“L3C” spells “caveat emptor”

Here’s something strange: a concept thrown around routinely and casually in conversations among nonprofits and philanthropies is simultaneously the subject of fierce debate and sometime disapproval by the Internal Revenue Service, a committee of the American Bar Association, and other experts. What is going on?

The notion of Low Profit Limited Liability Corporations (L3Cs, for short) is that they’re a vehicle for doing well by doing good and therefore an improvement over the typical nonprofit structure. L3Cs are permitted to earn profits but proponents claim that their praiseworthy intentions—to end hunger or provide clean water or whatever—make those who lend to them eligible for the special tax benefits attached to program-related investments. In other words, this is a legal structure presented as a technique for gaining access to capital (always a struggle for nonprofits) by providing a tax benefit to lenders.

Of course, foundations already get a tax benefit for program-related investments in regular nonprofits, so what, exactly, is the appeal? In theory, foundations might be more interested in program-related investments that generate a reliable flow of capital (in the form of profit) than in program-related investments that generate nothing but additional nonprofit programs and services. Likewise in theory, regular venture capitalists outside of foundations will be more interested in making investments in profit-making entities than in pure nonprofits. This—the notion goes—will increase the amount of capital available to support general good-guy behavior.

However, a number of scholars and lawyers (Daniel Kleinberger of William Mitchell College of Law prominent among them) see the L3C as, at best, redundant and, at worst, an invitation to fraud. They point out that regular limited liability corporations can be organized for any purpose, including public-spirited and low-profit ones. They point out that the IRS has not yet issued (and does not seemed inclined to create) a rule awarding automatic program-related investment status to any investment in an L3C. So anyone who invests in an L3C on the basis that it provides a higher return than a regular nonprofit with the same tax benefits will find out to his/her sorrow that this is not the case.

What strikes the Nonprofiteer as peculiar, though, is that in the many discussions she’s heard and read about L3Cs, only one mention (specifically, Professor Kleinberger’s Nonprofit Quarterly article) has ever surfaced of this opposition from the bar and Federal regulators.  Not until her tax lawyer Stuart Levine asked about the [successful] efforts in Illinois to create L3Cs did she realize there was anything controversial about the phenomenon.  After bringing her up to speed Levine wisely said,

L3C’s don’t work unless there is a change in federal tax law.  In other words, L3C’s are a little like Oreo-Tycin-Myacin—the wonder drug for which there is no known disease.

L3C’s raise difficult issues of fiduciary duty and the inherent conflict between “charitable” purposes and “business” purposes.  At the least, these conflicts cannot be dealt with via a quick-fix state statute.

Doubtless the Nonprofiteer spaces out on frequent occasions and misses aspects of what’s said or done in the sector.  But she suspects there’s also a disconnect between what nonprofit executives and L3C promoters expect and describe and what lawyers and regulators understand.

So if you’re considering investment in an L3C, be the aware buyer of whom you’ve heard.

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8 Responses to ““L3C” spells “caveat emptor””

  1. Adam Huttler Says:

    There is indeed a disconnect between the L3C enthusiasts (of which I am one) and the perspective of the lawyers/regulators. You are correct that, in theory, a regular old LLC can technically do anything an L3C can do, including receive bona fide PRI from a private foundation. (Although one could debate whether operating an LLC in this way would compromise its implicit fiduciary duty to maximize shareholder value.) But you’re ignoring some perceptual issues that are deeply rooted in American philanthropic culture.

    Institutional funders are notoriously risk-averse, which is part of why PRI has been so underutilized as a tool for social entrepreneurship. Many also are stuck on the old-fashioned and dangerously simplistic notion that Stuart Levine repeats, namely that there’s an “inherent conflict between ‘charitable’ purposes and ‘business’ purposes.” This reflects a naive and one-dimensional understanding of the ways in which charitable organizations operate and the ways in which their charitable missions can be realized. Yes, clearly there is *tension* between those purposes, but it can just as easily be a healthy, dynamic tension that strengthens the organization’s work as an irreconcilable conflict.

    In this cultural context, the L3C is valuable as a powerful signal of charitable intent and long-term commitment to pursuing social ROI; after all, you’ve tied your hands with the entity’s very charter. My hope (and perhaps I’m being naive here) is that foundations will simply be more comfortable investing in an L3C than in a plain vanilla LLC.

    Additionally, while the IRS is unlikely to ever establish a bright line rule that investment in an L3C is automatically considered PRI, it’s not unreasonable to think that such investment could present prima facie evidence of PRI, and perhaps shift the burden of proof from the foundation to the IRS.

    • Nonprofiteer Says:

      I agree that the proper term for the relationship between business and charity in the social-entrepreneurial context is “tension” rather than “conflict.” I’m simply less sanguine than you are about the likelihood that foundations will embrace the new form, and more concerned than you are about investors’ likely difficulties in tracking how, and for whose benefit, their invested monies are used. I appreciate your writing, though, and sharing the L3C enthusiast’s perspective.

  2. Daniel S. Kleinberger Says:

    Unfortunately, the assertion that “it’s not unreasonable to think that such investment [in an L3C] could present prima facie evidence of PRI, and perhaps shift the burden of proof from the foundation to the IRS” entirely misses the point about the relationship between a PRI and the foundation. The nature of the PRI recipient could not by itself ever create “prima facie” evidence, because the PRI determination FUNDAMENTALLY and INESCAPABLY requires analysis from the perspective of the foundation. A label on the recipient organization is essentially immaterial to that analysis.

    As I’ve tried to explain elsewhere, “[Each time a foundation considers making a PRI, the foundation must make a situation-specific determination that carefully takes into account the foundation’s mission, the purpose of the organization receiving the investment, the relationship of the receiving organization’s purpose to the foundation’s mission, and how the governance and financial structure of the receiving organization ensures that the receiving organization will operate within the PRI requirements.” 35 Del. J. Corp. Law 879, 891 (2010)

    • Nonprofiteer Says:

      Professor, Thanks so much for the expanded explanation of problems with the new form.

    • Adam Huttler Says:

      I may have overstated the case. My only point is that investment in an L3C can generally be assumed to be compatible with charitable purposes in a way that investment in an LLC cannot. The language authorizing the formation of L3Cs (at least in Vermont, which is where my experience lies) very closely parallels the language in section 501(c)(3) of the Internal Revenue Code. To that end, I’d think the L3C status of the recipient organization does address (if not exhaustively or definitively) the question of “how the governance and financial structure of the receiving organization ensures that the receiving organization will operate within the PRI requirement.”

      I don’t dispute that there are important additional questions related to mission-alignment, etc.

  3. Weekend Link Roundup (March 19-20, 2011) | Philanthropy Says:

    […] investors may want to think twice before they invest in a limited liability corporation (LC3), writes The […]

  4. Low-Profit But How Much Potential? (Part 1) « Art Matters! Says:

    […] note that I was among the first in our field to note the arrival of the L3C, and I’ve written and debated about it quite a bit since then. Fractured Atlas formed an L3C subsidiary for our insurance program […]

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