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.