Business Better Than Usual: L3Cs Put Purpose Above Profit
In this Business Better Than Usual series, social enterprise attorney Kyle Westaway explains the fundamentals of different legal structures available to social entrepreneurs. Earlier, Kyle discussed the benefit corporation.
The Low Profit Limited Liability Company (L3C) is a new class of LLC for mission-driven companies. In most respects, the L3C operates like an LLC, including the ease of set up, liability protection, flexible management and pass through taxation. However, L3C has two primary distinguishing features. First, the L3C elevates purpose over profit. Secondly, the L3C is designed to receive both philanthropic and private capital.
The L3C statute requires that the company exists to further a charitable purpose as defined by the within the definition of charitable purpose found in Section170(c)(2)(B) of the Internal Revenue Code. An L3C may not have the primary goal of making a profit as its primary goal, though there is no prohibition on making a profit, and if profits are made the L3C may distribute the profits to the owners.
Mix of Philanthropic and Private Capital
Just like an LLC, the L3C can receive private funding in the form of debt or equity, but the L3C is designed to attract a very specific type of philanthropic funding called Program Related Investments (PRI). PRI is capital—in the form of either equity or debt—from a foundation to a for-profit company that is doing work in line with the charitable purpose of the foundation. The L3C is a flexibly designed LLC that allows a mix of foundations, trusts, endowments, pension funds, individuals, corporations and government to partner for a shared social objective while offering financial return on investment.
In order for private foundations to receive beneficial treatment under federal tax law, they are required to distribute five percent of their assets to social programs every year. Typically, foundations will donate this money to a nonprofit. However, the other option is to make a program-related investment (PRI). PRIs are usually made into for-profit endeavors, but are intended to achieve some charitable purpose. PRIs are not common occurrences because the transaction costs (mostly legal and due diligence) in guaranteeing that the target of the investment will meet PRI requirements are prohibitive. If a private foundation makes an investment that turns out not to qualify as a PRI, the foundation may suffer penalties and be required to pay substantial taxes.
The risks and costs of PRIs prevent most foundations from making any investments with the five percent that result in financial profits. The L3C aims to make it significantly easier for foundations to make PRIs by taking the three requirements for a PRI and including them in the legislative language regarding the L3C (the three requirements in the prior paragraph mirror the Internal Revenue Code’s requirements for something an investment to qualify as a PRI).
While the creators of the L3C hope that the Internal Revenue Service (IRS) will begin to recognize any investment in an L3C as automatically qualifying as a PRI, the IRS has warned that foundations may not currently rely on L3C status for determining whether something qualifies as a PRI.
The ability to facilitate both private and philanthropic capital in an L3C could open up some creative options for funding. For instance, many L3C commentators have posited that foundations could use PRI to take a low-risk/high-reward tranche of financing, which would then incentivize the private investors to invest by giving them a lower risk/higher reward tranche of financing.