization in California (and in many states) can either be a nonprofit public benefit corporation or a nonprofit mutual benefit corporation. Because it is rare for a mutual benefit corporation to gain tax exempt status under 501(c)(3), we focus on nonprofit public benefit corporations here, and specifically those that are tax exempt under 501(c)(3).

Although the nonprofit public benefit corporation is governed by California state law, tax exemption is largely a matter of federal law. The most familiar type of tax exemption falls under section 501(c)(3) of the Internal Revenue Code. To obtain tax exemption under section 501(c)(3), the organization must be organized and operated for a limited set of purposes, the most common of which are charitable, educational, scientific, or religious.

Beyond 501(c)3: Note that there are many other types of tax exemption under section 501(c) of the Internal Revenue Code. Tax exemption under section 501(c)3 has a unique benefit, in that the donations to the organization are tax deductible to the donors.  However, tax exemption under sections 501(c)4, 501(c)5, 501(c)6, 501(c)7, or another section may afford an organization greater flexibility and allow a broader range of purposes.  It is also possible for a nonprofit corporation to operate without obtaining tax exemption, in which case the corporation would be taxed like a normal corporation.

Nonprofits Doing Economic Development Work In General

The IRS has provided guidance to nonprofits that want to do economic development work, such as providing resources and assistance to for-profit businesses in low-income communities. The IRS issues what are known as “Revenue Rulings” which are public rulings that apply the tax laws to particular cases. These rulings can be relied on by the public to analyze how the IRS would view a similar case in the future. We use these rulings to try to understand how the IRS would view a nonprofit that is trying to do for-profit activities and what factors the IRS uses to determine whether these activities have a tax-exempt or “charitable” purpose.

In analyzing nonprofit organizations providing business education services, the main question that the IRS is seeking to answer is whether this work is primarily benefiting the public, which would make it a charitable or exempt activity, or primarily benefiting private individuals, which would make it a non-exempt activity.[1]

As discussed above, many nonprofits are set up to pursue charitable purposes. The IRS has interpreted the term “charitable” to mean, for example:

  • relief of the poor, distressed, or underprivileged
  • lessening the burdens of government,
  • the promotion of social welfare by organizations designed to lessen neighborhood tensions,
  • eliminating prejudice and discrimination,
  • combating community deterioration,
  • combating juvenile delinquency. [2]

A nonprofit organization that seeks to develop for-profit businesses, such as cooperatives, would want to argue that the charitable work it is doing is accomplishing one of the exempt purposes listed above.

The IRS has also provided guidance to show when a nonprofit’s work on behalf of a for-profit is not a charitable, or tax exempt purpose. The following activities tend to show a “nonexempt”, or commercial purpose:

  • Competition with commercial firms,
  • Lack of voluntary financial contribution from the public,
  • Presence of net profits,
  • Failure to offer any free or below-cost services,
  • Failure to limit its clientele to exempt organizations.[3]

By reading IRS publications and Revenue Rulings, you will find that the items in the bullet lists above have much more nuanced meanings than you can draw from simply reading the lists. That’s why it’s important to have a lawyer explore the legal grey areas with you, and/or to do your own research. We provide greater depth on some of these matters below.

The factors that the IRS considers

When the IRS analyzes tax-exempt organizations that are doing economic development work, the following factors are very important in determining whether the organization is primarily accomplishing charitable purposes, despite the fact that private individuals are benefiting from the work. The IRS looks to see if the nonprofit’s assistance is targeted to:[4]

(1)  benefit a “charitable class,” such as minorities, the unemployed or underemployed, or other disadvantaged groups;

(2)  aid an economically depressed or blighted area;

(3)  aid businesses that would locate or remain in the economically depressed or blighted areas and provide jobs and training to the unemployed or underemployed from such area only if the nonprofit’s assistance was available; and

(4)  aid businesses that have actually experienced difficulty in obtaining conventional financing due to

  1. the deteriorated nature of the area in which they were or would be located or
  2. their composition by minority or disadvantaged people.[5]

While all of these factors are important, the IRS generally considers the first factor to be most important because it provides a direct link between the economic development activity and assistance to the disadvantaged through the provision of jobs.

Private Inurement

The IRS is concerned that a nonprofit may use its tax-exempt funds to benefit a private individual, especially someone who has a relationship with the organization. This is called “private inurement” and is a concern when a nonprofit is doing business development work that will benefit a group of private individuals. Moreover, an organization whose primary purpose is to render services to individuals in their private capacity generally cannot qualify as a tax-exempt, charitable entity.

The exception to this general rule is where the private individuals receiving the benefit are members of a “charitable class,” or if they are not part of this class, then the individuals are a means for advancement of a charitable objective. Finally, the IRS also looks to see if the private benefit involved is incidental to achieving the charitable purposes, meaning that the private benefit was not the goal, but was an unintended or unavoidable result of the charitable activity.

Charitable Class

A “charitable class” of people includes terms like “poor and distressed,” “minority” or “disadvantaged.” In our modern parlance that usually refers to low-income, people of color, or marginalized individuals. If the nonprofit can show that the direct beneficiaries, i.e. the worker-members of the new cooperative, are members of a charitable class of people, then it has a much stronger argument for why its business development work with the cooperative is “charitable.” This is because by helping such people form their own business, the nonprofit can show that its activity is contributing to relief of the poor or disadvantaged.

Charitable Purpose

By contrast, if the nonprofit is not working directly with disadvantaged or low-income people, then the nonprofit will want to show that its assistance to these individuals to form a cooperative will accomplish a charitable goal such as relief of community deterioration. It would be even stronger if the nonprofit could show that by aiding non-poor people in creating a cooperative, this cooperative will provide increased employment opportunities to low-income or disadvantaged people.

In such cases, the nonprofit should show that the assistance it is providing is primarily creating jobs for low-income people, relieving poverty and lessening tensions caused by the lack of jobs in the area,  lessening prejudice and discrimination against minorities, or some other similar charitable purpose. To make the case that the activity is charitable, it can be especially helpful to collect data on the geographic region served, such as unemployment rates, poverty rates, business closures, and any other information that helps to show that there is a need for revitalization.

The main lesson is that the nonprofit should not merely be providing business development assistance to non-poor or non-disadvantaged people, without showing that this assistance is achieving a charitable purpose.

Is the Green Cooperative a charitable activity of Jobs Now?

In the example of Jobs Now! and the Green Landscaping Co-op, the first question to consider is whether the primary purpose of the organization is to provide business development services to a charitable class of people. Jobs Now! can probably show that its business development work with low-income day laborers will contribute to relief of the poor by showing that:

  • it is directly benefiting a charitable class of individuals,
  • its services are targeted to assist that class,
  • it is not in competition with commercial firms,
  • it is providing services that are free and below-cost,
  • it is not making net profits off its work; and
  • it has support from the public.

By helping these workers to create their own business, it is directly benefiting the charitable class of low-income and disadvantaged people.  In addition, Jobs Now! can show that its services are targeted to assist disadvantaged people, not just anyone who wants a job.

In addition, Jobs Now! should show that its assistance to the cooperative is not in competition with commercial firms, because there are no commercial firms that would provide analogous free and low-cost support to employ day laborers.[6] Finally, Jobs Now! will want to show that the services it does provide are free and below-cost to the new cooperative, that the nonprofit is not making net profits off of the business development services it provides, and that Jobs Now! has support in the form of voluntary contributions from the public. All of these factors point to Jobs Now!’s business development activity as charitable in nature.

Beware: Jobs training is not always an exempt activity!

While we’ve given examples of where the IRS permits nonprofits to operate businesses that are conducted for the primary purpose of providing skills training to the disadvantaged, the IRS is not always consistent!

For example, in one case, the IRS deemed a nonprofit’s business to have a charitable purpose because it trained and provided employment to people who were unemployed or underemployed. The nonprofit manufactured and sold toy products using the labor of these disadvantaged residents. The trainees were placed in permanent positions in the community as soon as they were adequately trained.[7]

But in another case, the IRS denied tax-exempt status to a nonprofit that provided job-training to unemployed residents. In that case the nonprofit operated a low-price grocery store in which only a small portion of earnings was allocated to provide job training to unemployed residents from the surrounding low-income community. The nonprofit made a profit off of food sales, although they were sold at low prices to the community. However, food was not distributed free or at reduced cost to those who could not afford to pay.  For these reasons, the IRS found that running the grocery store was not a tax exempt purpose.[8]

Because operating a business for a tax-exempt purpose can be tricky, it is important to carefully plan your business such that it meets the IRS requirements. Consult a nonprofit attorney for assistance with setting up any business your nonprofit may want to operate.

Nonprofits Making Money

Thus far, we have discussed the issue of whether a nonprofit can provide business development services to a worker cooperative. But we must also address the question of whether the nonprofit can engage in business itself, either within the nonprofit, or by forming a subsidiary. This is because the nonprofit may want to create the cooperative as a part of the nonprofit’s activities, or eventually spin it off as a “subsidiary” business.

Related Versus Unrelated Business

The law allows nonprofits to operate income-generating businesses of two sorts: 1) related (the income from which IS NOT taxed) and 2) unrelated (the income from which IS taxed).

Related Business

A “related” business is one in which the primary purposes behind the conduct of the activities are substantially related to the tax-exempt purpose of the organization, as discussed aboveThe primary purpose of the activity must be to further the exempt purpose, and it must have a substantial causal relationship to achieving those purposes.  The primary motivation behind the activity and its primary impact should be the furtherance of the tax-exempt purpose; the primary motivation should not be to earn money. The money that you earn must be incidental to, and not the primary goal of the project.  When the nonprofit makes decisions about the business activity, it should be with the question: “What will most help us achieve our educational or charitable goals?” and not “How can we earn the most money?”  The IRS is especially concerned that nonprofit business activities do not unfairly compete with for-profit businesses. A nonprofit’s business activity should not be operated on a scale that is larger than necessary to achieving the tax exempt purposes.

Also, it’s not what you do WITH the money, it’s what you do TO EARN the money.  Many organizations believe that their business should be tax exempt simply because they reinvest all profits into the nonprofit organization.  However, this is a given with any nonprofit – the earnings should not be distributed to private individuals.  What matters to the IRS is the nature of the activity that earns the money, and whether the activity is operated with the primary purpose of achieving a tax-exempt, or charitable purpose.

Unrelated Business

In contrast to a “related” business, an “unrelated” business can be operated with the primary goal of earning money for the nonprofit, so long as it’s a small portion of the nonprofit’s total activities.  Income from such a business is subject to Unrelated Business Income Taxable (UBIT), and must be reported in the organization’s annual 990 filing.  The purpose of UBIT is to ensure that nonprofits do not gain an unfair advantage if they are competing in a regular market. The most important thing to remember about unrelated business is that it should not become substantial in relation to the nonprofit’s total activities. There is no bright-line rule for determining when the unrelated business has become “substantial,” but the safest thing to do is keep it at less than 10% or 15% of the organization’s activities or income. If the activity grows and is successful in generating income, the organization may want to create a for-profit subsidiary.

What Is A Subsidiary?

Often nonprofit organizations choose to form subsidiary entities to undertake business activities. Forming a subsidiary can help to protect a nonprofit’s tax exempt status. If the nonprofit seeks to engage in business activity that is not related to the nonprofit’s tax-exempt purpose, then forming a subsidiary can be a good strategy. Another reason for forming a subsidiary is to protect the nonprofit from liability.

A subsidiary is usually owned or controlled by the nonprofit “parent” entity. The nonprofit exerts control over the subsidiary in a variety of ways. Usually the nonprofit controls the new entity by owning the stock, received in exchange for capital contributed by the nonprofit. This allows the parent nonprofit to select the subsidiary’s board of directors and officers. Additionally, the nonprofit may incorporate the subsidiary, choose the subsidiary’s business purpose, and create bylaws that protect the parent’s ability to control the subsidiary. By controlling the board of directors, the nonprofit ensures that its vision is carried on in the subsidiary’s activities.

The importance of corporate formalities

In order to prevent the nonprofit from becoming liable for the subsidiary’s activities, the two should be treated as distinct entities. This means observing “corporate formalities.” Corporate formalities include ensuring that both the nonprofit and the subsidiary having their own boards of directors with separate meetings and minutes; have separate officers and employees; maintain separate bank accounts, bookkeeping, records and financial accounts; and use separate stationery. In addition, the subsidiary should enter into transactions in its own name. If these procedural formalities are followed, then the two entities will be treated by the courts as separate legal entities. If anyone tries to sue the nonprofit parent organization for the actions of the subsidiary, the lawsuit will likely fail because the parent will usually not be liable for the actions of the subsidiary.

Are worker cooperatives subsidiaries?

As we will see, depending on how the relationship between the nonprofit and the worker cooperative is structured, it may or may not be considered a subsidiary for tax or liability purposes. This is because the nonprofit can either decide to retain control over the board of directors of the new cooperative and be the sole member of the cooperative, in which case it may be considered a subsidiary. Or, the nonprofit could decide not to be a member of the cooperative and have little control of the board of directors, in which case the cooperative would probably not be a subsidiary.

Nonprofits Creating Cooperatives

In California, when someone incorporates a cooperative corporation, that person (known as the “incorporator”) has the power to appoint the cooperative’s initial board of directors. California cooperative law provides that only “natural persons” may hold seats on a cooperative’s board of directors. This means that a nonprofit entity cannot be a member of the cooperative’s Board.[9] However, the cooperative law allows for a “specified designator” to choose “all or any portion of the directors authorized in the articles or bylaws” of the cooperative.[10] By selecting itself as the specified designator of board seats for the new cooperative, the nonprofit can ensure that, after the initial board of director’s term expires, it retains indirect influence over the activities of the cooperative through representation on the Board. However, by granting itself too much control over the cooperative’s board, the nonprofit risks violating the fundamental principles of a worker cooperative, which grants governing authority to the workers.

The Nonprofit as Member

 

We do not recommend that you have your nonprofit become a member of a California cooperative corporation without speaking with an attorney familiar with nonprofit law.

California cooperatives allow for different classes of membership. This means that the nonprofit could create a class of membership for the workers and a class for itself, as an organizational member. However, how the IRS would view a nonprofit member of a California cooperative corporation is not a settled area of law. In the LLC context, the IRS views nonprofit members of LLCs as entering into a joint venture with the other LLC members. Such LLCs are subject to strict rules: that the LLC must be set up to achieve one of the nonprofit’s charitable purposes; and that the nonprofit retains control of the LLC to ensure that this charitable purpose is the primary focus.

Rather than become an official member of the cooperative, it may be advisable for the nonprofit to retain influence over the cooperative through designating a minority of seats on the board of directors, as described above. Alternatively, or in addition, the nonprofit could retain influence over the cooperative vision by naming itself in the bylaws of the new cooperative as a “specified person.” This specified person has power to ensure that certain changes to the bylaws, such as a decision to stop operating as a cooperative, or to merge or sell to another business entity, cannot happen without the nonprofit’s approval.[11]

For example, the nonprofit may want to ensure that the worker-members of the cooperative do not sell out to another corporate entity or to people who do not share the cooperative vision. In this way the nonprofit can serve as an “anchor” to ensure that the cooperative maintains its founding principles and vision.

Reasons to avoid characterizing the cooperative as a subsidiary

It may be that the nonprofit would like the new cooperative to retain its own independence and not be considered a subsidiary of the nonprofit. This could help the nonprofit to avoid liability for the actions of the cooperative. In addition it could help the nonprofit if it wishes to show that it is not liable for the taxes of the cooperative.

From a tax perspective, it is risky for the nonprofit to exert too much control over the cooperative. Even if the nonprofit and the cooperative are not in a “parent-subsidiary relationship,” the IRS may find that the relationship exists due to the nonprofit’s excessive control and close supervision of the affairs of the cooperative.[12] If a parent entity exerts too much control over a subsidiary, the IRS could find that the subsidiary is not in fact a separate entity, but rather an “instrumentality” of the parent entity. The rationale behind this is that when the parent nonprofit is too involved in the day-to-day management of the subsidiary, the activities of the subsidiary are imputed to the parent. The effect of this could be that the income of the cooperative will be “attributed” to the parent nonprofit.

In order to avoid being considered a subsidiary of the nonprofit, the new cooperative should allow the workers to become members with voting powers in all respects. In addition, the nonprofit should not reserve to itself too much power to appoint the board of directors or too much veto power over changes to the bylaws as a “specified person.” As the cooperative becomes established, the nonprofit may want to designate itself to appoint no more than a minority of the board seats and let the rest be elected by the workers. By allowing the workers to elect a majority of the board seats, and thus retain democratic control of the board, the nonprofit will be well-positioned to show that the cooperative is not its subsidiary.

Services provided to the cooperative

The nonprofit can provide essential services to ensure the success of the cooperative such as: pre-startup business development planning and analysis, investment of start-up capital, development of business systems, management of human resources, strategic planning, start-up financing, public education and creating strategic partnerships for the cooperative. If desired, staff members of the nonprofit can be independent consultants or employees of the cooperative. The cooperative may pay the nonprofit reduced feeds for the provision of these services.

Note that some of the services provided to the cooperative by the nonprofit would be considered “related business” activities (described near the beginning of this section), which means the nonprofit would not pay tax on any income for those services. However, some of the services may be considered operation of an “unrelated business,” in which case the nonprofit would need to pay taxes on the income (including any patronage dividends) derived from those services.

Note, also, that if the nonprofit provides certain services for free to the cooperative, such services could be seen as providing an improper benefit to private individuals, who are now members of the cooperative. This may be true especially in cases where the members of the cooperative are not members of a charitable class, as discussed earlier. To ensure that the nonprofit is not seen as funneling money and resources to private individuals (the cooperative members), in certain cases it may be important that the nonprofit be paid by the cooperative for the fair market value of the services it provides.

Cooperatives should “operate on a cooperative basis”

The purpose of a cooperative is to be democratically-controlled by its members. Although the nonprofit may exert control over the cooperative through designating the board of directors, it should not fully control the cooperative. The other worker members should have the ability to control the cooperative through electing the board of directors and having a voice in the daily operations of the cooperative. If the nonprofit exerts too much control, this may violate fundamental cooperative principles as well as violate IRS provisions in Subchapter T of the Code. At the same time, this may be justified in the early years of an incubated cooperative, and it may be worth foregoing the tax benefits of Subchapter T at that time.

One of the advantages of Subchapter T is that the cooperative may deduct from its taxes patronage dividends that are distributed to members based on their contribution to the cooperative.

The IRS allows Subchapter T tax treatment for cooperatives that are “operating on a cooperative basis.” This means that the cooperative should: (1) subordinate capital, (2) have democratic control by members, and (3) allocate and distribute net earnings to members.[13] In order to “subordinate capital,” the cooperative should place the control and direction of the organization in its members, not outsiders. Similarly, member democratic control requires the cooperative to generally govern itself on a one-member, one-vote basis. Thus, the nonprofit should avoid undue control over the cooperative, either through control of the board of directors or unequal voting power, which may violate the IRS requirements that the cooperative operate on a cooperative basis. However, this is a disputed topic and deserves more discussion. In some cases it may make sense for the nonprofit to exert control in the initial stages of the co-op’s development, to ensure that the business is successful.

The third principle, allocate and distribute net earnings to members, means that in general the profits of the cooperative should be allocated or distributed to the members’ accounts.

Be careful about how much the nonprofit controls

In sum, it may not be a good idea for the nonprofit to have too much control over the new cooperative it creates for several reasons. How much is too much? This is a gray area and deserves more attention than can be given in this manual. Some argue that the nonprofit needs to retain control in the startup years of the co-op to ensure that the co-op is successful. This is especially true if the co-op’s members are disadvantaged workers who may lack access to the business and financial resources required to run a business. As we have discussed above, however, too much control over a Subchapter T governed cooperative may violate IRS rules about “operating on a cooperative basis.” Because this has not yet been tested, we recommend you consult with an attorney about incubating a worker cooperative corporation subject to IRS Subchapter T rules.

Protecting your tax-exempt status

In sum, take care to ensure that the business development work falls into the nonprofit’s tax-exempt purpose. Then make sure that all services provided to the cooperative from the nonprofit are “arms-length,” that is that they are fair to both the nonprofit and to the cooperative. If the cooperative is composed of a charitable class of individuals, then the nonprofit can offer these services free or at substantially lower costs. If these two conditions are met, then the non-profit is unlikely to face a threat to its tax-exempt status.

Steps to Take If Your Nonprofit Wants to Get Involved In Business Activities

Review your nonprofit’s incorporation documents and tax exemption determination

Before your nonprofit undertakes to provide business development services for the development of new worker cooperatives, review your nonprofit’s articles of incorporation. Make sure that these articles, filed with the state, empower your nonprofit to engage in charitable economic development-type of work. Your articles could include some specific purpose which allows this, such as to promote employment opportunities for the disadvantaged poor, minorities, unemployed, and/or underemployed in the community. If this is so, a business that employs significant numbers of this charitable class is consistent with this specific purpose.

Also, check to see whether your nonprofit’s articles have a general purpose clause that allow the nonprofit to engage in “any activities that further its charitable or educational purposes.” If this is so, then your nonprofit might be able to make the case that business development work futhers an existing charitable purpose as discussed above.

If the activity is not authorized in the articles, then you must amend the articles and send a copy of the amendment to the IRS and the California Franchise Tax Board with your next income tax filing. If you did not describe the activities in your tax exemption application your 990 tax return will  ask you to describe any new purposes and activities, and it would be a good idea to explain why the nonprofit organization considers them to be charitable or educational.

For more information on nonprofits starting for-profit subsidiaries see this article: http://www.adlercolvin.com/pdf/revenue_generating_activities/AC_Web_Docs–Revenue_Generating_Activities_(00160207).PDF.

Different entities available for formation of cooperatives

Most of this section has been written under the assumption that a nonprofit has formed a cooperative corporation. However, a nonprofit that incubates cooperatives may choose, for a variety of reasons, to form the cooperative as an LLC, partnership, or other entity. For more information on this, see sections of the site related to entity choice and employment law, including “Forming Cooperatives of Foreign Nationals.”

Non-legal considerations: Does your nonprofit have the capacity or experience to start a cooperative?

Hilary Abell, a non-profit management and cooperative development consultant, speaks about the “entrepreneurial culture” and long-term commitment required of the nonprofit organization itself, if it is going to find success in incubating worker cooperatives.  As former executive director of Prospera, a nonprofit that incubates worker-owned businesses for Latinas, Hilary has helped incubate successful co-ops in low-income communities and has advised nonprofits that are exploring or involved in co-op development. In her view, one of the main non-legal considerations for nonprofits is the fit between the sponsoring nonprofit and the organizational capacities and culture needed to build a successful cooperative business. She states, “While the competencies needed for community organizing or providing social services may be helpful in co-op incubation, the daily rhythm, underlying logic, and actual activities of incubating and operating a business are quite different. Experience has shown that the nonprofits that are most likely to succeed at social enterprises or co-op development are the ones that already have the entrepreneurial skills and business-like culture that are needed to make small businesses thrive, or that recognize that the culture and skills needed to run their other programs may be different from what they’ll need to incubate businesses. Some complex negotiations and cultural shifts are often necessary in order to integrate people with new skill sets and enable the staff or department responsible for the co-op project to do their job well.

It is also important for non-profits to realize that co-op development is a long-term commitment. If the sponsoring organization removes its technical assistance and organizing support prematurely, it can backfire both for the nonprofit and for co-op members. A nonprofit should know in advance how many years of support it can provide to the new co-op and how it will secure the skilled staff and resources to fulfill this commitment. Because people put so much of their heart and soul into cooperatives, a developer does a dis-service if it is too optimistic or idealistic in its assumptions about what is needed. As we know, about half of small businesses fail within five years due to lack of experience, planning or investment capital. In under-resourced communities, small businesses may need even more support. The cooperative model can be more intensive and, when done well, can yield great rewards, but it is a complex undertaking.”

There are many non-legal considerations to take into account in incubating a worker cooperative. Nonprofit organizations may not have the staff with the requisite skills or experience necessary to start or manage a new business, especially one that is to be eventually owned and controlled by other people. Before embarking on such a project, you should consult with a social enterprise or nonprofit management consultant to determine whether your nonprofit has the capacity to take on a new venture.

If Your Nonprofit Wants To Start A Cooperative, Consult A Lawyer!

The ability for nonprofits to contribute to the worker cooperative movement by creating new cooperatives is very promising. Nonprofits that are considering such a move should seek legal and tax advice from certified public accountants and attorneys who are familiar with nonprofits engaging in business ventures as well cooperative attorneys to properly structure the relationship.


[1] See, e.g., Robert Louthian and Marvin Friedlander, “Economic Development Corporations: Charity Through the Back Door” (an IRS publication), (providing that the IRS recognizes the charitable purpose of economic development activities that benefit for-profit companies where “the ultimate good received by the general public outweighs the private benefit accorded to the direct beneficiaries”), available at http://www.irs.gov/pub/irs-tege/eotopicg92.pdf.

[2] IRS Regs. 1.501(c)(3)-1(d)(2).

[3] See B.S.W. Group, Inc. v. Comm’r, 70 T.C. 352 (1978).

[4] See Robert Louthian and Marvin Friedlander, “Economic Development Corporations: Charity Through the Back Door” (an IRS publication), available at http://www.irs.gov/pub/irs-tege/eotopicg92.pdf.

[5] See IRS Rev. Rul. 74-587, 1974-2 C.B. 162; Rev. Rul. 76-419, 1976-2 C.B. 146; and Rev. Rul. 77-111, 1977-1 C.B. 144.

[6] See IRS Rev. Rul. 69-572 for an example of where a nonprofit differentiates its services from those offered by for-profit providers. Please note that the issue of competition applies to the non-profit’s activities, not those of the cooperative. It is assumed that the cooperative business itself will be competing with other businesses, and helping it compete may in fact be the goal of the nonprofit providing technical assistance.

[7] IRS Rev. Rul. 73-128, 1973-1 Cu. Bull. 222 (1973).

[8] IRS Rev. Rul. 73-127, 1973-1 Cum. Bull. 221 (1973).

[9] Cal. Corporations Code Section 12233.

[10] Cal. Corporations Code Section 12360(d).

[11] California Corporations Code Section 12330(d) provides that a cooperative’s bylaws may allow that the repeal or amendment of the bylaws (or any specified parts of the bylaws) “occur only with the approval in writing of a specified person or persons other than the Board of Directors or members.”

[12] Rev. Ruling 68-26 (finding that even though a technical parent-subsidiary relationship did not exist between two nonprofits, the parent-subsidiary relationship can be present if a “substantially similar relationship does in fact exist through the control and close supervision of its affairs.”).

[13] The Internal Revenue Code does not define “cooperative” or “operating on a cooperative basis.” Instead case law and IRS guidance have provided the determining criteria. The seminal case which provided these three factors is Puget Sound Plywood, Inc. v. C.I.R., 44 T.C. 305 (1965); see also Charles Autry and Roland Hall, The Law of Cooperatives, American Bar Association, (2009), pg.88.

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