LAW AND SOCIAL ENTREPRENEURSHIP

LC3 Part 3: Critique and Conclusion

Critique:

A simple internet search on the L3C will quickly reveal how popular the concept has become with social entrepreneurs, non-profit bloggers and organizations, some politicians and many attorneys. However, there are a number of cautious voices as well.

Among the naysayers are attorneys Daniel Kleinberger and J. William Callison, co-authors of a recent article, “When the Law is Understood-L3C No.” The authors first point to the failure of L3C lobbyists to convince the federal government to view L3C investments as automatically qualifying as PRIs. Unless and until Congress, the IRS, and Treasury create a rebuttable presumption that L3C investments are PRIs, private foundations will not be more attracted to L3Cs than they are to investments in ordinary LLCs. L3Cs are in no better of a position to receive PRI treatment than the LLC form to which they may default. See also William Callison, L3Cs: Useless Gadgets?, Business Law Today Volume 19, Number 2 (2009).

Second, Callison and Kleinberger raise concerns over the “tranched investment” structure of the L3C and note the potential of non-charitable investors receiving non-profit tax exempt privileges if the L3C is not structured carefully. Third, the authors question the branding capacity of the L3C in light of the first two concerns that the L3C has no legal or market substance.

Finally, and most importantly, the authors question how the required L3C language providing that “no significant purpose of the company [can be] the production of income or the appreciation of property” can work with tranched investing. If the L3C is structured so that the third-tier investor (hypothetically an institutional investor) receives a market rate of return, it seems to necessitate that profit is a significant purpose of the company. Other authors have raised similar worries over the lack of “ceiling” on profit in these “low-profit” entities and the lack of an agreed upon definition for what “low-profit” means. Rick Cohen, in Washington Nonprofit Insight, asks, “When does some profit become too much profit, if ever?” L3C: Pot of Gold or Space Invader?, September 30, 2009.

Conclusion:

It is prudent and understandable to be hesitant regarding jumping on the L3C bandwagon just because it is the newest and most exciting legal structure to come along in a decade. After all, in addition to the concerns regarding the lack of automatic designation of all L3C investments as PRIs and other possible tax issues related to the tranche structure, there’s a distinct possibility that L3Cs will result in the diverting of foundation funds from important non-profits.

However, the momentum behind the L3C movement is such that it has gained substantial lobbying power and will be able to continue pressuring the IRS to designate L3C investments as PRIs. Additionally, while the nonprofit ecosystem may suffer a slight downturn, overall charitable efforts may see a significant upturn.

Thus, social entrepreneurs who understand the structural benefits and shortcomings of the L3C may see the market benefit of being an early adopter, the branding capacity, and the potential for attracting foundation dollars as reasons enough to risk adopting the L3C structure. As it gains more widespread acceptance, the L3C will likely help social ventures access billions of dollars from private investors looking for social return and foundations looking to invest their five-percent charitable minimum through PRIs. While the L3C is not the right structure for every social venture, it is a powerful and innovative legal solution that will be an important part of social entrepreneurship achieving more rapid growth and widespread recognition.

photo: Nicholas Valentin

L3C PART 2: DEFINING CHARACTERISTICS OF AN L3C

Since the L3C is a form of limited liability company (LLC), it has many of the defining characteristics of a traditional LLC:  flexible ownership and management structure; limited liability for the actions and debts of the company; and, default classification as a “pass-through entity” for federal tax purposes. The profits generated by an L3C are default taxed at the member level on the members’ individual tax returns, but tax-exempt nonprofits that invest in L3Cs may receive profits tax-free (so long as the L3C’s income is related to the non-profit’s charitable purpose and the non-profit uses the profits to further charitable purposes).

In order for private foundations to receive beneficial treatment under federal tax law, they are required to distribute five percent of their assets to social programs every year. IRC § 4944(c). Typically, foundations will donate this money to a non-profit. However, the other option is to make a program-related investment (PRI). PRIs are usually made into for-profit endeavors, but are intended to achieve some charitable purpose. PRIs are not common occurrences because the transaction costs in guaranteeing that the target of the investment will meet PRI requirements are prohibitive (for instance, to “guarantee” that an investment qualifies as a PRI, private foundations may apply for a private letter ruling from the IRS, but it is difficult and expensive to do so). If a private foundation makes an investment that turns out not to qualify as a PRI, the foundation may suffer penalties and be required to pay substantial taxes. See Allison Evans, Christine Petrovits & Glenn Walberg, L3C: Will New Business Entity Attract Foundation Investment?, 63 The Exempt Organization Tax Review 457 (2009).

The risks and costs of PRIs prevent most foundations from making any investments with the five percent that result in financial profits. The L3C aims to make it significantly easier for foundations to make PRIs by taking the three requirements for a PRI and including them in the legislative language regarding the L3C (the three requirements in the prior paragraph mirror the Internal Revenue Code’s requirements for something to qualify as a PRI). While the creators of the L3C hope that the Internal Revenue Service (IRS) will begin to recognize any investment in an L3C as automatically qualifying as a PRI, the IRS has warned that foundations may not currently rely on L3C status for deciding whether something qualifies as a PRI. Many experts continue to expect guidance from the IRS this year (2010).

The flexibility of the limited liability structure allows ventures to structure differing levels (tranches) of investment opportunities. For instance, a L3C may offer three different tranches of capital with the first tranch to foundations (PRIs with lower rate of return, greater risk, high emphasis on social purpose), the second to socially conscious investors (medium rate of returns, lowered risk, emphasis on social return), and the third to regular investors (market rate of return, less emphasis on social purpose).

Americans for Community Development further explains the structuring benefits of an L3C:

“[The L3C] also facilitates tranched investing with the PRI usually taking first risk position thereby taking much of the risk out of the venture for other investors in lower tranches. The rest of the investment levels or tranches become more attractive to commercial investment by improving the credit rating and thereby lowering the cost of capital. It is particularly favorable to equity investment. Because the foundations take the highest risk at little or no return, it essentially turns the venture capital model on its head and gives many social enterprises a low enough cost of capital that they are able to be self sustainable.”

The distinguishing factor of the L3C is that, although a for-profit entity, it is designed primarily to achieve a social aim and secondarily to achieve a profit. Each state that has passed L3C legislation has: (1) included some language requiring the L3C to “significantly further the accomplishment of one or more charitable or educational purposes”; (2) specified that the company must not have the significant purpose of “the production of income or the appreciation of property” (remember, the L3C is designed to earn profit, it just cannot be the significant purpose of the company); and, finally, (3) disallowed the L3C from being organized to achieve “political or legislative purposes.” These three requirements must be adopted in the organizational documents of the L3C (typically the operating agreement) and, just as the liability veil of an LLC can be breached if formalities are not complied with, the L3C can revert to a traditional LLC if any of the three requirements stop being complied with.