Please meet a new business entity form that is quickly attracting attention of businesses with social message, investors and entrepreneurs all around the country. L3C, a low-profit limited liability company, is a hybrid legal entity form that has a flexible structure of an LLC but a well defined purpose of a nonprofit. Five states have already adopted L3C as a legal entity form, and many more states have L3C legislation pending. New York is about to adopt (in my opinion) an L3C act (Senate passed the bill S6726 on June 29, 2010 and it is now in front of the Assembly).
L3C is an exciting business form that is designed to tap into a wealth of tax-exempt funds while still attracting regular capital, all for a social good. At least in theory, L3Cs have the capability of channeling numerous funds into the nonprofit or social enterprise sector and making a difference where our taxes fail to work. But in practice, it is not certain that L3Cs will achieve their objective. Here is why.
Purpose:
An L3C is a regular business and can be profitable. The primary purpose of an L3C cannot be to make a profit, but rather to further a social purpose. In particular, an L3C must significantly further the accomplishment of one or more charitable or educational purposes; it would not be formed except to further such purpose(s); it cannot make the production of income or appreciation of property as its primary purpose; and it cannot be created for any political or legislative purpose.
Taxation:
L3C is not exempt from federal or state tax and contributions to L3C are not tax deductible. L3C can be classified as a “pass through” entity, which means that the entity itself does not pay federal tax, but rather the tax is passed through to its members and is allocated proportionally to their ownership. L3C profits are also subject to taxation.
Good things:
L3Cs are not subject to nonprofit regulation, which can be quite complex. L3Cs are designed to attract funding from both nonprofit and for-profit sectors: program-related investments (PRIs) from private foundations, as well as private investments from individuals and businesses. Private foundations can become part owners or lenders to an L3C. In fact, since L3C has no limitation on ownership, all entities (foundations, trusts, pension funds, for-profit businesses, etc) and individuals can be members of an L3C.
Problems:
Mainly, L3C structure is created to attract PRIs from private foundations, which are seen as a great underutilized source of funding (in 2006 and 2007, less than 1% of all foundation funding was PRI). And here lies the main challenge of L3Cs: foundations are still reluctant to invest PRI money into L3Cs for reasons I explain below.
PRI investments are quite rare and risky because when the foundation is filing its tax returns, IRS can refuse to recognize PRIs if the investment is not made in furtherance of the foundation’s charitable purpose. This can result in high excise taxes, both on the foundation and the foundation’s manager. Foundations can request an advance ruling from the IRS, but such requests may be expensive and time consuming. Additionally, even a qualified PRI may be subject to expenditure excise tax unless the foundation monitors that the L3C uses the funds in furtherance of the charitable purpose. This requires expenditure approval by the foundation and a detailed report by L3C. The foundation may even lose its tax-exempt status if the PRI confers a benefit on a third party (if the terms of the investment are unfavorable).
The foundations’ involvement with the L3Cs is also complicated by the proposed tranche investment scheme. Investments by the foundations would be in a tranche with high risk and low return, so as to attract private capital to be invested in a separate tranche with low risk and high return. A flexible LLC structure allows for uneven distribution of returns, but may create problems for the foundations unless the investment is in line with the foundation’s charitable mission and is therefore a PRI.
The IRS is still silent regarding whether investments into L3Cs by private foundations can automatically be considered PRIs. Until the IRS adopts this position, PRI investments by the foundations remain risky and the most promising funding option for L3Cs remains uncertain. Even if IRS adopts this position, foundations may be discouraged by the amount of policing and monitoring they’ll have to do to ensure that L3Cs use their PRI money in furtherance of the right purpose.
Conclusion:
The idea of having L3Cs is very appealing. The ability of using private capital together with tax-exempt capital for social purposes while still generating profits seems perfect from all angles. However, to make L3Cs a success, L3Cs would need to be carefully regulated and monitored to ensure that their social purpose remains primary at all times and the IRS will need to qualify investments into L3Cs as PRIs.
This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.
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