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Commentary: L3C businesses become popular despite criticism

Missouri Bar committee has opposed the ‘fad’

Everyone is familiar with the proverb “give a man a fish and feed him for a day, but teach a man to fish and you feed him for a lifetime.” Although the origins of this quote are debatable, its wisdom is unquestionable — a long-term solution beats the short fix any time. If you can do more with limited resources, why not?

Tim Jones (R-Eureka)

Tim Jones

The same concept can be applied to nonprofit private foundations. By law, foundations must distribute at least 5 percent of their assets each year or they risk losing their tax-exempt status. Typically, foundations meet this requirement by giving away money through monetary grants. However, another much less common, but potentially more impactful, approach is for a foundation to make “program-related investments” related to the foundation’s tax-exempt purpose. Internal Revenue Service regulations require that such investments be made for a charitable purpose, do not support lobbying or political activities, and do not have the production of income as a significant purpose.

Examples of PRIs include low-interest loans, guaranties and even equity investments, including ownership interests in a new specialized form of limited liability company called a

Randy Parham

Randy Parham

“limited profit limited liability company” or an “L3C.” Unlike grants, PRIs offer the potential for a charitable foundation to receive a return on their investment that can be reused in future years to continue serving the foundation’s tax-exempt purpose.

David Baker, with Giving Design Group Inc., specializes in nonprofit law and explains that “the primary benefit from a private foundation perspective is that they aren’t giving away the farm — they are just ‘putting the farm at risk’ with the opportunity/objective for a societal return and possible investment return. Grants give away the farm — especially in a down market cycle.” PRIs thus increase the amount of resources available to advance social causes. In addition, under IRS regulations, no portion of a foundation investment in a PRI is included in determining the foundation’s assets for purposes of the 5 percent payout requirement.

So using PRIs is a longer-term approach to meeting a foundation’s tax-exempt objectives, and the enactment of L3C legislation around the country provides hope that foundations will finally begin to embrace the value of PRIs.

Although the opportunity to invest in PRIs has been an option for over 40 years, foundations have been reluctant to do so because of the perceived risks involved. If the IRS determines that an investment does not in fact meet the requirements under its regulations, it may characterize such investment instead as a “jeopardizing investment” and impose an excise tax on the foundation under Section 4944(a) of the Internal Revenue Code (the “Code”). Under IRS Regulation §53.4944-1(a)(2), a jeopardizing investment occurs when the foundation’s managers fail to exercise ordinary business care and prudence, as determined on an investment-by-investment basis. Two alternative ways to avoid this risk of making a jeopardizing investment are for the foundation 1) to obtain an opinion of counsel that the investment qualifies as a PRI, or 2) to seek a private letter ruling from the IRS that it is a PRI. Unfortunately, both strategies are time-consuming and expensive, both disadvantages that have historically outweighed the perceived benefits of making a PRI.

However, PRIs may become more attractive to foundations based upon recent legislative developments. First, several states have enacted L3C legislation that is intended to make it easier for foundations to identify appropriate investments that meet the PRI requirements. Secondly, last year the IRS issued temporary Regulations that provide better guidance on what investments qualify as PRIs.

An L3C is a special type of limited liability company specifically formed under state law to qualify as a PRI. While L3Cs provide the same limited liability protection and flexibility in governance and tax-planning as other LLCs, their state legislation requires that the L3C’s articles of organization mirror the qualifications for PRIs under the Code and the IRS regulations. Specifically  in Illinois, for example, to qualify a company as an L3C, it must “at all times significantly further the accomplishment of one or more charitable or educational purposes” under the Code. The company must also indicate in its Articles of Organization that it intends to qualify as a limited profit LLC and must state that i) no significant purpose of the company is the production of income or the appreciation of property, and ii) no purpose of the company is to accomplish one or more political or legislative purposes under the Code. Note, however, that the fact that an entity produces significant income or capital appreciation shall not, in the absence of other factors, be conclusive evidence of a significant purpose involving the production of income or the appreciation of property. The ability to make a profit is one of the characteristics that sets L3Cs apart from traditional nonprofit 501(c)(3)s.

L3Cs are less complicated and more flexible than 501(c)(3)s, and allow the owners to maintain more control, but they do not qualify as public charities and donations to them do not qualify for tax deductibility. The intent of the promoters in establishing this new form of business model is to make it easier for foundations to identify companies that qualify as PRIs without the time and expense of obtaining a private letter ruling or an opinion of counsel. Baker warns, however, that the “make it easier” purpose has not been completely and explicitly blessed by the IRS. “It is not a safe harbor for the private foundation,” and private foundation managers must still perform appropriate due diligence to confirm that the L3C qualifies as a PRI.

Since the first adoption in 2008 of legislation in Vermont formally recognizing L3Cs, a total of nine states and two tribes have done so. As a result, in a very short time, approximately 850 L3Cs have been formed across the country. Part of this surge in L3C formations could be linked to the second major legislative development, the IRS’s issuance of temporary Regulation 144267-11, enacted on May 21, 2012, which provide additional guidance on what constitutes PRIs. Under T-Regulation 144267-11, the Internal Revenue Service provided nine new examples of what qualifies as a PRI. In addition, Regulation 144267-11 sets forth some basic principles for establishing PRIs. In addition to the nine states that have enacted L3C legislation, the Council on Foundations, Americans for Community Development reports that such legislation has been proposed but not yet enacted in 26 additional states.

Although L3C legislation has been proposed in Missouri over the past several years, it has not gained support and was not reintroduced during the 2013 session. Also, discussions at the federal level about ways to simplify the process in obtaining IRS approval of an investment in a proposed PRI. The Philanthropic Facilitation Act of 2010, would have amended IRC §4944 to provide a rebuttable presumption that investing in an L3C would qualify as a PRI. The PFA would also have created a voluntary compliance procedure for L3Cs, but Congress failed to act on the PFA.

L3Cs have been organized for a number of activities, including a charter school, a child care center, a company aimed at curing disease, a historic preservation group, a social service organization, a faith-based program, a work-force development training program, a venture that provides employment or economic growth opportunities to disadvantaged minority groups in deteriorated area and a venture that provides low-interest loans and affordable credit to disadvantaged persons and business owners. One proposed strategy is for a startup L3C to use private foundation money as a “tranche financing mechanism,” In such a strategy, the private foundation may agree to accept a below-market rate of return in order to encourage other private investors to invest and obtain a higher rate for making a risky investment. In theory, the early in-flow of foundation money will provide needed capital and encourage private investment. The foundation that makes such an investment gains a higher “social return” in exchange for a lower “monetary return”.

While the concept of L3Cs may be progressive and worthy, it is not without controversy.

Numerous state and national organizations have publicly opposed enactment of L3C legislation. In 2010, the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities Section of Business Law adopted a Resolution Against Enactment of L3C legislation, arguing that “the promotion of L3C legislation has led to the incorrect assumptions that: (i) absent such legislation, it is not possible to structure an LLC as an appropriate vehicle for the receipt of a PRI, (ii) using the L3C structure somehow facilitates the PRI process, and (iii) structuring an enterprise to receive PRIs can and should be simple and straightforward.”

Locally, in 2010 when Missouri State Rep. Rachael Storch introduced L3C legislation as House Bill 1890, The Missouri Bar’s Executive Committee expressed its disapproval in a memorandum to her declaring that the “concept appears to be a fad that will provide no real benefit but will introduce junk provisions into the LLC law” and feared that it would “enable unethical or fraudulent activities by providing a guise of legitimacy.”

Other critics fear that L3Cs, once they catch on, will become too successful and harm the traditional nonprofit sector. As the economy has been slow to recover from the recent recession, tax-exempt charities have found it harder to keep their contributions up. Many of them rely heavily on foundation grants, and L3Cs may be in a better position to compete for foundation dollars.

Whether persuaded by the public criticism of L3Cs or simply tied to traditional concerns about PRI funding, private foundations have yet to embrace the L3C concept. There are a number of successful L3C organizations, but they have succeeded without receiving the private foundation support that was anticipated with enactment of L3C legislation. Elizabeth Schmidt, associate professor at Vermont Law School, surveyed all of the L3Cs formed in Vermont between 2008 and 2010.

Surprisingly, not one of the L3Cs organized in Vermont during that time had received any investment from private foundations. The study did not conclude why there has been little success in attracting foundation investment, but the entrepreneurs were not discouraged by these results. To these business owners, the L3C form of entity is a “hybrid business form” that better represents such owner’s desire to make a positive social impact with their ventures.

With the widespread criticism for L3C legislation and the lack of data to support a conclusion that such legislation encourages PRI investing, it is surprising that the popularity of this new hybrid business form has continued to grow. Yet in the first half of 2013 alone, approximately 100 new L3Cs have been formed nationwide.

Perhaps as their numbers grow, L3Cs as a group will become recognized and help foundations make more out of their limited resources.

Tim Jones is Missouri’s speaker of the House and a managing member at the law firm of DosterUllom, in Chesterfield, and Randy Parham is in the firm’s business, real estate and estate planning departments.