Three Objections to L3Cs Answered

1 CommentTuesday • August 2, 2011 • by Kyle Westaway

Though many sections of the American Bar Association are in favor of L3C legislation, the Nonprofit Organizations Committee and the Limited Liability Companies, Partnerships and Unincorporated Entities Committee of the Business Law Section of the American Bar Association are planning to oppose the L3C legislation based on three primary objections. Below are the objections and the responses by leading nonprofit attorneys excerpted from their letter.

1. L3C’s are no better at receiving PRI’s than an LLC

Your letter indicates that “The L3C is no better than any other business form for receiving program related investment[s] ….”  In our view, an L3C is a better vehicle for accepting program-related investments than a standard LLC. The state-law L3C restrictions will make it easier for private foundation investors to conduct the due diligence necessary in order to complete a program-related investment and comply with expenditure responsibility. Acharitable purpose would necessarily be articulated in the L3C’s operating agreement, helping to ensure that the L3C’s purposes and operations are aligned with PRI requirements. Persons who form L3Cs are likely to be better informed about the  requirements applicable to private foundations for PRIs and for expenditure responsibility and so draft their operating agreements accordingly.  The L3C designation automatically sets the entity apart from ordinary LLCs that may or may not be structured in  a way compatible with PRI requirements.We agree, and understand that, L3C is not necessary for an LLC to serve as the vehicle for a program-related investment, and we have represented many foundations that have made PRIs into LLCs, but we believe that in many cases L3C will make it easier for foundation investors to make the findings that they need to make for a proper PRI and for compliance with expenditure responsibility.

2. Traunched investment results in private benefit for profit-seeking investors.

Your letter indicates that “tranched investing purposefully uses foundation funds to subsidize (and thereby attract) private, profit-seeking investors” so that such a PRI “almost inevitably results in private benefit.” Tranched financing does not lead to per-se private benefit, as you suggest.  Private benefit depends on all of the  facts and circumstances in a given situation.

In fact, a PRI (other than one made to a charity) always involves some level of private benefit, but rather than a disqualifying private benefit, it is deemed incidental to the accomplishment of charitable purposes. One example in the Treasury regulations involves a foundation making a below-market-rate loan to a “business enterprise which is financially secure and the stock of which is listed and traded on a national exchange,” in order to encourage the enterprise to establish a factory in a depressed urban area. In this example, there is clearly private benefit, since the corporation receives a below-market-rate loan from charity – but the private benefit is incidental. In any PRI investment in a for-profit entity there is private benefit, but the private-benefit doctrine involves a weighing of public good against private benefit.

In any case, there is  nothing in the L3C statutes that requires or even addresses tranched financing anymore than there is in the LLC statutes. L3C is now a creature of the states and American Indian nations that have adopted it, not of some promoters. Just because some promoters of L3C have talked about tranches does not mean that tranched financing is an inherent part of L3C. It is simply not in the L3C legislation

3.  Supposedly “Low Profit” companies could make significant profits.

Your letter also points to a purported “technical error” in the L3C legislation, suggesting that there is some contradiction between the requirement that “no significant purpose of  the company  is the production of income or the appreciation of property” on the one hand and the label “low-profit” and the involvement of for-profit investors on the other. But there is no such contradiction.

L3C requires that the primary purpose of the organization must be charitable, but permits the production of income to be a secondary purpose. As with a tax-exempt charity that must have a charitable purpose by law, yet also must, from an economic standpoint, have sufficient revenue to conduct operations, institutional decisions must be made with the L3C’s overarching charitable purpose in mind, but profit may certainly be the result. The fact that an investment produces significant income or appreciation is not, in the absence of other factors, conclusive evidence of a significant purpose involving the production of income or the appreciation of property.

In fact, an example in the Treasury regulations, in analyzing an investment by foundation “Y,” states that the investment “is a program-related investment even though Y may earn income from the investment in an amount comparable to or higher than earnings from conventional portfolio investments.” When assessing whether a “significant purpose” of a foundation’s proposed investment is the production of income for purposes of the PRI rules, the IRS finds it “relevant whether investors solely engaged in the investment for profit would be likely to make the investment on the same terms as the private foundation.”

Such an investment is less likely to be a PRI to the extent that for-profit investors would enter it on the same terms as a foundation. The clear corollary is that for-profit investors may enter such investments on terms more favorable to them than those under which a foundation is willing to invest. Thus, L3C can bring together foundations’ PRIs and investments on more favorable terms by for-profit investors to accomplish the L3C’s primary charitable purpose through a business that, because of its inherent risk and low likelihood of profit, simply would not be attractive solely to for-profit investors.

photo: Kate Gaensler

share: