More States Are Considering Low-Profit LLCs

At least 10 state legislatures are considering bills to authorize low-profit limited liability companies (L3Cs) – all introduced in the last two and a half months:

Arizona; Senate Bill No. 1503

Arkansas; Senate Bill No. 5

Hawaii; Senate Bill No. 674

Indiana; Senate Bill No. 501

Kentucky; House Bill No. 110

Maryland; House Bill No. 552

Montana; House Bill No. 415

New York; Senate Bill No. 3011

Oregon; House Bill No. 2745

Rhode Island; Senate Bill No. 353

These have the potential to more than double the number of states that authorize L3Cs. Currently eight states have authorized L3Cs: Illinois, Louisiana, Maine (effective July 1, 2011), Michigan, North Carolina, Utah, Vermont, and Wyoming.

The L3C is a relatively new type of limited liability company, a hybrid which attempts to combine a charitable purpose with a profit-making motive. An L3C is not a nonprofit and is taxed on its profits like any other LLC. I have previously written about L3Cs, here.

Advocates of L3Cs suggest they will encourage investment by private foundations in L3C enterprises. Typical program-related investments (PRIs) made by private foundations in either for-profit or tax-exempt enterprises include equity investments and loans, on terms more favorable to the recipient than a market rate investment. The purpose of the investment must be to support the foundation’s charitable purpose. L3Cs are promoted as facilitating increased investment by private foundations, because the state statutes apply to L3Cs the Internal Revenue Code requirements for the recipient of a PRI made by a private foundation. IRC § 4944(c). The idea is that because L3Cs automatically apply those standards to L3Cs, private foundations will be more willing to invest in L3Cs.

L3Cs have generated a lot of interest in the non-profit and social enterprise community, and a fair amount of commentary is becoming available. The Vermont Law Review sponsored a symposium on L3Cs and other developments in social entrepreneurship in February 2010. (Vermont was the first state to authorize L3Cs.) Articles related to the Symposium were published in a symposium edition of the Vermont Law Review, Symposium, Corporate Creativity: The Vermont L3C and Other Developments in Social Entrepreneurship, 35 Vt. L. Rev. 1 (2010).

Two articles in the symposium edition caught my eye. The first was Program-Related Investments in Practice, 35 Vt. L. Rev. 53 (2010), by Luther M. Ragin, Jr., Chief Investment officer of the F. B. Heron Foundation. Heron has been an active PRI maker since 1997, and at the end of 2009 had $21 million in outstanding PRIs, in 38 separate transactions. Heron’s PRIs were made to a variety of organizations. Most were to non-profits, but 10 were equity or subordinated debt investments in limited partnerships, LLCs, and corporations.

The critical driver for Heron is not the legal form of the organization seeking capital. Heron has found that it can apply the PRI rules and reach positive decisions on PRIs to various types of for-profit entities as well as non-profits, provided the PRI serves a charitable purpose. (The two other PRI tests – no lobbying, and income from the PRI not being a significant purpose of the foundation’s decision to make the investment – must also be satisfied.)

The other article in the Symposium edition that jumped out was The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 275 (2010), by J. William Callison and Allan W. Vestal. The article nicely reviews the law of private foundations and PRIs. It then examines the L3C requirements of the state LLC laws and how they attempt to match the PRI requirements. The article concludes that the statutory form does not match well with the PRI requirements and that private foundations will still need to conduct the same due diligence they would conduct before making a PRI to a non-L3C entity.

The experience of the F. B. Heron Foundation buttresses Callison and Vestal’s analysis. The type of entity, and whether it is a for-profit or a non-profit, play little part in Heron’s decisions about making PRIs.

The article concludes with a discussion of why L3Cs are considered harmful. First, smaller, less well-advised foundations may unduly rely on the L3C status of the recipient when making a PRI rather than on their usual due diligence, resulting in non-compliance with tax requirements and possibly endangering the foundation’s charitable status. Second, in an L3C with profit-seeking participants, where the foundation makes a high-risk, low-return investment vis-à-vis the other investors, there is risk that the foundation may run afoul of the “private benefit” doctrine, which is intended to prevent tax-exempt organizations from conferring private benefit on private participants.

Callison and Vestal’s conclusion is succinct: without changes to federal PRI rules there is little or no value to the L3C structure, the existence of the L3C form is a dangerous trap for the unwary, and the form should be shelved.

The article makes a strong case for the states to stop adopting the L3C form, and for the states that currently authorize the L3C form to revise their LLC laws to delete the L3C authorizations.

Will careful legal analysis and commentary take the wind out of the sails of the L3C movement? It’s hard to say. Popular enthusiasms and fads take on a life of their own. And one of the drivers of the L3C movement is the laudable goal of increasing the flow of private foundation money to ventures with charitable purposes. But that goal appears to be blinding the L3C promoters and some state legislators to the legal realities – L3Cs don’t and won’t accomplish that goal unless and until the federal tax rules are changed, which appears unlikely.

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Robert Lang - March 19, 2011 10:47 AM

It never ceases to amaze me that so called reputable journalistic operations tolerate the kind of hatchet jobs that this blog reflects.It is very easy to slant the news but editors and publishers should insist on some kind of journalistic standards. Yes it is true that there was one negative article out of many in the Vermont Law Review. That article was by Callison and Vestal who were the only ones not to appear at the symposium and expose themselves to review and question. Like a few others in the small group of business bar lawyers who oppose the L3C they work in the dark of night being sure they never have to face any of us who support the L3C.

The notes on the author of this blog state:" Doug Batey is a principal in the Seattle office of Stoel Rives LLP. He has a business law practice and advises companies and executives on a broad range of issues, including mergers and acquisitions, corporate, securities and commercial law, limited..." Notice he is a business lawyer. Would you go to a business lawyer to file a malpractice suit or patent your invention? Social sector law is normally practiced by nonprofit counsel and that sector normally fits within the Section of Taxation of the ABA which has opined favorably on L3Cs. Where is your standing Mr. Batey?

He also picks out Luther Ragin from the Herron Foundation who I consider a friend. I have told Mr. Herron many times that if the other 79,999 foundations in this country had a Luther Ragin I might never have bothered to create the L3C at least for foundations. But they do not so yes there is created value in a specialized vehicle for the rest of the foundations. Luther is a unique individual not an example of the majority of the sector.

Mr. Batey also hauls out the old saw about dangers to foundations but this only reflects his lack of knowledge of nonprofit law. The IRS considers foundations to be similar to sophisticated investors when it comes to PRIs. The IRS holds the foundations responsible for PRIs they make and expects them to engage in proper due diligence before making a PRI.So all of the so called risks Mr. Batey points out are ones the foundations face now and nothing in the state L3Cs laws relieves them of this duty nor should it. Size of the foundation is no excuse. The IRS would state if you cannot stand the heat stay out of the kitchen. For a Foundation to claim having been fooled by the L3C laws are akin to saying the dog ate my homework - fat chance with that one.

In so far as saying the L3C is no use without federal law change this again shows lack of legal knowledge in the area. The federal laws and regs relevant to PRIs have been on the books for over 40 years and they are clear and contain clear examples. Foundations are free to make a PRI whenever they want subject to no prior review. L3Cs are just an easier way to deal with some of the issues in the laws and provide a template for the ordinary people who wish to form a business that earns money while doing good.Of course this is another area where business lawyers are often out of step. They will always tell you to see them before forming a corporation or an LLC. They always have a few draconian examples of the people who did not. Yet millions of these entities are formed every year without lawyers and the website of every state in the union makes it easy to do so without a lawyer being needed. A large portion of the l3Cs that have been formed fit into this mold. I created the L3C for the people not the lawyers.

A federal law change will improve the PRI process not just for L3Cs but for PRIs in general. We are working with Congress to bring this about but Congress generally does not lead it reacts. So thank you Mr. Batey for making this statement. I guess every time I meet with a Congressman I can point to the fact that the business bar supports the need for a federal law.

Maybe Mr. Batey will join us at the ACD conference in June and learn what the l3C is really about.Or maybe he has the courage to call me and have a real discussion on the L3C.

Bob Lang, Creator of the L3C and Founder
Americans for Community Development

Hold June 6th - 7th 2011 for the first annual Americans for Community Development Conference entitled The "L3C A to Z" to be held in Evanston (Chicago) Illinois. Our co-producer for this conference is the Levy Entrepreneurship Center of the Kellogg School of Management at Northwestern University.

This Inaugural Conference hosted by ACD will be the first ever of its kind. To this point, there has not been a conference solely dedicated to the education and networking of professionals dealing with the L3C. This conference will set the tone for further professional development opportunities held by ACD and will be the most comprehensive opportunity to understand the aspects of the L3C.

More information shortly on the ACD website.

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