CALIFORNIA FORMS OF ORGANIZATION Morrison & Foerster LLP Susan Mac Cormac and Clare Reilly 1

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1 Last Updated: October 2013 CALIFORNIA FORMS OF ORGANIZATION Morrison & Foerster LLP Susan Mac Cormac and Clare Reilly 1 Table of Contents 1. Nonprofit Corporations 2. For-Profit Corporations 3. Limited Liability Companies 4. Flexible Purpose Corporations 5. Benefit Corporations 6. Low-Profit Limited Liability Companies 7. Joint -Ventures 8. Partnerships and Limited Partnerships 9. Sole Proprietorships 10. New Corporate Forms 11. Resources The most common legal form of organization utilized by the social sector is the nonprofit corporation although for-profit corporations, limited liability companies (LLCs), flexible purpose corporations, benefit corporations, joint ventures and various kinds of partnerships, including limited partnerships, are increasingly being used--typically to accommodate plans to earn revenues or access capital markets. Each of these forms of organization has advantages and disadvantages and sometimes, with the help of experienced counsel, they are used in combination to maximize strengths and minimize weaknesses of a particular form. The following chart provides a high-level overview of various organizational forms that can be used in the social sector. More detailed descriptions of each form follow in the subsequent text. 1 Previous reviews completed by Nancy White, Pat Derdenger and Ben Gardner of Steptoe & Johnson LLP.

2 Nonprofit 501(c)(3) Corporation For-Profit Corporation Formation File articles or certificate of incorporation (containing specific info required by IRS) with state and pay filing fee. File application on Form 1023 for tax-exempt status unless below gross receipts threshold. Recruit directors, draft bylaws and hold organizational meeting. Take steps to comply with license, tax and employment law/regs. File articles or certificate of incorporation with state and pay filing fee. Decide on board of directors, draft bylaws, hold organizational meeting and issue stock. Take steps to comply with license, tax and employment laws/regs. Management and Control Liability Tax Factors Capital and Loans Managed by directors Members, directors, who appoint officers officers and employees to run day-to-day are generally not liable operations as specified for debts and in bylaws. Some obligations of the nonprofit corporations corporation, including have members (like shareholders) who elect directors. Managed by directors that are elected by shareholders. Directors appoint officers to run day-to-day operations as specified in bylaws. for unlawful acts of others involved in the affairs of the corporation. They can be held liable for injuries due to their own misconduct but some states provide limited immunity to such persons and also to volunteers. Shareholders are generally not liable for debts and obligations of the corporation, including for unlawful acts of others involved in the business. Unless indemnified by the corporation, directors, officers and employees can be held liable for injuries caused by certain of their own acts or failures to act. Generally exempt from federal and state taxes if receive 501(c)(3) exemption. Liable for tax on unrelated business income, and other taxes such as property and sales (unless local and state exemptions apply). Donors can deduct contributions. A C Corporation is subject to corporate tax on net income. If net income is paid to shareholders as dividends, the individual shareholders are taxed. If a corporation elects to be an S corporation and meets several criteria, it can receive pass through taxation. Can accept charitable donations and grants. Eligible for program related investments (PRIs) by foundations. Can borrow money and issue debt instruments but cannot raise capital by issuing stock. Can raise capital by issuing stock (equity) and by borrowing money through loans or other debt instruments. Corporation may be able to accept PRIs from foundations in the form of loans or equity.

3 Flexible Purpose Corporation (California) Formation Management and Control Liability Tax Factors Capital and Loans See for-profit See for-profit See for-profit See for-profit See for-profit corporation, but must corporation. corporation. corporation. corporation. have a name that includes Flexible Purpose Corporation or an abbreviation thereof. Also must include the shareholder agreed special purpose in its articles. Benefit Corporation (California) See for-profit corporation, but must state in its articles of incorporation that it is a benefit corporation. Also must operate for a general public benefit and is permitted to recognize one or more specific public benefits, which must be included in its articles. See for-profit corporation. See for-profit corporation. See for-profit corporation. See for-profit corporation.. LLC File articles of organization or certificate of formation with state and pay filing fee. Negotiate and execute operating agreement. Take steps to comply with license, tax and employment law/regs. Flexible structure like a partnership with management responsibilities specified in operating agreement (usually management committee or single manager). Same as a corporation. Usually not taxed as an entity because most LLCs choose pass through treatment whereby the member/owners report profits and losses on personal tax returns. Tax-exempt member/owners treat their share of income as exempt or subject to unrelated business taxable income, depending on the character of the income. Can raise capital through contributions by member/owner. Otherwise, same as for-profit corporation.

4 L3C (low-profit LLC) (NOTE: Not available in California as of 2013) Partnership Formation Management and Control Liability Tax Factors Capital and Loans Similar to LLC but See LLC. Same as a corporation. See LLC. Same as for-profit must be formed for a corporation except L3C charitable or enabling legislation is educational purpose. written to comply with Only permitted in PRI regs and is thus certain states (e.g., VT, intended to attract IL, MI, UT, ME, WY). equity or debt investments by foundations. No filing requirements Partners have equal, Partners are personally Generally not taxed as Can raise capital unless limited full control unless liable for the debts and an entity. Partners through contributions partnership (LP) or otherwise specified obligations of the report profits and by partners and by limited liability in partnership partnership, including losses on personal tax borrowing money partnership (LLP), but agreement. for unlawful acts of returns. through loans or other partners should sign other partners and debt instruments. partnership agreement. employees. Risk can be Take steps to comply limited by creating an with name, license, and LP or LLP. tax and employment law/regs. Sole Proprietor No filing requirements. Has no legal existence apart from owner. Take steps to comply with d/b/a name, license, tax and employment law/regs. Owner has full control. Owner is liable for all debts and obligations, including for unlawful acts of employees. Not taxed as an entity. Owner reports business profits and losses on personal tax return. Owner provides funds for capital investment and owner can borrow money through loans or other debt instruments. 1. Nonprofit Corporations a. Overview The California Nonprofit Corporation Law (Cal. Corp. Code ) governs the formation, operation and dissolution of various types of California nonprofit corporations. The majority of California nonprofit corporations are one of the following types: (i) the public benefit corporation, (ii) the mutual benefit corporation and (iii) the religious nonprofit corporation. Each of these subtypes of nonprofit corporations differs from the other in the following respects: the purposes for which each is organized, the manner in which its assets may be distributed, and the manner in and extent to which it is regulated. Public benefit corporations may be formed for any public or charitable purpose and may be used by foundations, community chests and hospitals. Public benefit

5 corporations are governed by Cal. Corp. Code and are subject to extensive governmental regulation and supervision. Public benefit corporations may not make distributions of corporate assets to members at any time. Mutual benefit corporations may be formed for any lawful purpose and are often the corporate form of choice for societies, fraternal orders, trade and homeowners associations, clubs and similar organizations conducted for their members benefit. Mutual benefit corporations are regulated by Cal. Corp. Code and are subject to less comprehensive state regulation and supervision than the public benefit corporation. Assets may be distributed to members only upon dissolution of the mutual benefit corporation and, subject to certain requirements set forth in the California Nonprofit Corporation Law, in connection with the purchase or redemption of a membership. Religious corporations may be formed primarily or exclusively for religious purposes such as churches, seminaries and other religious organizations like hospitals and schools if the organization s primary purpose is religious in nature. Religious corporations are regulated by Cal. Corp. Code and are subject to less comprehensive state regulation and supervision than the public benefit corporation. Religious corporations may not make distributions of corporate assets to members at any time. Note also that some religious organizations may wish to consider a unique form of organization called a corporation sole as an alternative to a religious corporation(see Cal. Corp. Code ). For a more detailed discussion and comparison of these various forms of organization, please see Advising California Nonprofit Corporations (3 rd ed. Cal CEB 2013). In addition to the three major nonprofit corporations outlined above, there are several minor types of nonprofit corporations recognized by California law including, without limitation, the corporation sole, and other special purpose corporations such as the consumer cooperative corporation, societies for the prevention of cruelty to animals, chambers of commerce and boards of trade, small business development corporations, and nonprofit cooperative agricultural marketing associations, which are also subject to General Corporation Law. Because it is the most common type of California nonprofit corporation, the discussion in this Chapter 1 is generally focused on the public benefit corporation, unless otherwise specifically indicated.

6 All activities and affairs of a nonprofit corporation in California are conducted and all corporate powers exercised by or under the discretion of its board of directors. The board of directors may delegate the management of the activities to the corporation s officers and employees. Instead of shareholders, a nonprofit corporation may, but is not required to, have members. Nonprofit corporations can make a profit, but cannot be designed primarily to earn profits. Rather, a nonprofit corporation exists primarily to fulfill its public or charitable purpose as described above. No part of the income or surplus of a California nonprofit corporation may be distributed to its members, directors or officers; however, reasonable compensation may be paid for services rendered. A nonprofit corporation has an existence of its own, independent of the terms of office or employment of members, directors or officers. Among other powers, a nonprofit corporation can sue or be sued in its own name, carry on a business at a profit and apply any profit that results from the business activity to any activity in which it may lawfully engage, and can own real estate in its own name. b. Advantages of Incorporation: Pros and Cons of Nonprofit vs. For-Profit The principal advantage of incorporation, either as a nonprofit or a for -profit corporation, is that it protects the shareholders or members from personal liability for the obligations and liabilities of the corporation, including unlawful actions of officers, directors and staff acting on behalf of the corporation. In addition, incorporation establishes continuity of existence which may be for a set period of time or perpetual unless earlier terminated or dissolved as described herein. Corporations (both nonprofit and for-profit) are subject to a body of statutes that provide very specific guidance as to their formation and operation; and incorporation brings stature to the organization and implies stability. Where profit is not a goal and the enterprise can be funded without the need for access to capital, the nonprofit corporation is the preferred vehicle for pursuing social objectives. Although nonprofit corporations are not prohibited from engaging in commercial activities, the directors of a nonprofit are duty-bound to devote primary attention to the promotion of the social mission of the corporation rather than the production of net income or profits. On the other hand, if access to capital markets is needed, a for-profit corporation (or limited liability company, discussed below) is likely to be the preferred option because nonprofit corporations cannot issue capital stock. The directors of a for-profit corporation, however, owe strict duties to the shareholders to maximize profits and value. Therefore, unless the directors and managers can tie the social

7 mission of their for-profit corporation directly to its business purpose, they can be sued for breach of their duties to shareholders and for misuse of corporate assets if they focus too much on the social mission and forego profits. This problem can be avoided where all shareholders agree to pursue a social mission or devote a percentage of revenues to charitable causes. Such agreements may be temporary because a change in control or a drop in earnings can lead to amendment or termination of shareholder agreements with stated social mission purposes. This problem can also be avoided by forming an entity using a new corporate form, such as the flexible purpose corporation, which provides flexibility to form corporations that may pursue both economic and social objectives. This corporate form is discussed in greater detail below. c. Formation A nonprofit corporation attains its separate legal status through the filing and approval by the California Secretary of State of its articles of incorporation. This document is in essence a contract between California and the nonprofit corporation to which California grants individual legal status in exchange for the corporation s commitment to follow its rules. One or more persons may form a nonprofit corporation by filing articles of incorporation in the form required by the California Secretary of State. If initial directors are named in the articles, each must sign and acknowledge the articles; otherwise, the articles shall be signed by one or more incorporators. One additional fully executed copy of the articles must be provided to the Secretary of State for delivery to the California Attorney General. The following discussion is directed to the most common type of California nonprofit corporation, the public benefit corporation. The articles must include the following information: the name of the corporation; the following statement: This corporation is a nonprofit public benefit corporation and is not organized for the private gain of any person. It is organized under the Nonprofit Public Benefit Corporation Law for (public or charitable [insert one or both]) purposes. The articles must also include the initial street address of the corporation, the initial mailing address of the corporation if different from the initial street address and the name of the corporation s initial agent for service of process (an individual or entity located in California appointed by the corporation to accept service of process on behalf of the corporation if an individual, the articles must also include the agent s street address in California). The statutory agent agrees to accept official documents such as pleadings in a law suit or legal proceeding and deliver them to the officers and directors of the corporation. The articles may set forth other provisions such as a limitation on the duration of existence, classes

8 of members, if any, voting rights and any other provision for the conduct of the affairs of the corporation not in conflict with law. A nonprofit corporation may not use, and the Secretary of State will not file, articles which set forth a name which is likely to mislead the public or which is deceptively similar to the name of another California corporation or any non-california corporation which is authorized to do business in California or which has registered its name with the California Secretary of State, unless that existing corporation consents in writing and the Secretary of State finds that under the circumstances the public is not likely to be misled. The availability of a name may be checked by accessing the website of the California Secretary of State at It is possible to reserve a name, if available, by payment of a fee for a period of 60 days. There are further limitations on name choices for California nonprofit corporations in that such names may not contain the words bank, trust, trustee or related words. If the nonprofit corporation intends to obtain exemption from federal and state income taxation, the articles of incorporation must conform with applicable statutes and regulations (discussed in the Recordkeeping, State Reports, and State Taxes section below). Samples of articles of incorporation and related materials can be found at: The California Secretary of State s office (California nonprofit, public benefit) Insight Center for Community Economic Development (California model articles of incorporation for nonprofit public benefit corporation (and includes a model cover letter for filing and with model name reservation request) on.pdf. d. Management and Control Once the nonprofit corporation has been established, the initial board of directors should meet (in person or/by written consent instead of a board meeting) to ratify the acts in connection with the initial formation of the corporation and adopt bylaws, which set forth the rules and procedures governing the decision-making process of the board of directors and the general operation and management of the corporation consistent with the applicable California statutes and the corporation s articles of incorporation.

9 Typically, the bylaws of a nonprofit corporation contain provisions governing member, director and officer qualifications, powers, and duties; voting; filling of board vacancies; board and shareholder meetings; property holding and transfer; indemnification of directors and officers; committees; bank accounts; fiscal year audits and financial reports; conflicts of interest; and amendment and dissolution procedures. Samples of bylaws that may be adapted for California nonprofit corporations can be found at: Insight Center for Community Economic Development (California model bylaws for a nonprofit membership corporation) s.pdf Insight Center for Community Economic Development (California model bylaws for a nonprofit non-membership corporation) 20nonmembership%20bylaws% pdf American Bar Association, Business Law Section Pro Bono: ABC Toolbox (California bylaws for nonprofit non-membership public benefit corporation) /bylaws_cali.doc e. Liability of Members, Directors and Officers Because of the importance of attracting services of directors and officers of nonprofit corporations and the sometimes prohibitive cost of appropriate liability insurance, it is the public policy of the State of California to provide protections to individuals who perform these functions. Subject to certain exceptions, a nonprofit corporation has the power to indemnify directors, officers, employees and other agents who are party to, or threatened to be party to, any proceeding because of the fact that such person is or was an agent, against litigation expenses, if the person acted in good faith and in a manner he or she believed is in the best interest of the corporation. Indemnification cannot be provided in cases where the agent has breached his or her fiduciary duty of loyalty to the corporation by engaging in certain self-dealing transactions (that is, transactions to which the corporation is a party and in which the director has a material financial interest). There are other circumstances under which an agent cannot be indemnified, which are described in the California Nonprofit Corporation Law.

10 With specific exceptions outlined below, no law suit for monetary damages shall be recognized against a volunteer officer or director of a California nonprofit corporation (i.e., a person serving in such capacity without compensation) arising out of a negligent act or omission of such person while he or she is performing such duties so long as such person acted within the scope of his or her duties and in good faith, the act or omission was not reckless, wanton, intentional or grossly negligent, and damages caused by the act or omission are covered by a liability insurance policy or, if not covered, so long as the corporation and the volunteer had made all reasonable efforts in good faith to obtain available liability insurance. This limitation on liability applies to nonprofit corporations that are exempt from federal income taxation under Sections 501(c)(3) or 501(c)(6) of the Internal Revenue Code, provided that the nonprofit corporation maintains liability insurance policies with amounts of coverage sufficient based on the corporation s annual budget. To the extent an officer or director of a nonprofit corporation uses corporate funds to pay private debts, makes any distribution of corporate assets or fails to observe typical corporate formalities (recognizing the corporation as a separate legal entity), or as necessary to prevent fraud on creditors, the officers or directors committing such acts maybe personally liable for damages resulting for such acts. f. Mergers, Acquisitions and Dissolution The requirements related to mergers of California nonprofit corporations are in Cal. Corp. Code for public benefit corporations; Cal. Corp. Code for mutual benefit corporations; and Cal. Corp. Code 9640 for religious corporations. For sake of simplicity, and because public benefit corporations are the most common form of California nonprofit corporations, the following discussion is limited to public benefit corporations. A California public benefit corporation may merge with any domestic for-profit corporation, a foreign for-profit corporation or other business entity. However, subject to certain exceptions, without the prior written consent of the California Attorney General, a public benefit corporation may only merge with another California nonprofit corporation, foreign nonprofit corporation, or unincorporated association if such entity s governing documents state that its assets are dedicated exclusively to charitable, religious or public purposes. The merger process may be summarized in the following steps: i) The board of each corporation that wishes to merge must approve an agreement of merger which contains the following information:

11 The terms and conditions of the merger; Any amendments to the articles of incorporation or bylaws that are required for the corporation who will survive the merger or continue to exist after the merger is effected (the surviving corporation ); The name, place of incorporation and status of each corporation participating in the merger; The identity of the surviving corporation; The manner, if any, of converting memberships of the corporations into memberships, shares, or other securities of the surviving corporation, or the securities, cash, rights or other property that members are to receive in exchange for their memberships or securities; Any other provisions or details required by the parties; and Any other details required by the laws of the state of incorporation of one of the corporations, if not California. ii) The terms of the merger must be approved by members of the participating corporations and as may otherwise be required by each party s articles of incorporation; iii) The merger agreement must be signed by the authorized officers of the participating corporations; and iv) The surviving corporation must then file with the Secretary of State the agreement of merger with an officer s certificate from each participating corporation, setting forth specific facts relating to the voting and approval of the merger required by each participating corporation, and must pay the required filing fee. It is also possible for a California for-profit corporation and a nonprofit corporation to merge. The requirements for such merger (approval of the boards of the participating corporations, appropriate votes, execution and filing of a merger agreement) are detailed in the California statutes governing nonprofit and for -profit corporations. A nonprofit corporation may voluntarily dissolve and wind up its affairs by either approval of the board of directors or approval of a majority of the members of the nonprofit corporation. The board of directors alone may choose to wind up and dissolve a corporation, if the corporation: (i) has been the subject of an order for relief in bankruptcy; (ii) has not conducted business within the last five years and which has already disposed of all its assets; (iii) has no members; or (iv) is required to dissolve under the terms of the corporation s articles of incorporation providing for termination of its existence as of a specific date.

12 Once a corporation has decided to dissolve and wind up its affairs, it must file a dissolution certificate evidencing its intent to dissolve with the Secretary of State and the California Attorney General. The certificate must be an officer s certificate, or must be signed by a majority of the directors or by one or more members. It must recite the number of votes in favor of dissolution and whether the decision to dissolve was made by the board or by the members. Once the corporation initiates the dissolution process, it may no longer conduct its normal activities except as necessary to wind up its affairs and/or to prepare for a sale or disposition of its assets or both. Another notice of dissolution must then be provided to all members who did not vote in favor of dissolution, the California Attorney General and all known creditors and claimants whose names and addresses appear in the corporation s books and records. A corporation voluntarily dissolving must provide notice to creditors and claimants explaining how to make a claim against the dissolving corporations and provide a deadline no fewer than 120 days from the date of notice within which the corporation must receive a written claim submitted by such creditors. It is possible to seek court intervention and supervision of the dissolution of a California nonprofit corporation if requested by the corporation itself, the authorized number of members (or 5% of the voting power, unless there are 1,000 or more members), if any, the California Attorney General, or by three or more creditors. When a corporation has been wound up without court involvement, a majority of directors must sign and verify a certificate of dissolution which states, among other things, that the corporation has been wound up, that it has filed or will file its last franchise tax return, that it is dissolved, that all debts and liabilities have been paid, and, if there are known debts and liabilities for payment of which adequate provision has been made, a description of the provision made, the name and address of the person, corporation or governmental entity who has assumed or guaranteed payment of the corporation s liabilities. Before the certificate of dissolution will be accepted for filing by the California Secretary of State, the corporation must attach either a written waiver of objections to the distribution of the corporation s assets issued by the California Attorney General or a written confirmation issued by the California Attorney General that the corporation has no assets. In addition to voluntary dissolution proceedings, it is possible for an action for involuntary dissolution to be filed in the superior court of the proper county by any of the following: at least half of the directors then in office, a person(s) holding at least 1/3 of the voting power, any member if the ground for dissolution is that the period for which the corporation was formed has terminated without extension, the California Attorney General or any person authorized in the

13 corporation s articles to file such an action. The grounds for such a lawsuit include abandonment of corporate activities for more than one year; deadlock on the board with respect to ongoing management and operation or internal dissension among members such that the activities of the corporation can no longer be conducted to advantage or so that there is danger that its property or activities will be impaired or lost; fraud, mismanagement or misapplication of assets or corporate property; or expiration of the corporation s term of existence set forth in its articles. The California Attorney General may also bring an action to obtain dissolution on similar grounds set forth in Cal. Corp. Code 6511(a). The court may appoint a provisional director to break a tie or management deadlock, or it may appoint a receiver to take over and manage the orderly disposition of the corporation s assets. The powers of the court in an involuntary proceeding are set forth in Cal. Corp. Code 6516 and include, among other things, management of claims against the corporation and approval of payments of such claims and/or retention of assets to provide a fund for payment of claims. The mechanics for notice to creditors and claims payments are set forth in Cal. Corp. Code g. Recordkeeping, State Reports and State Taxes Every nonprofit corporation in California is required to keep a copy of its articles and bylaws at its principal office in California and to keep adequate and correct books and records of account and minutes of meetings of the members, board and board committees. It shall also maintain a record of its members names, addresses and class of membership. No later than 120 days after the close of its fiscal year, unless the corporation receives less than $25,000 in gross revenues or receipts during its fiscal year, the board is required to send an annual report to members. The annual report must contain a report of its assets and liabilities as of the fiscal year end, principal changes in such assets and liabilities, the revenues and receipts of the corporation for the fiscal year, its expenses and disbursements, as well as a statement of any indemnification payment of $10,000 or greater by the corporation to or on behalf of any officer or director or any corporate transaction or series of transactions with an interested director, officer or holder of more than 10% of the voting power involving over $50,000 in the aggregate. The obligation to report indemnification disbursements applies without regard to the corporation s gross revenues or receipts unless such indemnification is approved by the members. The annual report must be accompanied by the report of the corporation s

14 independent accountants or, if none, a certificate of an authorized officer that such statements were prepared without audit from the corporation s books and records. Corporations are also required to file with the California Secretary of State within 90 days of the filing of its articles of incorporation and every other year thereafter a Statement of Information containing the following information: (i) the name of the corporation and the Secretary of State s file number; (ii) the names and addresses (business or residence) of its chief executive officer, secretary and chief financial officer; (iii) the street address of its principal office in California; (iv) the mailing address of the corporation if different than that of its principal office or if its principal executive office is outside of California; and (v) if the corporation elects to receive notices from the Secretary of State electronically, a valid address for the corporation. The Statement of Information shall also include the name of the corporation s statutory agent and his, her or its business or residence address. The link to this form on the California Secretary of State website is In addition, upon the request of an assessor, a corporation must make available its business records relating to property it owns at its principal office in California or at a place mutually acceptable to the assessor and the corporation. A nonprofit public benefit corporation must also file an Annual Registration Renewal Fee Report (Form RRF-1) with the California Attorney General within four and a half months after the end of the corporation s accounting period, unless the corporation is exempt from the general requirements for registration with the California Attorney General, and both Form RRF-1 and IRS Form 990, Form 990-PF or Form 990-EZ, as applicable with the Registry of Charitable Trusts. California tax laws also apply to nonprofit corporations in unique ways. Primarily, qualifying nonprofit and charitable entities are exempt from state franchise tax (similar to an income tax ). Real and personal property held by a nonprofit corporation is generally subject to California property taxes, except that California law exempts from property tax property of a specific type or property owned or used by certain types of organizations, including the property a qualifying nonprofit organization uses for religious, hospital, scientific, or charitable purposes. California law also provides a broad property tax exemption for property used only for religious worship. On the other hand, California, unlike some states, does not generally exempt sales to or by nonprofit organization from sales tax or use taxes. However, some specifically enumerated exemptions that may apply to nonprofit organizations are interspersed throughout California s sales and use tax provisions. These

15 exemptions include, for example, flags sold by nonprofit veterans organizations, sales by certain qualified youth organizations, and sales by certain charitable organizations engaged in the relief of poverty. Finally, nonprofit organizations will be subject to employment taxes to the extent that they meet the definition of employers and to the extent that they have persons meeting the definition of employees working for them. h. Insurance Nearly every type of activity by a nonprofit corporation can become the target of some kind of a claim by a firm or an individual that alleges damage or injury by the corporation or individuals responsible for it (i.e., directors, officers or employees). Even if the claim is without merit, the costs of defending against the claim can be very substantial. To encourage qualified individuals to accept positions as directors and officers, many nonprofit corporations purchase insurance to cover director and officer (D&O) liability. In addition, most responsible nonprofit corporations purchase a basic comprehensive general liability policy that covers liability for accidents in the corporation s offices, at sponsored meetings and the like. Liability insurance for nonprofit corporations is often a very complicated matter. Consultation with an experienced and knowledgeable agent or consultant is essential in order to obtain the right coverage at the lowest premium. i. Hybrid Structures Nonprofit corporations also can partner with for-profit corporations to accomplish their goals. For example, a nonprofit corporation may form a for-profit subsidiary or make an investment in a for-profit entity consistent with its public or charitable purpose. By owning a certain amount of stock or membership interests in the for-profit entity and having representation on the for-profit entity s board of directors, the nonprofit may be able to exert some measure of control over the operations of the for-profit entity, which is able to separately access capital markets to raise funds. Alternatively, an existing for-profit corporation may form a nonprofit foundation that pursues a charitable purpose separate from the business operations of the for-profit entity. One specific hybrid structure that may be used involves a for-profit entity setting up a separate nonprofit corporation (typically a private foundation) whose charitable purpose the for-profit entity otherwise supports or whose goals are aligned with the for-profit s social mission. The for-profit then contributes certain intellectual property assets (e.g., a valuable trademark) to the nonprofit, which, in turn, licenses such intellectual property back to the for-profit pursuant a license

16 that (i) is contingent on the for-profit using the intellectual property to pursue an agreed-upon mission and (ii) provides for revenue-based royalty payments back to the nonprofit. This structure allows the nonprofit and the for-profit to work together to pursue and preserve a social mission, while the royalty payments provide funds to the nonprofit that can be used to further pursue its own public or charitable purpose. Note that there are a number of important issues that must be considered when pursuing a hybrid structure, because a nonprofit entity risks generating UBIT (unrelated business income tax) and/or losing its status as a tax-exempt organization if it engages in activities that are not sufficiently related to its public or charitable purpose. For example, the IRS rules and regulations generally stipulate that any income or surplus of a nonprofit corporation cannot inure to a private individual, such as a member, director or officer. Similarly, the assets of a nonprofit cannot be used to benefit a for-profit corporation without reasonable consideration. For these reasons, it is important for a nonprofit corporation to consult with legal and tax advisors before setting up a hybrid structure to properly structure and document all transactions between the nonprofit and the for-profit and avoid losing its tax exempt status or inadvertently violating any other tax, corporate or other applicable laws. j. Alternatives to Nonprofit Corporations Nonprofit and charitable enterprises may also operate as unincorporated associations. (See generally Title 3 of the California Corporations Code.) A nonprofit association is defined by statute as an unincorporated association with the primary purpose other than to operate a business for profit. Unincorporated association is defined as an unincorporated group of two or more persons joined by mutual consent for a common lawful purpose, whether organized for profit or not. The applicable California law relating to unincorporated associations is set forth in Cal. Corp. Code Compared to other business entities, unincorporated associations are subject to relatively few statutory formation requirements and regulations. The primary disadvantages of using the unincorporated association form include uncertainty of the laws governing the association and its members (including such issues as personal liability for torts, standards of care for officers and directors, lack of express statutory authority giving officers, directors or members authority to act by and on behalf of the association). Given these uncertainties, the task of drafting organizational and operating documents that may relieve some of these uncertainties is more challenging. The California Secretary of State has provided a link to the appropriate form for reservation of an unincorporated nonprofit organization at: For a more detailed discussion of unincorporated associations and their advantages and

17 disadvantages in the nonprofit sector, please see Advising California Nonprofit Corporations (3 rd ed. Cal CEB 2013), Chapter 2, ) A nonprofit organization in California can also organize itself as a charitable trust. Charitable trusts are arrangements whereby one or more parties (individuals or corporations) agree to hold legal title to certain property for the benefit of a charity or for other religious, charitable, scientific, literary, educational or certain other purposes enumerated in the Internal Revenue Code. The applicable California law relating to charitable trusts is set forth in of the California Probate Code. Charitable trusts must be registered with the Attorney General s Registry of Charitable Trusts. See Supervision of Trustees and Fundraisers for Charitable Purposes (California Government Code ). See Chapter 2, of Advising California Nonprofit Corporations (3 rd ed. Cal CEB 2013) cited below for further discussion. k. Resources Oleck and Stewart, Nonprofit Corporations, Organizations & Associations (Prentice-Hall, 1994, Cum. Supp. 2002) Jacobs, Jerald A., Association Law Handbook (ASAE & The Center for Association Leadership 4 th ed., 2007) Nonprofit Governance and Management (American Bar Association and American Society of Corporate Secretaries, 2002) Guide to Nonprofit Corporate Governance in the Wake of Sarbanes-Oxley (American Bar Association Section of Business Law, 2005) Guidebook for Directors of Nonprofit Corporations (American Bar Association Section of Business Law 2d ed., 2002) Advising California Nonprofit Corporations (3 rd ed. Cal CEB 2013) 2. For-Profit Corporations a. Using For-Profit Corporations to Pursue Social Objectives The for-profit form of organization can and frequently is used as a vehicle for conducting a business that also has a social mission or objective. Although for-profit corporations are usually formed for the purpose of making profits and distributing them to shareholders, there is no reason why a for-profit corporation cannot include a social mission in the purposes clause of its articles of

18 incorporation or in a shareholders agreement. Although it is typically understood that the primary duty of a director of a for-profit corporation is to maximize shareholder value, this duty is not legally required in all cases. The primary fiduciary duties of directors of for-profit corporations are the duties of care and loyalty. The duty of care requires directors to use the same level of diligence and care that an ordinarily prudent person would use in similar circumstances this means that directors should inform themselves of all material information reasonably available and take the time and opportunity to carefully deliberate before making decisions. The duty of loyalty requires directors to act without self-interest, in good faith and in a manner reasonably believed to be in the best interest of the corporation. When courts are evaluating these fiduciary duties of directors, they are viewed in light of the business judgment rule, which creates a safe harbor for directors and provides considerable latitude so long as directors of a corporation are looking out for the long-term best interests of the corporation and its shareholders. It is not absolutely required that directors focus on short-term maximization of profits, so long as decisions (including decisions to promote social or environmental goals) are well informed and preceded by careful deliberation, the director did not engage in self-dealing and the decision benefits the corporation as a whole in the long term. While a social mission provision in the articles of incorporation would authorize the corporation to pursue social objectives, it would not require the corporation to do so only the shareholders/owners have this power. Unless all shareholders agree to pursue social aims, dissenters could potentially bring an action against the corporation s directors for failing to operate the corporation in the best economic interests of the shareholders. Although, as noted above, a court would most likely apply the deferential business judgment rule standard of review in any such action (again, so long as the directors had otherwise satisfied their duties of care and loyalty). Still, any litigation matter can be costly and time-consuming and may have negative reputational effects for the directors. Further, if the social mission is not tied at all to profitability, particularly in a change of control situation, there could be liability. Therefore, a shareholders agreement is probably the best way to address this problem, rather than including a social mission provision in the articles of incorporation. Such an agreement, entered into by all shareholders and the corporation, would require the corporation to be managed and operated so as to pursue specified social objectives thereby tempering to some degree the duty to maximize shareholder value and similar legal principles that govern typical behavior of for-profit corporations. Note, however, that even the most skillfully drafted shareholders agreement is not a perfect solution, because agreements can always be terminated or amended

19 by a vote of the parties to such agreement and the shareholders of a for -profit corporation may and often do change as a result of a sale, gift or inheritance. Moreover, a tightly drafted shareholders agreement that makes it difficult to respond to business changes over time may tend to render the for-profit corporation much less attractive to certain investors (potential new shareholders) who do not share the passion for the corporation s social mission. Another means by which a for-profit corporation can pursue and preserve its social mission is by creating and issuing separate classes of stock one class of stock is issued to the founders of the corporation, who established the for-profit corporation for the primary purpose of pursuing the social mission, and a separate class of stock is issued to outside investors. The founder stock is granted certain rights, such as protective provisions in the articles of incorporation that allow the founders to preserve the social mission. For example, the approval of the class of stock held by the founders would be required to change the purposes clause of the articles of incorporation or to merge the corporation with another entity, whose purpose may not be aligned with the corporation s social mission. As discussed above in Chapter 1 on nonprofit corporations, for-profit corporations can also establish a hybrid structure to pursue a social mission. This can be particularly effective if some valuable intellectual property is donated to the nonprofit and licensed back to the for-profit, which license includes requirements aligned with the social mission. b. Formation The General Corporation Law governs the formation, operation and dissolution of for-profit corporations in California. One or more natural persons, partnerships, associations or corporations may form a corporation by executing and filing articles of incorporation. If initial directors are named in the articles, each director must sign and acknowledge the articles. If initial directors are not named, the articles may be signed by one or more persons who initiate the formation activities ( incorporators ) who also sign the articles. The corporation begins to exist upon filing of the articles with the California Secretary of State and continues perpetually unless earlier terminated by law or as provided in the articles. The articles of incorporation must set forth the information set forth in Cal. Corp. Code 202, including, among other items, the purpose of the corporation (usually broadly stated to engage in lawful act or activity for which a corporation may be organized); the name and street address of an initial agent for service of process; if the corporation is authorized to issue only one class of shares, the total number

20 of shares the corporation is authorized to issue; if more than one class or series of shares is authorized, the number of each class or series of shares authorized to be issued or a statement that the board is authorized to fix the number of shares in any such class or series; and any rights, preferences, privileges or restrictions granted to and imposed upon each class or series of shares. The articles may set forth other provisions not inconsistent with California law, including limitations on the business in which the corporation may engage; a provision requiring shareholder consent for any corporate action ; or provisions eliminating or limiting personal liability of a director except for certain breaches of directors duties (intentional misconduct, or acts believed by the director to be contrary to the best interests of the corporation), among others. The articles may also eliminate the liability of directors to the fullest extent permitted by law. The Secretary of State shall not file articles which set forth a name that is likely to mislead the public, or which resembles closely the name of a domestic corporation or a foreign corporation registered with the Secretary of State and authorized to transact intrastate business, or a name that has been reserved with the Secretary of State. The availability of a name may be checked on the website of the California Secretary of State by accessing the following link: A specific name may be reserved for 60 days by an applicant by filing and paying the required fee. If the corporation is a close corporation (i.e., no more than 35 shareholders), the name must contain the words corporation, incorporated or limited or an abbreviation of such words. c. Management and Control A for-profit corporation has a hierarchical control structure. It is managed by or under the direction of a board of directors, who has the right to appoint its officers, although its shareholders vote on important corporate issues such as election of directors, mergers, sales of all or substantially all assets and dissolution. Similar to a nonprofit corporation, once the for-profit corporation has been established, the initial board of directors meets (in person or by a written consent instead of a meeting), ratifies the acts taken in connection with initial formation of the corporation and adopts bylaws, which set forth the rules and procedures governing the decision-making process of the board of directors and the general operation and management of the corporation consistent with the applicable California statutes and the corporation s articles of incorporation.