A good rule of thumb in life is to never get on the bad side of a litigation-happy centibillionaire with a Rolodex of law firms at his beck and call.
But Elon Musk’s second lawsuit against OpenAI, to whom he made charitable donations amounting in total to more than $50 million, may be the least of its immediate concerns. There is one authority that still has greater resources at its fingertips than the man tipped to be the world’s first trillionaire — the government.
And it can make OpenAI’s life hell if it chooses to investigate and prosecute any missteps as the ChatGPT creator attempts to shed its nonprofit shell and emerge as a public benefit corporation capable of one day enriching its shareholders.
In fact, the state is really the only entity capable of pursuing legal measures to ensure nonprofits don’t cheat the system. And in a matter of weeks the levers of government power will be in the hands of close Musk ally, Donald Trump.
“If I was OpenAI and you asked me what should worry me more,” Luís Calderón Gómez, an assistant professor at Yeshiva University’s specializing in tax policy, tells Fortune, “it wouldn’t be Musk’s lawsuit, it would be the conversion.”
In a statement to Fortune, OpenAI chair Bret Taylor pledged the nonprofit board would honor its fiduciary obligation by ensuring the company remains well-positioned to fulfill its stated mission.
“While our work remains ongoing as we continue to consult independent financial and legal advisors,” he said, “Any potential restructuring would ensure the nonprofit continues to exist and thrive, and receives full value for its current stake in the OpenAI for-profit with an enhanced ability to pursue its mission.”
Open-AI’s for-profit subsidiary is already valued at $157 billion
The stakes are unusually high for the otherwise sleepy sector of U.S. nonprofits, estimated to account for $3.3 trillion of America’s annual economic output. Despite its significance as the company behind the boom in generative artificial intelligence, an IRS filing this week from OpenAI reveals just how little value is actually assigned to the nonprofit.
Thanks to the goldrush triggered by the commercial launch of ChatGPT nearly two years ago, a recent fundraising round valued OpenAI Global, LLC, the operating company, at a staggering $157 billion. Earlier this year one of Asia’s foremost experts in the field, Kai-fu Lee, even suggested it could make history as the first privately-held company worth $1 trillion.
For all intents and purposes, it operates like a normal company, counting Microsoft alongside Khosla Ventures and LinkedIn co-founder Reid Hoffman as major investors.
Yet its controlling shareholder, OpenAI, Inc., is classified a 501(c)(3) corporation under the tax code of the Internal Revenue Service (IRS). It was exempted from paying into the public purse after pledging to “advance digital intelligence in the way that is most likely to benefit humanity as a whole, unconstrained by a need to generate a financial return.”
The health care sector blazed the trail for hybrid nonprofits
This seemingly bizarre hybrid corporate structure, adopted by OpenAI in March 2019, resulted primarily from developments in the healthcare sector.
In order to prevent financially struggling clinics from closing, which could cut off the supply of medical services in their local community, the IRS in 1998 began allowing them to team up with for-profit competitors so long as the nonprofit retained final control.
Courtesy of OpenAI
The ruling remains controversial, however. In August of last year Elizabeth Warren joined up with three of her Senate colleagues in a bipartisan effort to crack down on the practice after a recent study found that three out of four nonprofit clinics spent less on charitable care than they received in tax exemptions.
As founder and CEO of nonprofit consultancy Altruist, Donald Summers argues governance problems and lack of proper scrutiny are partly due to the broader public laboring under an antiquated and naïve notion of the charitable sector.
“People think nonprofits are soup kitchens and homeless shelters. They can be powerful, multibillion-dollar organizations that can own for-profit subsidiaries and take on debt,” Donald Summers, founder and CEO of Altruist tells Fortune. “They just can’t be bought and sold for the benefit of private individuals.”
Like a rainforest charity that decides to chop down the Amazon
OpenAI CEO Sam Altman has attributed his plans to convert to a for-profit (likely next year according to Fortunesources) as an organic evolution of its legal structure over time. As donations failed to keep pace with the spiraling costs for training its neural network, management decided the only option left to fulfil its charitable mission was to begin raising private money.
Since then, however, it has been more judicious about the research it publishes, with no publicly available information revealing the full technical capabilities of its GPT-4 model, first released in 2023. It has also entered into exclusive deals with commercial partners that experts say run contrary to the ideals it claims to espouse.
“It’s illegal and OpenAI is a house of cards,” scathed Musk, who cut all ties to the company four years ago. He has described OpenAI’s plans to relinquish its nonprofit status as a Shakesperean betrayal and likened it to donating money to a charity to save the Amazon rainforest only for it to decide cutting trees down for timber was a more profitable idea.
While the primary purpose of a nonprofit must be to provide a benefit to society as a whole, that means by extension, the pursuit of capitalistic motives doesn’t have to be in conflict with its mission.
“They aren’t necessarily mutually exclusive,” says Darryll Jones, professor of law at Florida A&M University and co-editor of the Nonprofit Law Professors Blog, in an interview with Fortune.
And when they are, he adds, this need not be a problem—so long as the nonprofit’s goal take precedence. “That’s probably one reason why we haven’t heard [publicly] about an attorney general or the IRS challenging OpenAI.”
‘I don’t think we’ll set a precedent here’
The argument has been that OpenAI’s change in corporate structure could give other startups the same idea, in other words with launch as tax-exempt nonprofits, only to convert to normal ownership once their business model has been ironed out and a commercially successful product can be launched.
Speaking in March earlier this year, Altman refuted the idea his actions would effectively incentivize companies to play fast and loose with the tax code on the public’s dime.
“I would heavily discourage any startup that was thinking about starting as a nonprofit and adding a for-profit arm later,” he said. “I don’t think we’ll set a precedent here. If we knew what was going to happen, we would have done that too.”
Transitioning is tricky since it involves privatizing what was once chartered for the public good. Any mistakes can result in hefty tax liabilities should the golden rule be violated that assets have to be exchanged dollar for dollar.
“The basic principle is that the converting entity has to pay into the charitable sector an amount equivalent to what it’s taking out,” Robert Weissman, president of a corporate accountability advocacy group Public Citizen tells this publication. “But in this case it’s not obvious what the value of nonprofit OpenAI is.”
Err on the generous side
According to its 990 tax return for the 2023 fiscal year just filed this month, its nonprofit listed net assets worth a paltry $21 million.
That’s the absolute minimum the for-profit would have to provide to the state in exchange, yet it remains a drop in the bucket when compared to the $157 billion valuation of the for-profit.
Weissman argues, however, any conversion means the tax-paying public must also be compensated for the loss of control, once the company is owned by shareholders.
He estimates the premium for relinquishing this ought to be worth 20% of the for-profit entity over which it has final say. In other words, they’d shell out more than $30 billion.
These funds that OpenAI Global LLC would have to pay then remain rightfully in the hands of the public, and can be then used for the endowment of a new charitable foundation, possibly devoted to AI safety, just as an example.
For now however, it remains a guessing game that investment bankers will ultimately have to hash out in a third-party assessment. Florida A&M’s Jones believes OpenAI and Microsoft will be careful to err on the generous side.
Any potential attempt to short-change taxpayers could trigger an investigation and potential lawsuit by the government that binds management capacity and consumes time and resources—something the duo can ill afford in the race with fast-moving competitors like Musk’s xAI.
“After OpenAI talked up how great their technology is, it’s going to be difficult for them to lowball the price,” Jones argues.
A lot of high-paid lawyers knocking their heads together
Following years of pushing the envelop both in technology and in tax law, the conversion does solve one thorny issue and that is the risk it may already be in breach of its nonprofit obligations. Public Citizen’s Weissman has repeatedly written to the attorney general of California, home to its headquarters, to press him on this very topic.
Delaware, legal domicile of OpenAI, appears to be taking initial steps to ensure taxpayers aren’t cheated. Axios reported recently that state attorney general Kathleen Jennings had lodged an official request with the company for additional information with regards to its conversion plan.
“It is important that my office have an opportunity to review the terms of any such transaction prior to its consummation,” Jennings was quoted as writing in October. “The current beneficiaries of OpenAI have an interest in ensuring that charitable assets are not transferred to private interests without due consideration.”
The Delaware AG’s office did not respond to a request by Fortune for comment but its counterpart in California office has said it does not comment in principle on the existence or progress of an investigation.
Gomez agrees with Altman’s assessment that OpenAI won’t be creating an all-new business model for startups because of just how easily it could fall afoul of the government if officials feel the public purse has been cheated.
“There aren’t many ways to do this without incurring a big tax liability and without getting sued by the state, either Delaware, California, the Department of Justice or the IRS,” he tells Fortune. “So I am very confident there are a lot of lawyers getting paid a lot of money to work on this right now.”
