Opponents of the low-profit limited liability company (L3C or low-profit LLC) welcomed the new year on a positive note. On January 1st, 2014, North Carolina became the first state to get rid of the L3C, a legal form currently available in several US states created with the intention of allowing businesses the flexibility to undertake a socially beneficial mission on top of turning a (low) profit. In other words, the L3C is a legal business structure intended for social enterprises.
On paper, Vermont was the first to introduce the L3C in 2008. North Carolina was on the verge of introducing the L3C in 2007 through the Endangered Manufacturing and Jobs Act on the argument that it would help revitalize the state’s manufacturing industry and economy as a whole. The bill didn’t survive the legislative session. Still, the L3C materialized in 2010, only to be abolished three years later.
An L3C boom
Since 2008, Michigan, Wyoming, Utah, Illinois, Louisiana, Maine, and Rhode Island have passed legislation allowing the organization of L3Cs with relative ease. According to Doug Batey, a principal at US law firm Stoel Rives LLP, a major reason the L3C took off is the expectation that L3Cs can attract program-related investments (PRIs) from private foundations.
PRIs are described by the Internal Revenue Service (IRS) as investments that further a foundation’s exempt activities which can involve a potential return but cannot significantly produce income or increase value in a property, and cannot be used to influence legislation or support political activity. Examples of a PRI would be an investment in low-income housing projects or low-interest loans to small businesses owned by members of economically disadvantaged groups. For social enterprises, PRIs would be an avenue to get much-needed early-stage operating capital.
But even though foundations give out billions of dollars each year, PRIs are not a popular financial tool, mainly because of the high transaction costs foundations have to undertake to ensure that the investments qualify as PRIs. The IRS imposes strict rules on how private, tax-exempt foundations spend their money, and if foundations don’t meet the IRS’s requirements for a PRI, it can endanger the foundation’s charitable status and result in substantial taxes and penalties. The hope is that L3Cs would make it easier to carry out PRIs.
Another reason for the popularity of L3C is branding, says Batey. L3Cs send a message to customers, employees, vendors, and communities that they are businesses for public benefit.
Wake up call
Bill Callison, partner at law firm Faegre Baker Daniels LLP, and Allan Vestal, dean of Drake University Law School, believe the L3C legislation was adopted without difficulty because legislators could painlessly pass it. There was no clear harm to adoption and there was no opposition. But in late 2010, business lawyers around the US who have invested time and energy to understand the LLC structure became aware of the L3C, and concerns ensued.
Their major claims are that the L3C does not work as promoted, does not fit with the LLC model, and could reputationally and otherwise harm LLCs.
Although the intention was to ease and encourage PRIs to L3Cs, in reality it remains troublesome. Foundations still have to ensure that their investment qualifies as a PRI based on their charitable purposes. Callison and Vestal point out that a foundation organized to improve the condition of distressed urban communities would not be able to make a PRI to a suburban charter school that furthers educational purposes. Put differently, a PRI made to an L3C may not qualify as a PRI when made to another L3C. They say, “the L3C form gives rise to the delusion that the form actually does something, and ill-advised people may use it believing that the form enables PRI treatment”.
“Further,” they continue, “not all private foundations are large and well-advised, and it is likely that some smaller foundations will give undue credence to the L3C form. This is particularly harmful since such foundations may run afoul of various tax provisions and, indeed, may endanger their charitable status. Thus, we believe that there is positive harm to unleashing a business form that does not serve its intended purpose. Someone is going to use the L3C improperly and will get burned, and there is no countervailing benefit to the form.”
The Program-Related Investment Promotion Act of 2008 was drafted to create a rebuttable presumption that foundation investments in L3Cs are PRIs, thereby removing the dangers foundations face when making PRIs, but it was not introduced in Congress. Another attempt using the Philanthropic Facilitation Act of 2010 was likewise met with inaction.
Callison and Vestal further warn that private foundation investment in a venture with profit-seeking participants can be “problematic”, and encourage foundations to act with caution before investing in what is fundamentally a business enterprise since the “private benefit” doctrine requires charitable organizations operate exclusively for exempt purposes.
In April 2012, the American Bar Association Business Law Section released a letter opposing legislation for L3Cs on behalf of its LLCs, Partnerships and Unincorporated Entities Committee and Nonprofit Organizations Committee. It urged the rejection of a bill in Minnesota that would introduce the L3C.
The letter states that the L3C is no better than any other business form for receiving PRIs from private foundations, but the L3C implies otherwise and gives the wrong impression. It also states a serious risk of improper “private benefit” transactions, similar to Callison and Vestal’s claims. PRIs made to LLCs would also have this concern, but the letter claims that the L3C status, because of its charitable ties, may be misleading.
The bill was not passed. Batey speculates that concerns are getting through to the states, pointing to the fact that it has been two years since the last state – Rhode Island – passed its L3C legislation in 2011.
All is not lost
Rather than abolish the L3C, some want to see it strengthened.
The main argument against the L3C structure is that it doesn’t work as advertised – it doesn’t facilitate PRIs. But Ron Schultz, senior technical adviser with the IRS, has given new life to promoters.
According to a new paper by Villanova University management professor John Pearce II and attorney and American College professor of taxation Jamie Patrick Hopkins, Schultz said that “at the federal level, no one has really signed off” on whether a private foundation’s investment in an L3C qualifies as a PRI.
Pearce and Hopkins call for more oversight and regulation of L3Cs, pointing to the UK’s community interest company (CIC) as a successful model.
The CIC is UK’s version of the L3C and is a few years older than the L3C. Similar to L3Cs, CICs do not receive tax breaks enjoyed by nonprofits. But unlike L3Cs, CICs build investor confidence and security through transparency, restrictions on dividends, an asset lock, community benefit requirements, and oversight by the Office of the Regulator of CIC – an independent statutory office holder appointed by the Secretary of State for Business Innovation and Skills under the Companies Act 2004 – to determine the eligibility of a CIC, provide guidance, and investigate complaints.
CICs represent a multimillion pound industry for the UK, say Pearce and Hopkins, whereas the lack of government incentives and regulation have inhibited the growth of L3Cs.
It took 11 years since the LLC was first introduced in Wyoming in1977 before the IRS clarified that Wyoming LLCs would be treated as a partnership for tax purposes. That was the turning point for LLCs. Other states began, albeit slowly, to enact legislation to allow the formation of LLCs. In 1990, Colorado and Kansas passed LLC statutes, followed by Virginia, Utah, Texas, and Nevada in 1991. Momentum picked up in 1992 when ten states passed LLC legislation. By the end of 1996, LLC legislation had swept across the US. Nationwide adoption took almost 20 years.
The L3C developed at a much quicker pace. Not counting North Carolina, eight states have enacted L3C legislation within 5 years. But the L3C is being tested and it’s unknown whether it will develop across the US. With the way things are, opponents and proponents can agree that the L3C structure is flawed and PRIs remain unused. Warren Kean, partner of law firm K&L Gates LLP, said that L3Cs in North Carolina “were deleted as unnecessary”.
Under the new North Carolina Limited Liability Company Act, current L3Cs may continue to use the designation unless the company amends its articles of organization to change its name.
“North Carolina’s rejection of L3Cs is a step in the right direction,” said Batey, “and perhaps a harbinger of more to come.”
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