Structuring Social Ventures: The L3C as a Non-Traditional Business Entity
By: B. Ray Dinning, JD, LLM (taxation)
December 7, 2009
The conundrum facing most social entrepreneurs is choosing between several imperfect options when it comes to structuring most social ventures as these ventures typically contain both for-profit and nonprofit elements and there is generally no single “all purpose” entity which completely addresses the myriad of issues in structuring a social venture. However, government, academia and the private sector are responding to this void in enacting new legislation and create new entities to address the needs of social entrepreneurs. The first of these new entities is the L3C or low income limited liability company.
First enacted by Vermont (April 30, 2008), the L3C is rapidly gaining momentum as a social venture entity (my office is receiving calls on a weekly basis from people interested in setting up L3Cs). In 2009, several states have followed Vermont’s lead including: Michigan (January 15, 2009), Wyoming (February 26, 2009), Utah (March 23, 2009), Maine (effective September 12, 2009) and Illinois (signed August 4, 2009 and effective January 1, 2010) as well as the Crow Indian Nation and the Oglala Sioux Tribe. Reportedly, L3C legislation is pending in Georgia, Missouri, Montana, North Carolina, North Dakota, Oregon, Tennessee and Washington.
The L3C Generally:
The L3C is a form of limited liability company (LLC) which possesses many of the same entity characteristics a typical LLC. For example, like a traditional LLC, the L3C is a for-profit business entity. Like a traditional LLC, the L3C offers a flexible ownership and management structure, whereby each member’s management responsibility, ownership interest, financial and tax interests may vary according to individual needs of the social entrepreneur or social venture. Like a traditional LLC, the L3C’s members enjoy limited liability for the actions and debts of the company. Finally, like a traditional LLC, the L3C is generally classified as a “pass-through entity” for federal tax purposes.
In fact, the L3C legislative structure is virtually identical to that of the traditional LLC. Vermont provides that “Organizing the L3C is the same as the regular LLC except that the L3C designation must be indicated when the articles of organization are filed and the name must include the words “L3C”.” See Vermont Secretary of State: Corporations Division.
However, there is one important distinction between the L3C and the LLC. Although both are profit-making entities, the primary purpose of the L3C is not to earn a profit, but to achieve a socially beneficial objective, with profit as a secondary goal. Whereas a traditional LLC may be organized and operated for any lawful business purpose, the L3C must be organized and operated at all times to satisfy the following requirements:
• The company must “significantly further the accomplishment of one or more charitable or educational purposes,” and would not have been formed but for its relationship to the accomplishment of such purpose(s). (For example, Vermont requires that the L3C must satisfy “one or more charitable or educational purposes within the meaning of Section 170(c)(2)(B) of the Internal Revenue Code of 1986”).
• “No significant purpose of the company is the production of income or the appreciation of property” (though the company is permitted to earn a profit). (Vermont adds that “the fact that a person 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 company must not be organized “to accomplish any political or legislative purposes.”
Finally, if the L3C ceases to satisfy any one of these requirements after its formation, it shall cease to be a L3C but shall continue to be a traditional limited liability company under state law.
L3C Requirements Intended to Assist Private Foundations in Funding L3Cs:
These three requirements, which must be specifically contained in the organizational documents of an L3C, are designed to mirror the requirements in the Internal Revenue Code governing the Program-Related Investments legislation for Private Foundations. Thus, the L3C was created and structured to meet the IRS requirements for Private Foundations and to set forth rules which would allow the L3C to qualify as a recipient of Program-Related Investment (hereinafter referred to as a “PRI”).
PRIs are allowable investments made by private foundations (such as the Bill Gates Foundation), usually into for-profit business ventures, to support a charitable project or activity. PRIs may involve significant risk, low return, or both, but these investments are made by foundations (despite the risks) because the PRIs are intended to achieve charitable purposes—and, as a result, receive special treatment under the federal tax law. Federal tax law generally requires private foundations to distribute at least five percent of their assets to social programs every year – or by making socially beneficial “program-related investments” of five percent or more of their assets every year in order to receive their tax benefits.
Prior to the L3C legislation, few private foundations chose to make PRIs, usually because of the difficulty, uncertainty and expense of ensuring that a proposed investment will qualify as a PRI. While the IRS has not ruled on whether investments to L3C’s will qualify as PRIs and has further warned that foundations may not rely on L3C status in determining whether or not an investment qualifies as a PRI, that guidance from the IRS will likely come in 2010. Until such time, a private letter ruling is still required to “guarantee” that an investment by a private foundation in an L3C will qualify as a PRI.
New Financing Options with the L3C:
As a new, non-traditional business entity with both nonprofit and for-profit characteristics, the L3C can access the PRIs of private foundations to access billions of dollars of market-driven capital for social ventures designed to generate a social return on investment as well as a potential for a financial return on investment. Because the L3C allows for a flexible ownership structure and it can have different classes of investors which may include: individuals, nonprofits, for-profits, and even governmental agencies, the L3C is the perfect vehicle for a social venture with both nonprofit and for-profit partners.
Because each of these “partners” in the L3C have different investment goals (social goals, financial goals and even public relations goals with various financial return requirements), then each of these partners in a social venture will likely be willing to assume different levels of financial risk. This is vitally important in the structure of the financing of a social venture – particularly when significant capital is needed in the project.
For example, in a recent Poverty Alleviation and Educational Social Venture that I structured in the hotel and tourism industry, three differing levels (or tranches) of investment were involved in the social venture. Thus, the L3C had three levels of investors to fund and finance the social venture.
The first level (named the junior tier or equity tranche) is the capital that is the most at risk in the social venture. Because the private foundation serves a social purpose with its PRI, this risky capital was provided by the private foundation in the form of PRI. Under this structure, the private foundation in the L3C has the least seniority or last claim on the assets of the social venture upon dissolution or termination and, based on the PRI discussion above, are willing to accept a lower rate of return on their investment. By allowing private foundations to absorb greater risk and receive lower returns, the first level or junior tier of investment from the private foundation provides the foundational capital of the L3C, strengthening its balance sheet and positioning it to attract additional capital from non-charitable individuals or financial investors.
In second level (intermediate tier or mezzanine tranche) of financing for the L3C social venture is designed for profit-seeking investors. This second level, mezzanine tranche was designed to attract socially-conscious individual investors whose were interested in “doing good and making money” and who were willing to forego market-rate financial returns and instead accept part of their return in the form of a social welfare return on investment (which has been referred to as the SROI or social return on investment).
The third level or senior tranche of capital in the tourism social venture was provided by investors that need to generate market rates of return and, as an ancillary benefit, are happy to invest in a project that meets a social need. With the PRI capital and the mezzanine tranche in place, the L3C was able to offer an attractive, market rate of return with a lower level of risk to institutional investors (e.g., banks, pension funds, investment banks and other traditional investors. Thus, the L3C’s investment structure was able to generate substantial new funds to meet the financing needs of this tourism social venture.
General Tax Structure:
While L3Cs are specifically created under state law to further charitable purposes, L3Cs are not tax exempt charitable organizations. Thus, L3Cs are not exempt from paying federal and state taxes and investments in L3Cs are not tax-deductible. L3Cs, like traditional LLCs, are pass-through entities similar to partnerships. So, no federal or state income tax is payable by the L3C itself. Instead, all items of income, loss, deduction and expense are “passed through” the L3C to its individual members who are allocated these tax items in proportion to the members, and are reported on the members’ individual tax returns.
So, while L3Cs are intended to promote and further charitable purposes, the profits generated by the L3C are subject to taxation at the member level on the members individual tax returns. Tax-exempt nonprofits, however, will generally be able to receive profits from an L3C on a tax-free basis as long as the income is related to the charitable purposes of the nonprofit and the profits are used to further charitable purposes.
L3C Advantages in Structuring Social Ventures:
At the end of the day, the L3C is here to stay. While it may take state government, the IRS, private foundations, investors, social entrepreneurs and social ventures time to adjust to and adapt the L3C to its highest and best use, it is still an excellent step forward for structuring social ventures. To summarize, the basic advantages to using the L3C include (but are not limited to):
• The L3C is a defined for-profit entity organized under state laws which is established specifically to promote social ventures and to assist social entrepreneurs in providing a SROI or social return on investment;
• The L3C provides an excellent social joint venture entity for use in projects where there will be for-profit, nonprofit, individual, institutional and government partners where free market principles can apply unburdened by nonprofit governmental and IRS tax exempt organization regulations;
• The L3Cs financial structure allows for the flexible and tiered financing by promoting the creation of a salable product by the structured financial market of banks, investment banks and others;
• The L3C provides an investment vehicle for the PRIs of private foundations where the private foundations may buy ownership shares, make loans to, or otherwise financially invest with the L3C;
• The L3C is easy to set up, easy and flexible to operate and the set-up cost is minimized in comparison to other structural choices for entities and joint ventures;
• If the investment by the private foundation qualifies as a PRI then all or part of that investment will count towards the private foundation’s minimum payout requirement; and
• Finally, the L3C has a flexible structure to promote the investment of private financing and capital to further a social purpose. Through the tiered financing approached discussed herein, the financial horizon of social ventures has been increased significantly.
In conclusion, to a large extent, the field of social enterprise is still in its infancy. While social ventures and social entrepreneurship is growing rapidly, the economic success of this new sector on a significant scale is dependent on innovative, non-traditional legal structures which allow many parties to participate in social ventures. Furthermore, by allowing new, flexible financing structures, the L3C opens up financial markets to private foundations and investors who seek to align their own social values with their investment strategy, and who see social ventures as a means to this end. The legal structure of any social entrepreneur should therefore be driven by the financial and capital structure and business model it intends to pursue for its social venture, rather than some abstract notion of how a social enterprise “should” be structured. And, while there is in fact no single, correct way to structure a social venture from a legal point of view, the L3C is a formidable, potential tool to structuring social ventures. Of course, the market will ultimately determine if the L3C “works” best for them or not. At this early stage, only time will tell.
B Ray Dinning is a US attorney specializing in tax, mergers & acquisitions, social ventures, nonprofit joint ventures and corporate law. Mr. Dinning assisted Professor Michael I. Sanders with the research and drafting of the authoritative legal text in this area called “Joint Ventures Involving Tax Exempt Organizations” by John Wiley & Sons in 1994 with later editions. To contact Mr. Dinning with comments or questions, please call (757) 232-2619.