L3Cs are designed to meet the federal tax law’s requirements for attracting social purpose investments from private foundations.
In early August 2009, Illinois became the eighth jurisdiction to recognize “low-profit limited liability companies” or “L3Cs”—hybrid entities that mix elements of for-profit and not-for-profit organizations—as separate entities that may proliferate socially beneficial investments from private foundations. Nearly a year and a half after Vermont first recognized L3Cs as a legal business entity, Illinois joins Michigan, Wyoming, Utah, Maine, the Crow Nation and the Oglala Sioux Tribe as jurisdictions recognizing the official legal structure of L3Cs.
L3Cs Are Not Tax-Exempt, But Are Subject to Similar State Law Restrictions on Their Activities
On August 4, 2009, Illinois Governor Pat Quinn signed Public Act 96-0126 into law which amends the Limited Liability Company Act (the Act) to allow for the formation of L3Cs. Click here for a copy of the Act .
While an L3C is a for-profit limited liability company (LLC) whose purpose is socially motivated, an L3C is not a tax-exempt charity under the federal tax laws, unless it otherwise satisfies the requirements of Section 501(c)(3) of the Internal Revenue Code (the Code). In Illinois, as in other jurisdictions, an L3C must meet the following requirements:
- The L3C must significantly further the accomplishment of one or more charitable or educational purposes within the meaning of the Code and must affirm that it would not have been formed but for the organization’s relationship to the accomplishment of its charitable or educational purposes.
- The L3C may not have as its significant purpose the production of income or the appreciation of property.
- The L3C may not seek to accomplish political or legislative purposes.
As discussed below, these three characteristics of L3Cs mirror the Program-Related Investment (PRI) requirements under the federal tax laws. See Section 4944 of the Code and Section 53.4944-3(a)(1)of the Treasury Regulations. The PRI rules allow private foundations to invest in business entities without triggering penalties under the Code’s jeopardy investments provisions.
Under the Illinois provision, organizations currently formed as LLCs may amend their articles of organization to establish themselves as L3Cs by electing a charitable or educational business purpose and complying with the other L3C formation requirements. The Act also works the other way: if an L3C no longer complies with the Act’s requirements, it must amend its articles of organization to become a traditional LLC.
As a new entity, L3Cs would have various state and federal reporting requirements. Federal and state tax filing requirements would depend on whether the L3C elects to be treated for tax purposes as a corporation or a partnership. Moreover, under the Act, which references the Charitable Trust Act, the Illinois Attorney General has regulatory authority over L3Cs. Because the solicitation statutes are not implicated, L3Cs have no annual audit requirement. Nonetheless, L3Cs must register with the Attorney General’s Charitable Trust Bureau and file annual reports.
Although the Act’s effective date is January 1, 2010, the Illinois Secretary of State is accepting articles of organization from L3Cs.
L3Cs Proliferate Private Foundation Investments
L3Cs provide a mechanism for injecting additional funds into businesses that have a primary goal of achieving a socially beneficial purpose by permitting a capital structure that may include various tiers of investors, who have varied types of investments, with varied terms, and with varied rights to distributions. For instance, private foundations, which may accept lower financial returns, could make up one tranche of investment while private-equity investors, which may seek higher financial returns, make up another tranche.
Proponents of L3Cs believe these entities may help struggling newspapers, broadband service in rural areas and health care organizations in economically depressed communities. While the L3C structure permits private foundations to act as quasi-venture capitalists through PRI, these investments must include some socially beneficial element.
Federal Recognition of L3Cs
The federal government is not sure what to do with L3C entities. At a recent conference, Ron Shultz, a senior technical adviser in the Internal Revenue Service’s (IRS’s) Tax Exempt and Government Entities Division, shared his concerns and urged private foundations to exercise caution when considering investments in L3Cs. Shultz explained that “[a]t the federal level, no one has really signed off on [L3Cs] yet.” Thus, private foundation investments in L3Cs may be “premature” as “the jeopardy investment issue is [not] a slam dunk.”
In response, L3C supporters highlight numerous IRS authorities that permit private foundations to work with for-profit LLCs and corporations to further their charitable missions. Those authorities conclude that private foundation investments in for-profit entities, including LLCs, qualify as PRI.
If an L3C does not meet the Code’s PRI requirements, the IRS could impose an excise tax of 10 percent on the private foundation’s investments, which is generally measured based on the amount invested for each year of the investment. Further, the IRS may assess a 10 percent penalty against a foundation’s manager who knowingly, willfully and without reasonable cause participated in a jeopardy investment. Additional excise taxes may apply if these investments are not timely unwound or removed.
If investments in L3Cs do meet the PRI requirements, then, unlike the foundation’s traditional portfolio investments, these investments would be treated as a charitable use of the private foundation’s asset. Although private foundations must continue to exercise expenditure responsibility, PRI investments in an L3C would be qualified distributions. This means that private foundations could include PRI in L3Cs toward their annual 5 percent minimum distribution.
The only way to be certain of PRI treatment, currently, is for a private foundation to seek a private ruling from the IRS. However, the private letter ruling process consumes both time and money. The Program-Related Investment Promotion Act of 2009, proposed federal legislation, would simplify the qualification process for L3Cs with the IRS. L3Cs, instead of private foundations, would seek IRS recognition of their ability to receive PRI in a fashion similar to the IRS’s procedures for recognizing the tax exemption of charitable entities.
In addition to jeopardy investment concerns, private foundations must also be wary of potential excise taxes on “taxable expenditures,” as defined under Section 4945 of the Code. Unless the private foundation exercises “expenditure responsibility,” investments in L3Cs likely would be taxable expenditures whether or not those investments constitute PRI. For this reason, the results are potentially much worse for private foundations unless they implement specific oversight procedures.
As an entity, L3Cs are still in their formation stage. By being an early adopter, Illinois likely hopes to attract more investment from private foundations, which, in turn, could generate more taxable revenue for the state’s coffers, presuming that socially oriented businesses prosper. While L3Cs are gaining popularity, private foundations must carefully evaluate both their formation and support of L3Cs. Ultimately Congress or the IRS—which currently controls the process for approving PRI—will determine whether L3Cs advance beyond their adolescence. If those actors institute a presumption that investments in L3Cs constitute PRI, then many more than eight jurisdictions likely will adopt L3C legislation.