L3Cs -- A Hybrid Low-Profit Business Entity
An L3C is new variation of the limited liability company (LLC). It is also known as a low-profit, limited liability company. What sets it apart from regular LLCs and other for-profit entities (i.e. corporations, partnership, etc.) is its ability to pursue charitable, educational or socially beneficial objectives as its primary motive. Although the L3C can also pursue profit-oriented objectives, they are secondary to its social goals. The L3C is a hybrid entity taking on the flexible characteristics of an LLC in combination with a low-profit socially beneficial objective. There is considerable controversy on their usefulness and whether or not they will endure or be used as an alternative way to achieve social progress.
Origin and Purpose of L3C
Prior to 2008, the prevailing for-profit business entities required high returns on investment. Because most socially beneficial business ventures are not highly profitable, organizations pursuing these objectives are commonly set up as non-profit corporations. The problem with non-profit organizations is that they have very limited access to capital due to IRS regulations that restrict profit-seeking objectives. For social and community conscious business ventures to succeed, they need a flexible, lightly regulated business structure that allows access to investment capital. The L3C format was designed to satisfy this need.
In 2008, Vermont became the first state to enact legislation authorizing the creation of the L3C as a new business entity. Since then several states have enacted similar legislation making the L3C a viable option for socially conscious entrepreneurs. As of January 2012, the following states had enacted L3C legislation: Illinois, Louisiana, Maine, Michigan, North Carolina, Rhode Island, Utah, Vermont, and Wyoming.
An L3C is structurally exactly the same as an LLC. It has members, managers, an operating agreement, and flexibility with ownership rights. From a legal standpoint L3Cs differ from LLCs in one significant area: profit motive. In general, legislation authorizing the creation of low-profit limited liability companies has three requirements: (1) that the company significantly furthers charitable or educational purposes as defined by the IRS, (2) that no significant purpose of the company is the production of income or appreciation of property, and (3) that no purpose of the company is to accomplish political, legislative, or lobbying activities. This structure makes the L3C a more suitable vehicle for raising capital previously inaccessible to low-profit and non-profit organizations.
Investments from Private Foundations
When L3Cs first arrived on the scene, it was hoped they would be an attractive option for private foundations to use as investment vehicles. The IRS requires private foundations to give away a minimum of 5% of the foundation’s net assets each year. Most private foundations meet this requirement by making grants to IRS endorsed 501(c)(3) non-profit organizations. However, private foundations have the option of investing the mandated 5% minimum in something called a program related investment (PRI). The benefit of investing in a PRI is the potential for profits and recoupment of investment through dividends or liquidation.
The IRS defines a PRI as an investment whose primary purpose is to accomplish one or more of the foundation's exempt purposes. The production of income or appreciation of property cannot be a significant purpose, nor can influencing legislation or taking part in political campaigns on behalf of candidates. There is a risk is that the IRS may not recognize a PRI as such and could levy significant fines against the private foundation. This causes private foundations to avoid investing in PRIs unless the IRS provides an advanced private ruling which sanctions their investment. Obtaining an advanced private ruling can be time consuming and very expensive. As a result most private foundations do not use their mandated 5% to invest in PRIs.
With the introduction of the L3C, it was hoped that private foundations would have a way to invest in PRIs without wasting time and money on expensive advanced private rulings from the IRS. By law, the L3C is predefined to meet the requirements of a PRI. If the IRS decided to recognize and sanction an L3C as a vehicle for PRIs, then social entrepreneurs could have a simple and flexible business entity that allows access to new sources of capital through private foundations. However, many experts believe there are serious tax and other issues that cannot be overcome and that the L3C is not the proper vehicle for private foundation PRI investing.