An L3C is a low-profit limited liability company (L3C). It is a legal form of business entity, recognized in just a few states, designed to bridge the gap between non-profit and for-profit investing. The concept is that the L3C can provide a structure that facilitates investments in socially beneficial, for-profit ventures while simplifying compliance with federal tax laws governing program-related investments. From a tax perspective, the focus in understanding the L3C structure is on the type of investment that would qualify as a program-related investment, which could be made by a private foundation.
An L3C is a for-profit entity, but its purpose is to perform socially beneficial services, not maximizing income. The L3C is unique in that it is a hybrid entity sharing the legal and tax flexibility of a traditional LLC, the social benefits of a nonprofit organization, and the branding and market positioning advantages of a social enterprise. The L3C is designed to make it easier for socially oriented businesses to attract investments from foundations and additional money from private investors.
As with non-profit entities, the L3C’s articles of organization must meet the federal tax standards for program-related investing. Organizers prefer the L3C concept to maximize the benefits of program-related investment (PRI) as a way to satisfy a federal tax law requirement that foundations distribute at least 5% of their assets every year for charitable purposes.
An L3C is established under state law. Unfortunately, as of the date of this article, Indiana has not passed a law permitting the formation of a L3C. However, an L3C formed in another state would be recognized as a foreign entity doing business in Indiana law if properly registered with the Indiana Secretary of State. To date, the L3C is recognized only in Illinois, Louisiana, Maine, Michigan, North Carolina, Rhode Island, Utah, Vermont, and Wyoming and the federal jurisdictions of the Crow Indian Nation of Montana and the Oglala Sioux Tribe. 26 other states have considered legislation to allow L3C’s. Fewer than 1,000 L3C’s exist today.
In May, 2012, the IRS released proposed regulations that broaden the landscape of what constitutes an acceptable PRI by adding nine new examples of investments that would qualify, along with some general principles. Legislation is also pending at federal level that will simplify the process for receiving IRS approval that an investment qualifies as a PRI.
A principal advantage of the L3C is its qualification as a program related investment (PRI), an investment with a socially beneficial purpose that is consistent with and furthers a foundation’s mission. Because foundations can only directly invest in for-profit ventures qualified as PRIs, many foundations refrain from investing in for-profit ventures due to the uncertainty of whether they would qualify as PRIs or use costly time and resources to acquire a Private Letter Ruling from the IRS to verify that the venture is a valid PRI. An L3C’s operating agreement minimizes this problem by specifically outlining its respective PRI-qualified purpose in being formed, making it easier for foundations to identify social-purpose businesses as well as helping to ensure that their tax-exemptions remain secure.
Additionally, the fiduciary responsibilities of for-profit partners often prevent their participation in a foundation PRI in a for-profit venture. The L3C avoids this common problem through its flexible membership rules which allows partners to structure the L3C and adjust ownership to best fit their unique situations. By addressing these current investment challenges to PRIs, L3Cs are able to attract a greater influx of private capital from various sources of wealth in order to serve their charitable or education goals.
On April 30, 2008, Vermont became the first State to recognize the L3C as an official legal structure. Similar legislation has since been pushed in other States such as Georgia, Michigan, Montana and North Carolina. Although Vermont currently remains the only State to authorize the L3C, it has national applicability because L3Cs formed in Vermont can be used in any State or Territory.
Despite its socially-conscious mission, an L3C is not a tax-exempt organization under Section 501(c) of the Internal Revenue Code, and donations and investments in L3Cs are not tax deductible. Since the profits of an L3C “pass through” to its members and are taxed at individual rates, L3Cs operate like standard LLCs for federal tax purposes.
The L3C’s primary advantage is its ability to attract private foundation Program-Related Investments (PRIs) though its formal compliance with the PRI requirements set out in Regs. Sec. 53.4944-3(a). PRIs are a means for private foundations to invest in for-profit entities without incurring certain penalty taxes. State laws authorizing L3Cs require their organizing documents to track the provisions of Regs. Sec. 53.4944-3(a).
As a cautionary note, however, the IRS has not ruled whether private foundation investments in L3Cs qualify as PRIs. State laws authorizing L3Cs do not bind the federal tax authorities regarding PRIs, which may limit the utility of the business form until the IRS makes its determination.