L3C: Will the IRS favor Social Progress?

clip_image002.gifLast month at a peace rally, I saw a woman with a sign that read “where is my social progress?” and she got me thinking…. Where is social progress if not in socially active individuals? I thought of Margret Mead’s famous quote: “Never doubt that a small group of thoughtful, committed citizens could change the world. Indeed, it is the only thing that ever has.”
Inspired, I decided to take a plunge into social entrepreneurship and incorporate a new kind of socially beneficial company called an “L3C.” An “L3C” is an acronym for Low-profit, Limited Liability Company. An L3C is run like a regular business and is profitable, yet unlike a standard LLC, the L3C has primary charitable goals. To date, only Vermont and Michigan have ratified the legality of the L3C business model.
My L3C formation process was very simple. I chose a name “The Regenerative Group, L3C.” I filed the Vermont Secretary of State papers stating that my company’s charter is “to develop family education and outreach programs supporting the mission, vision and values of the sustainability movement”, and I paid the $75 processing fee with a check in the mail. I thought: “that was easy,” but I was warned: before I raise start-up capital and kick up my socially beneficial operations I should wait to hear what the IRS will say about the tax implications of the new legal entity: L3C.

The IRS ruling will be momentous because it will determine the ultimate fate of my L3C and others which have recently been formed across the country. I chose to incorporate an L3C because I believe in the underlying purpose. Let me explain.
And as the name states, the L3C can make a LOW Profit, but profit is not the primary purpose. Social “good works” is the mission of the L3C charter, with profits being a secondary concern. Yet, unlike a traditional charity organization, the L3C is free to distribute its low (1%-10%) profits, after taxes, to owners or investors.
The L3C is intended to be a “4th Sector Business” that brings together the three traditional economic sectors of: non-profit, public, and private sectors. That is, the L3C aims to synergize the interests and capital sources of (non-profit) private foundations, trusts, and endowment funds, plus government (public) entities, and other (for-profits) entities like pension funds, corporations, and individual investors – all into a L3C “4th Sector” hybrid organization designed to achieve social objectives while also operating according to for-profit metrics.
The purpose of the L3C hybrid structure is to use patient, long term, low return, or no return, philanthropic capital to entice market investors to build businesses that serve important social purposes. An example is a community L3C organization which sells locally grown fresh food in the inner city, thereby helping farmers and consumers, while also providing jobs and potentially building new schools with profits.
Yet again, the L3C is still in its “proof of concept” phase, but will be put to the test later this year. Because the first L3Cs were formed in 2008, this means 2009 will be the first year that the concept will be tested with the IRS. Hopefully, the IRS will readily accept Foundation investments in L3Cs as valid PRIs (Program Related Investments). If not, then L3C’s will not be able to receive tax deductible charity funds from large foundations, and will go the way of the Dodo. Yet, L3C seem to match all the PRI requirements.
Program-related investments (PRI) are those in which:
1. The primary purpose is to accomplish one or more of the foundation’s exempt goals
2. Production of income or appreciation of property is not a significant purpose, and
3. Influencing legislation or taking part in political campaigns on behalf of candidates is not a purpose.
L3C’s should (hopefully) satisfy the IRS’s definition of a PRI and thus stimulate more foundation funding and widespread social recognition of L3Cs. Other States can then hopefully follow Vermont’s lead and enact their own L3C legal recognition. This is how the LLC spread from Wyoming in 1977 to the entire Union.
The best case scenario for L3C’s social efficacy will be:
1) The IRS publicly recognizes the L3C as a PRI.
2) L3C’s will begin to be incorporated by individuals across the country
3) Foundations begin to flow money into L3Cs
4) Private “social responsible” investors will invest heavily in L3Cs
5) L3Cs will model “pure transperency” in their operations and financials
6) L3Cs will build and provide needed social services and ventures
7) L3Cs will stimulate more and more intentional “socially responsible” investing across all sectors of the economy
8) L3cs will further the beneficial efficacy of traditional non-profits.
Soon, time will tell. The IRS judgment should be known by the end of the year. I believe that the L3C can and will be an effective vehicle for creating a future that is more sustainable, bountiful, and socially equitable for the good of all American citizens.
For more information on L3Cs, see Vermont’s Secretary of State Website.
Brian Burnham Jones is a current MBA ’09 student at The LEEDS School of Business at the University of Colorado, Boulder. Brian’s MBA is focused on Sustainability and Entrepreneurship. Brian is seeking collaboration and support to further his L3C mission. Contact Brian at: Brian.B.Jones@Colorado.edu

13 responses

  1. L3C is a legal entity specific to Michigan and Vermont, but can operate in other states as long as the L3C has a local representative in Vermont or Michigan. A B-Corp is not a legal entity, but rather a business certification that holds no legal weight.

  2. Great summary of L3Cs, Brian. One note: The hope is that the IRS will accept the legal form of an L3C as eligible to receive Program-Related Investments by definition.
    But even if the IRS doesn’t “approve” the L3C as eligible to receive a PRI by definition, private foundations will still be able to make Program-Related Investments in them. It just means the foundation will have to go through the due diligence process to document that the project meets the criteria for a PRI. This is what happens now, and it’s a bit burdensome for the foundation but completely routine.

  3. Sorry to disappoint but the IRS will not rule on L3Cs because it cannot. The rules on what constitutes a PRI are very clear. So if someone sets up an L3C, the IRS does not know about it and will not rule even if it does. It has no power to rule. When a foundation invests in one (makes a PRI) they have to record it on their 990 PF the following year. Still nothing requires the IRS to care. But if the IRS decides to review that foundation’s 990 PF it might decide to ask the foundation for information on the PRI. If it does not like what it sees it might investigate further. At that point it could rule that the the foundation investment does not qualify as a PRI. It then still has lots of options left and the foundation can still appeal all the way to the Supreme Court. When it is all over the IRS will not have ruled on L3Cs it will have ruled on that particular investment and unless the case does wind itself through the courts there will not even be a true precedent for the next one
    Now someone could and might ask the IRS for a private letter ruling on a particular deal but that still would not be an IRS ruling on L3Cs in general and it would apply to how the deal in question was structured not whether or not they used an L3C and because it is a private letter ruling it will still not create precedent. The IRS is never going to give a blanket ruling that L3Cs are OK because the law does not give them that latitude. Each deal must obey the laws for PRIs and stand on its own. The L3C templates a deal, brands it and makes it easier to construct but it is not a warranty. Just because you buy a car that can safely go 150 miles per hour does not grant you the right to drive 150.
    I know because I created the L3C. All that said it is a great tool and those interested in it should go to our website http://americansforcommunitydevelopment.org/
    for more information. We are trying to get Congress to pass a law that would allow for IRS registration of PRis and L3Cs just like a nonprofit is registered. But even then it would not be the whole L3C concept that was approved but the specific deal. We have created a tool not a free pass.

  4. The L3C concept is really intriguing and has great appeal, but a few things need to be kept in mind:
    As Bob Lang notes, an L3C can accept PRI’s, but so can lots of other entities, including C corporations and partnerships. So the issue of whether a particular investment qualifies as a PRI is dependent on the intentions of the private foundation investor, not the recipient L3C.
    Second, an L3C is not a corporation, but a form of limited liability company (LLC), which is a hybrid that is part corporation and part partnership. While similar, LLCs and corporations have very different tax treatment and governance structures.
    Third, more states are introducing and enacting L3C legislation. go to Bob’s web site http://americansforcommunitydevelopment.org/ to get current information.
    Fourth, there is a scenario in which the IRS could “bless” L3Cs in a meaningful way, and that is to rule that a private foundation investment in an L3C is automatically treated as a PRI for tax purposes. It’s very unlikely but not impossible.
    Finally, Bob’s idea of federal statute, presumeably amending the tax code, to recognize L3Cs and confer favorable tax treatment upon them, is significant. Ideally, any such provision would go beyond L3C’s to include other types of entities, so long as they are willing to adopt appropriate limiting language in their organizing documents. Marc Owen raised this idea at an Aspen Institute meeting a few years ago, and I always thought it was pretty cool.

  5. Robert, Allen, do you know of any foundations that have made PRIs in L3Cs without private letter rulings in 2008?
    What are the potential consequences to the foundation if the IRS denies a specific PRI? To the L3C?
    Is the relevant question here “are foundations willing to risk PRIs in L3Cs without private letter rulings?”

  6. A PRI is an exception to the general rule against “jeopardy investments” by foundations. A PRI is also treated as an “exempt purpose expenditure”, which means it is treated like a grant and counts towards the foundation’s 5% minimum payout requirement.
    If a particular transaction fails to qualify as a PRI, two things happen: First, it has to be analyzed to determine if it is a jeopardy investment, and if it is, the foundation is liable for financial penalties. Second, the transaction has to be subtracted from the calculation of exempt purpose expenditures, and if the foundation then falls below the 5% minimum payout level, it may face additional fines and penalties. The rules on jeopardy investments and minimum payout are fairly complicated, so the consequences of any particular transaction depend on a lot of factors too numerous to detail here.
    It’s very hard to generalize about foundations, since they come in all shapes and sizes. In my experience, some foundations, including those that do PRI’s regularly, will make PRI’s without a private letter ruling, especially if they are similar to previous transactions, but they usually want an opinion of counsel to make sure they are protected.
    There is a good site called “PRIMakers” http://www.primakers.com/home that has more information for foundations interested in making PRI’s.

  7. I think one of the missing pieces is that a PRI is made in lieu of a grant. I have never heard anyone from a foundation tell me they were incapable of making the decisions needed to decide whether something would qualify as a grant or not. It has always amazed me that the same people become paralyzed when faced with a PRI. I have told many foundations, including those in PRI Makers to stop thinking of it as an investment and think of it as a grant. If you would make it as a grant then make it as a PRI and enjoy the fact that you might get a return and you might get your capital back and if you can bring in commercial dollars by doing so you reduce the strain on the social sector dollars.
    Yes there is due diligence and process involved but the rules are not in Sanskrit. Marc Owens did all our actual legal work of writing the exact laws. He spent 10 years as head of the Exempt division of the IRS and never found PRIs to be a problem during that period. The L#C is a brand and a template for simplifying the transactional portion of the process. It was never meant to eliminate the due diligence process of deciding what is a good PRI. At the end of the day that is all the IRS cares about. They do not judge the quality or the choice as long as it meets the law. PRIs, like the story about alligators in the NYC sewer system, seem to have acquired the aura of urban myth. As Allen will tell you the LLC route is not the only way to get from here to there. What I have tried to do is make people understand that for both parties the PRI can be a far better process than the grant. And the L3C can greatly simplify the process of making a PRI. Allen I know is already working on additional ideas for the space. Someday I think we both hope there will be several alternatives for using for profit dollars to perform socially beneficial activities.

  8. I am a business lawyer and consultant working with the Oglala Sioux Tribe at Pine Ridge Indian Reservation – we will likely incorporate the L3C into the OST Business Codes –
    I see this discussion about IRS rulings and possible statute – may I suggest that this could easily be handled by lawyers issuing pro forma opinions (like the old days prior to ‘check the box’ regs when we used to opine as to the partnership tax characterization of LLCs compared to an association taxable as a corporation) –
    Then the Bar was able to convince the IRS to issue the ‘check the box’ regulations pertaining to the characterization of LLCs – I would think that a similar approach would lead to the same result in terms of stability – can be implemented now and does not require an Act of Congress –
    On behalf of myself and also on behalf of the Oglala Sioux Tribe, many thanks to Mr. Lang and all those who have been working to get this going.

Leave a Reply