While
there are other entity structures, like B-Corporations, that adopt this dual
pronged approach, the L3C may be the most effective choice for those socially
motivated businesses who place social benefit at the forefront while still
aiming to garner tangible profit.
At its core, an L3C is a for-profit
LLC that serves to “streamline and encourage private foundation investment.”[5] It is
formed through filing articles of organization in one of the states that
authorize the entity, and is subject to the same requirements of an LLC – a
registered agent, for example.[6] Similarly,
they are taxed the same way as LLC for federal income tax purposes. An L3C with
one member, by default, is considered a disregarded entity for tax purposes,
and all income, credits, and deductions are reported on the member’s individual
tax return.[7] The L3C
may elect to be taxed as a corporation instead.
However, that is where the similarities end. In order to qualify for L3C status, your
business must satisfy these requirements:
1. Significantly
furthers the accomplishment of one or more charitable or educational purposes
within the meaning of Sec. 170(c)(2)(b) of the IRC and would not have been
formed but for the company’s relationship to the accomplishment of those
charitable or educational purposes.[8]
2. Does
not have as a significant purpose the production of income or the appreciation
of property.
3. Does
not have as a purpose the accomplishment of one or more political or
legislative purposes.
The purpose of these requirements is
to ensure that the L3C is able to receive Program Related Investments (PRIs).[9] Generally,
a foundation cannot make a monetary investment into a for-profit enterprise as
that investment will jeopardize the foundation’s ability to pursue its
tax-exempt purpose.[10] Luckily,
Program Related Investments serve as a way to allow foundations to make these
sorts of special investments, as they are “investment[s] into a for-profit
entity which is clearly pursuing a charitable endeavor.”[11]
State laws authorizing L3Cs work in conjunction with the IRS regulations of
PRIs, as they ensure that the socially beneficial purpose of the L3C is in line
with the “charitable” definition laid out in Section 170(c)(2)(B) of the
Internal Revenue Code, and that the entity cannot engage in lobbying or
political activities, which is in line with Section 170 (c)(2)(D).[12]
Generally, tax-exempt foundations are able to meet the IRS requirement that they pay at least 5% of their revenue towards a charitable project or activity each year through providing grants to tax-exempt organizations.[13] PRIs provide another avenue for them to meet this requirement. Outside of L3C’s, PRIs are significantly rarer than grants because it is often difficult to determine which investments qualify.[14] As the bar for qualification is difficult to meet, foundations usually need to obtain a Private Letter Ruling from the IRS in order to make these investments.[15] Since L3C’s, by statute, meet the requirements of PRI’s, foundations are able to donate to L3C’s without having to obtain a Private Letter Ruling from the IRS.[16] For an example of prospective risk-return arrangements for L3C investments, see the figure below.[17]
While, in theory, L3C’s sound like an optimal avenue for those looking to make an impact on their community and garner profits, there are drawbacks that still remain to be worked out. First, L3C’s are not recognized in every state, so it is important to be aware of where they are registered before you consider forming one. At the moment, L3C’s are recognized in Vermont, Illinois, Maine, Michigan, Louisiana, Rhode Island, Utah, and Wyoming.[1] North Carolina once recognized L3C’s, but repealed that recognition in 2013, claiming that it “is not necessary” and the same ends could be achieved simply through an LLC.[2] Secondly, and more concerning, is the fact that the IRS has yet to officially approve L3C’s as automatic recipients of PRIs.[3] While ultimately the hope is that it will, the process of securing a private letter ruling remains a difficult and costly process for these foundations. [4] Yet, the fact that the requirements of PRI’s are incorporated directly into the L3C’s entity structure should, in theory, make the process of securing a private letter ruling less costly and arduous for these foundations looking to invest into L3C’s.
Ultimately,
if you are interested in social impact but are still hopeful for your business’
earning potential, options like L3C’s are a strong consideration for those
looking for an alternative to nonprofits. It is important to be aware of the
disadvantages that remain to be worked out, but this entity structure can be
the optimal fit for those looking to garner profit while contributing to a
charitable purpose through their business. L3C’s remain full of potential and
can attract traditional financial investors to a social venture which otherwise
might not be of interest to them.
By Giovanni Lavoile
[1] Feldman, What Is an L3C
(Low-Profit Limited Liability Company): An Entity for Entrepreneurs who Value
Purpose and Profits.
[2] Annie Field, North Carolina
Officially Abolishes the L3C (Jan. 11, 2014), https://www.forbes.com/sites/annefield/2014/01/11/north-carolina-officially-abolishes-the-l3c/?sh=27f966913d7f.
[3] Should You Form an L3C?,
Digital Media Law Project, https://www.dmlp.org/legal-guide/should-you-form-l3c.
[4] Id.
[1] Sam Mesquita, Conscious
Consumerism: What it is, Why it Matters, and How to Become a More Conscious
Consumer, Pepperdine Business Blog (May 27, 2021), https://bschool.pepperdine.edu/blog/posts/conscious-consumerism.htm.
[2] Mich. Comp. Laws § 450.4204 (1993).
[3] Sandra Feldman, What Is an L3C
(Low-Profit Limited Liability Company): An Entity for Entrepreneurs who Value
Purpose and Profits, Wolters Kluwer (Mar. 03, 2020), https://www.wolterskluwer.com/en/expert-insights/what-is-l3c-low-profit-limited-liability-company.
[4] Id.
[5] Peter Smith, What is a
“Low-Profit Limited Liability Company” (L3C)?, Apex Law Group, https://apexlg.com/what-is-a-low-profit-limited-liability-company-l3c/.
[6] Feldman, What Is an L3C
(Low-Profit Limited Liability Company): An Entity for Entrepreneurs who Value
Purpose and Profits.
[7] Id.
[8] I.R.C. § 170 (c)(2)(b) (“For purposes of this section, the term
charitable contribution” means a contribution or gift to or for the use of a
corporation, trust, or community chest, fund, or foundation organized and
operated exclusively for religious, charitable, scientific, literary, or
educational purposes, or to foster national or international amateur sports
competition (but only if no part of its activities involve the provision of
athletic facilities or equipment), or for the prevention of cruelty to children
or animals”).
[9] Drake Forester, L3C,
Northwest Registered Agent, https://www.northwestregisteredagent.com/llc/types/l3c.
[10] Peter Smith, What is a
“Low-Profit Limited Liability Company” (L3C)?.
[11] Hana Muslic, A Jargon-Free
Guide to Low-Profit Limited Liability Companies, Nonprofit Hub (June 1,
2017), https://nonprofithub.org/jargon-free-guide-l3c/.
[12] Peter Smith, What is a
“Low-Profit Limited Liability Company” (L3C)?.
[13] Feldman, What Is an L3C
(Low-Profit Limited Liability Company): An Entity for Entrepreneurs who Value
Purpose and Profits.
[14] Should You Form an L3C?,
Digital Media Law Project, https://www.dmlp.org/legal-guide/should-you-form-l3c.
[15] Id.
[16] Anne Field, Another Reason to
Become an L3C, Forbes ( Aug. 22, 2014), https://www.forbes.com/sites/annefield/2014/08/22/another-reason-to-become-an-l3c/?sh=6e6acd0785af.
[17] Sue Woodrow, Steve Davis, The
L3C: A New Business Model for Socially Responsible Investing, Federal
Reserve Bank of St. Louis, https://www.stlouisfed.org/publications/bridges/winter-20092010/the-l3c-a-new-business-model-for-socially-responsible-investing.