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:
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Arizona; Senate Bill No. 1503 |
Arkansas; Senate Bill No. 5 |
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Hawaii; Senate Bill No. 674 |
Indiana; Senate Bill No. 501 |
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Kentucky; House Bill No. 110 |
Maryland; House Bill No. 552 |
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Montana; House Bill No. 415 |
New York; Senate Bill No. 3011 |
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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.
Low-Profit LLCs - The Newest Limited Liability Company Structure
This month Illinois became the latest state to pass enabling legislation for low-profit limited liability companies, or L3Cs, joining Vermont, Michigan, Utah and Wyoming. The new Illinois law becomes effective on January 1, 2010. According to the Nonprofit Law Blog several other states are considering adopting L3C laws.
An L3C is a limited liability company whose primary purpose is not to earn a profit but to “significantly further the accomplishment of one or more charitable or educational purposes.” E.g., Ill. Pub. Act 096-0126 (SB 0239). An L3C is not a nonprofit and is not precluded from earning a profit, but income or property appreciation may not be a significant purpose of the company. An L3C is a hybrid, a business entity formed to carry out charitable or educational purposes, and designed to attract philanthropic as well as private investment. In almost all respects other than its purpose, an L3C is treated like any other LLC, including income taxes.
To qualify as an L3C under the state laws, the LLC:
● must significantly further the accomplishment of one or more charitable or educational purposes within the meaning of IRC section 170(c)(2)(B);
● would not have been formed but for the accomplishment of the charitable or educational purposes;
● does not have as a significant purpose the production of income or the appreciation of property, although the fact that the company produces significant income or capital appreciation is not conclusive evidence of a profit motive; and
● does not have as a purpose the accomplishment of any political or legislative purpose.
These state law requirements parallel the Internal Revenue Code requirements for the target of a “program-related investment” by a private foundation. IRC § 4944(c). In addition, each of the five states requires that the name of the L3C contain either the abbreviation “L3C” or the words “Low-Profit Limited Liability Company.”
Vermont was the first state to pass legislation to authorize L3Cs, in April 2008. As of August 20, 2009 there were over 60 L3Cs formed in Vermont. In a little over a year four more states have amended their LLC Acts to authorize L3Cs. Illinois, the latest of the four, is a heavyweight in terms of its industry and commerce. L3Cs are here to stay and are growing in use and in public recognition.
There are two principal reasons why L3Cs are taking off. The first is the hope that L3Cs will attract program-related investments (PRIs) by private foundations. By combining philanthropic investment with private capital, L3Cs can offer the possibility of major social impact.
If an investment by a private foundation meets the Internal Revenue Code’s requirements for a PRI, the investment will count towards the foundation’s annual distribution requirements and will not jeopardize the foundation’s charitable purpose. IRC § 4944(c). PRIs by private foundations are not common occurrences today, in part because of the high transaction costs to the foundation in verifying that the target of the investment will meet the PRI requirements. The promoters of state laws authorizing L3Cs expect that foundations will be more willing to invest in companies organized as L3Cs.
A company’s status as an L3C under state law, however, is not adequate to qualify the L3C for a PRI. And if a private foundation makes an investment with an L3C and the investment turns out not to qualify as a PRI, the foundation can be assessed substantial taxes and penalties. The result is that unless and until the IRS issues guidance about qualifying L3Cs for PRIs, private foundations will likely conclude that they must continue to incur the transaction costs involved in determining the correctness of a specific PRI. Those costs often include expensive private letter ruling requests to the IRS.
These tax issues are well described in Allison Evans, Christine Petrovits & Glenn Walberg, L3C: Will New Business Entity Attract Foundation Investment?, 63 The Exempt Organization Tax Review 457 (2009). It appears that without regulatory guidance from the IRS or changes to the tax laws, private foundations will continue to be reluctant to make program-related investments in LLCs, whether or not they are structured as L3Cs.
Branding is the second reason why L3Cs appear to be attractive for companies with social missions. By being labeled as an L3C, companies send a signal to their customers, employees, vendors and communities that they have a charitable or educational purpose, even though they are not a nonprofit. The L3C movement appears to have tapped into this vein of entrepreneurial desire to provide public benefit.
We can expect continued growth in the number of states that authorize L3Cs and in the number of L3Cs being formed. That should increase the pressure for the IRS and federal regulators to come up with a more economically efficient way for L3Cs to qualify for program-related investments, so that private foundations will not be deterred from making investments in L3Cs compatible with the foundation’s mission.
