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