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Not For Profit/Exempt Organizations Blog

The Possibilities of the L3C

Posted in Formation

People have been whispering among themselves about the L3C, an emerging low-profit limited liability company structure that aspires to link business methods with charitable purposes and give socially oriented businesses greater access to investor capital.  The structure was created by Robert M. Lang, Jr., CEO of the Mary Elizabeth & Gordon B. Mannweiler Foundation.  Conceptually, the L3C is a hybrid not-for-profit/for-profit entity: like a not-for-profit, it has a primary purpose of charity, but like an LLC, it can have equity holders that have a right to distribution of profits.  Notably, although profit is allowed in an L3C, it cannot be a significant purpose of the organization.  Vermont passed the nation’s first L3C statute in April, 2008, effectively making the form legal in every state since a Vermont L3C can technically do business nationally (even internationally).  Illinois, Michigan, the Crow Indian Nation in Montana, Utah, and Wyoming have followed suit, and similar bills are currently pending in Arkansas, Missouri, North Carolina, Oregon, and Tennessee.

The L3C is taxed like any other for-profit entity and is not eligible for tax exemption under Section 501(c)(3) of the Internal Revenue Code.  L3Cs hope to encourage an influx of new capital into charitable causes that are too risky for for-profit ventures and that nonprofit dollars alone cannot sustain.  The L3C effectively creates a market for investment in companies that offer low rates of return, but contribute to the community, unlike the non-profit, which offers no rate (and sometimes a negative rate) of return on investment.  Therefore, if an entity has a charitable mission, but does not believe it can be profitable, or has a social mission, but probably could not secure program-related investments (“PRIs”)from private foundations, it would be better off forming as a not-for-profit or for-profit entity, respectively.

L3Cs envision a tiered investment structure. The first tier relies on PRIs to cover the areas of highest risk.  Under current law, private foundations are required to spend at least 5% of their net asset value annually.  PRIs essentially function as loans that will be, at least theoretically, repaid.  Even with no interest, the PRIs will still count as qualifying distributions towards the 5% requirement.  The L3C creators believe that private foundations will make PRIs with L3Cs because the PRI requirements are incorporated directly into the L3C structure itself, eliminating the need for private foundations to apply for private letter rulingsfrom the Internal Revenue Service (“IRS”), which can take up to 18 months to process and cost $50,000 or more in legal fees, plus a substantial fee to the IRS.

Once PRI funding is in place, the thinking is that the L3C should then be on firmer ground to attract investments from corporations and individuals and offer them a return on their investment.  This way, the PRI not only helps the L3C with its operating expenses, but also creates a type of equity cushion that enables the L3C to receive additional funds from more traditional funding sources.  At that point, the L3C will likely have some assets of value, so a third tier can involve investments with returns closer to the market rate, can attract for-profit investors, and even enable the L3C to receive bank loans at market rates.  Basically, the L3C structure offers flexibility in terms of investors and their expected returns.  Still, whether L3Cs will be able to achieve this level of success remains unclear.

If successful, however, L3Cs could allow organizations that rely heavily on donor support, such as symphony orchestras, to become self-sufficient. They could also help revitalize struggling, but vital industries, such as newspapers, and promote employment in those areas. For example, North Carolina’s L3C bill envisioned collaboration between local nonprofit organizations and failing furniture and textile businesses to help keep jobs in local communities.  The L3C model would also be especially helpful in the microfinance industry, where receiving different tiers of investments, particularly at the market level, would be integral to the success of microfinance institutions.  Opponents of the L3C are concerned that the creation of L3Cs will take away grant money that private foundations would have otherwise given to charities because the foundations will have given the money to L3Cs in the form of low-yield PRIs, which would decrease the amount of grants that the foundation could pay out.  Proponents of the L3C say that creation of the L3C does exactly the opposite and actually increases the amount of money available for charities since the L3C will be able to accept so many different types of investments.

The L3C is full of possibility, but whether that possibility will materialize is still up in the air.  For one thing, it is not clear how private foundations will react to the L3C structure, or whether private foundations will make PRIs without first seeking private letter rulings.  And without the initial influx of PRI funding, L3Cs will find it difficult to attract for-profit investors, which would affect the L3C model’s viability.  But, if foundations make PRI investments with L3Cs and if those investments are followed by different conventional sources, the possibilities of a world with L3Cs may be realized.

Most importantly, the IRS has yet to really weigh in on whether private foundations investing in L3Cs is safe.  Ronald J. Schultz, senior technical advisor in the Tax-Exempt and Government Entities Division, said that L3Cs raise a number of tax issues, including PRI, private inurement, and private benefit.  Schultz also mentioned that private foundations that think that investing in an L3C was a “slam-dunk” on the jeopardy investment issue (where a foundation is taxed on any jeopardizing investments it makes), would be premature.  He said that the IRS and Congress have not yet signed off on the idea of L3Cs, and private foundations should consider whether investing in an L3C could jeopardize the private foundation’s charitable activities.  For a great article discussing the response to Schultz’s statements, please visit The Nonprofit Times.

For more information on L3Cs, please visit Americans for Community Development and the Nonprofit Law Blog L3C entry by Gene Takagi and Emily Chan.