Philanthropy
“L3C” Spells “Caveat Emptor”
The notion of L3Cs is that they’re a vehicle for doing well by doing good and therefore an improvement over the typical nonprofit structure.
Here’s something strange: a concept thrown around routinely and casually in conversations among nonprofits and philanthropies is simultaneously the subject of fierce debate and sometime disapproval by the Internal Revenue Service, a committee of the American Bar Association, and other experts. What is going on?
The notion of Low Profit Limited Liability Corporations (L3Cs, for short) is that they’re a vehicle for doing well by doing good and therefore an improvement over the typical nonprofit structure. L3Cs are permitted to earn profits, but proponents claim that their praiseworthy intentions—to end hunger or provide clean water or whatever—make those who lend to them eligible for the special tax benefits attached to program-related investments. In other words, this is a legal structure presented as a technique for gaining access to capital (always a struggle for nonprofits) by providing a tax benefit to lenders.
Of course, foundations already get a tax benefit for program-related investments in regular nonprofits, so what, exactly, is the appeal? In theory, foundations might be more interested in program-related investments that generate a reliable flow of capital (in the form of profit) than in program-related investments that generate nothing but additional nonprofit programs and services. Likewise in theory, regular venture capitalists outside of foundations will be more interested in making investments in profit-making entities than in pure nonprofits. This—the notion goes—will increase the amount of capital available to support general good-guy behavior.
However, a number of scholars and lawyers (Daniel Kleinberger of William Mitchell College of Law prominent among them) see the L3C as, at best, redundant and, at worst, an invitation to fraud. They point out that regular limited liability corporations can be organized for any purpose, including public-spirited and low-profit ones. They point out that the IRS has not yet issued (and does not seemed inclined to create) a rule awarding automatic program-related investment status to any investment in an L3C. So anyone who invests in an L3C on the basis that it provides a higher return than a regular nonprofit with the same tax benefits will find out to his/her sorrow that this is not the case.
What strikes me as peculiar, though, is that in the many discussions I’ve heard and read about L3Cs, only one mention (specifically, Professor Kleinberger’s Nonprofit Quarterly article) has ever surfaced of this opposition from the bar and Federal regulators. Not until my tax lawyer Stuart Levine asked about the (successful) efforts in Illinois to create L3Cs did I realize there was anything controversial about the phenomenon. After bringing me up to speed, Levine wisely said:
“L3Cs don’t work unless there is a change in federal tax law. In other words, L3Cs are a little like the wonder drug for which there is no known disease. L3Cs raise difficult issues of fiduciary duty and the inherent conflict between ‘charitable’ purposes and ‘business’ purposes. At the least, these conflicts cannot be dealt with via a quick-fix state statute.”
Doubtless I space out on frequent occasions and miss aspects of what’s said or done in the sector. But I suspect there’s also a significant disconnect between what nonprofit executives and L3C promoters expect and describe and what lawyers and regulators understand.
So if you’re considering investment in an L3C, be the aware buyer of whom you’ve heard.
Kelly Kleiman, who blogs as The Nonprofiteer, is principal of NFP Consulting, which provides strategic planning, Board development and fundraising advice to charities and philanthropies. She is also a lawyer and freelance journalist whose reportage and essays about social justice, the arts, and woman’s issues have appeared in the Chicago pages of the New York Times as well as in the Wall Street Journal, Washington Post, Christian Science Monitor and other dailies; in magazines including In These Times and Chicago Philanthropy; in the Alternative Press; on Chicago Public Radio and the BBC; and on websites including The Huffington Post.
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COMMENTS
BY Caryn Capriccioso
ON March 17, 2011 01:24 PM
I’m wondering who would “invest in an L3C on the basis that it provides a higher return than a regular nonprofit with the same tax benefits?” An investment in an L3C is an investment, not a charitable donation.
BY Robert Lang
ON March 19, 2011 11:18 AM
SSIR claims to be a respected mainstream publication and Kelly Kleiman claims to be a lawyer and a journalist with some credentials yet she obviously failed to look at either our http://americansforcommunitydevelopment.org/ website or http://www.intersectorl3c.com/ website. Both sites contain a ton of stuff that contradicts everything she says. We even have a letter from the Section of Taxation of the ABA which in the opinion of Marc Lane, another respected authority on the L3C, “in formal comments to the Commissioner of Internal Revenue last year, went out of its way to opine that the L3C certainly has no lesser standing as a PRI recipient than any other LLC.” As a lawyer she should know the L3C is a variant form of LLC. She never talked to anyone at ACD, to Marc, or anyone at Intersector. What kind of person would claim to be a journalist and do such poor research?What does it say about the Stanford Social Innovation Review that it would publish such rubbish without any kind of fact checking.? They do not even deserve to claim to be a credible trade publication. Are there no adults left in journalism?
By the way her list of opponents is very short and I will donate $1000 to her favorite charity if she can post post any official statement by the IRS which reflects disapproval of the L3C. If she cannot I think she should do the came for me.In so far as attributing a wild list of statements to L3C supporters we have never said anything like this and as the creator of the L3C and founder of ACD I think I speak for all accredited supporters.
I hope she will come to the Americans for Community Development Conference in June where she can meet people like Rob Wexler, one of the authors of the ABA letter to the IRS, and do some real research. Where do I get a job that allows me to sit at the kitchen table and spout off without caring whether or not what I say is the truth or who I hurt?
Hold June 6th - 7th 2011 for the first annual Americans for Community Development Conference entitled The “L3C A to Z” to be held in Evanston (Chicago) Illinois. Our co-producer for this conference is the Levy Entrepreneurship Center of the Kellogg School of Management at Northwestern University.
This Inaugural Conference hosted by ACD will be the first ever of its kind. To this point, there has not been a conference solely dedicated to the education and networking of professionals dealing with the L3C. This conference will set the tone for further professional development opportunities held by ACD and will be the most comprehensive opportunity to understand the aspects of the L3C.
More information shortly on the ACD website. http://americansforcommunitydevelopment.org/
BY Rob Bryan, MBA, MPM.
ON March 19, 2011 02:59 PM
I see in the URL that this is an opinion piece but I don’t see it anywhere on the page. So if you’re a reader be aware that this is a poorly researched opinion piece. There are a number of experts on the subject, and Kelly did not speak with them.
The “expert” she does link to, (the “other experts” link) Carter Bishop’s abstract, also contains factual errors. For example it says regarding PRIs “To date that [PRIs] requires advance federal tax authority approval and it is unlikely the L3C statutory restrictions will serve as a proxy for federal approval”. That is wrong. PRIs do not require advance approval.
Foundations MAY seek prior approval in a private letter ruling but David Chernoff, Associate General Counsel for the John D. and Catherine T. MacArthur Foundation, writes he has sought private letter rulings for only 3 out of the more than 250 PRIs he has handled, the average exceeding $1m. The low priority reporting location on IRS form 990PF further illustrates the lack of problems associated with PRIs.
Bishop also doesn’t seem understand private inurement. Private Foundations have been making PRIs into for profit corporations for 40 years. So why is it suddenly a problem? With a business entity that actually has a statutory required charitable mission? It’s not. After 40 years of doing it, it is not “open to question”.
Kelly is right when she writes “IRS has not yet issued (and does not seemed inclined to create) a rule awarding automatic program-related investment status to any investment in an L3C.” They don’t seem inclined to because that is not their purview, that belongs in congress, hence the Philanthropic Facilitation Act Proposal. You can find it on http://americansforcommunitydevelopment.org/
I’m not an attorney, I’m someone doing social innovation, who has taken the time to get my facts right. But here are the comments of a really excellent attorney, who is an expert on the L3C, with his permission.
*************
Marc Lane • I endorse the author’s advice to proceed cautiously before selecting the L3C over other forms of entity, but caution should always be the watchword in any choice-of-entity decision. The tax, funding, governance, regulatory, securities and other relevant variables require careful consideration, especially since attorneys and entrepreneurs have more choices—both traditional and emerging (including the L3C)—than ever before.
However, the author’s skepticism, which I regard as healthy, betrays a fundamental misunderstanding of the L3C:
To correct the record:
1. The author reports “fierce debate and sometime disapproval” by IRS and an American Bar Association committee. In reality, the Service has issued no adverse opionion on the L3C and has historically—and without controversy—approved program-related investments in limited liability companies, of which the L3C is merely a subset (in fact, a subset whose articles of organization track the statutory requirements of program-related investments). As for the ABA, lawyers are not monolithic. (No surprise.) While one committee of the ABA has raised questions about the desirability of the L3C, the ABA’s Section of Taxation, in formal comments to the Commissioner of Internal Revenue last year, went out of its way to opine that the L3C certainly has no lesser standing as a PRI recipient than any other LLC.
1. The author reports that the L3C’s proponents claim that PRI lenders to L3Cs are eligible for special tax treatment. Not so. I’ve been critical of those L3C evangelists who oversell its features, but I’ve not heard any claim that the L3C, itself a taxable entity, offers tax shelter, and such a claim would be irresponsible.
1. The author suggests that the L3C’s appeal is based on an assumption that foundations are more interested in profits than programs. Such an assumption would be baseless and would fly in the face of foundation managers’ obligations to be responsible stewards of the assets in their care. To the contrary, the appeal of the PRI, and hence of the L3C, is program-driven. Contrasted with a grant, an expense gone forever upon distribution, a PRI is an investment maintained on the balance sheet of the foundation which may be recovered (with earnings) and redeployed for charitable purposes over and over again. It is this multiplier effect, optimizing foundation resources, which is particularly compelling to prudent foundation managers.
1. The author describes the L3C as “redundant,” which I take to mean “unnecessary,” since a traditional LLC may do much the same job. Not so: (a) The L3C’s statutory status imposes on its manager the duty to honor PRI requirements; while a traditional LLC’s operating agreement can do the same, a breach of contract is a lesser legal “sin” than a statutory violation. (b) The L3C suffix facilitates regulatory scrutiny, giving greater comfort to foundations that the venture will be accountable and transparent. (c) The fact that the L3C’s articles of organization are constrained as to purpose can jump-start the foundation’s due diligence process. (d) Capital markets are already speaking the language of the L3C, with private investors beginning to recognize this “new” opportunity and beginning to understand it. (e) Foundations are being sensitized to the opportunities for empowerment the L3C offers them, opportunities new to many of them.(f) L3Cs gain a branding and positioning advantage with customers, funders and other counter-parties unavailable to traditional LLCs.
1. The author sees the L3C as an “invitation to fraud.” One might say the same about the corporation. The form itself is neither virtuous nor vicious. It is up to those who adopt it to use it for its intended purposes or to abuse it.
1. The L3C presents fiduciary issues. Truth be told, it signals to all its stakeholders that their discrete objectives need to be harmonized, and indeed that’s what seems to happen, early and effectively.
Marc (Marc J. Lane, http://www.marcjlane.com)
There is also an excellent Linked In discussion group- L3C Connect. If you want to ask questions about it, and get the real story, please stop by. Tell em I sent you…
BY Mazarine Treyz, Author of The Wild Woman's Guide t
ON March 21, 2011 10:33 AM
Dear Kelly,
L3Cs = LLCS + 501 c3s mix the models of nonprofit and for profit. They are not really the answer. But people are trying to see how they can get venture capitalists to give to their nonprofits.
What has been happening is that people at the top have been getting richer and richer until 400 people now in the US have, combined, over half the wealth of the other half combined. It seems that if we want nonprofits to thrive, we have to find a way to talk to these “super-rich” and get them to spread their wealth around a bit with venture capital. What do you think?
I have a post on trends in nonprofits and L3Cs here and would love to get your thoughts on it:
http://www.wildwomanfundraising.com/learned-texas-nonprofit-sector
Peace,
Mazarine
BY Kelly Kleiman
ON March 21, 2011 07:27 PM
@Caryn: I should have written, ” . . . provides a higher return than [investment in] a regular nonprofit with the same tax benefits.” That is, the comparison is between PRIs made to nonprofits [e.g. to support their launching of social enterprises] and those made to L3Cs. Sorry for the confusion.
BY Kelly Kleiman
ON March 21, 2011 07:31 PM
@Robert Lang: I’m grateful to know about both the sites you mention, and to hear your opinion about L3Cs; but the fact that I didn’t solicit your opinion in advance of writing this piece means only that I focused my research elsewhere, specifically on Professor Kleinberger’s comprehensive critique of L3Cs. You’re correct that L3Cs are no less appropriate vehicles for PRIs than any other LLC; my point was that they don’t seem to be more appropriate, either.
There’s really no need to attack the credentials of those who disagree with you. L3Cs are indeed controversial, as the ABA committee statement demonstrates, but we should be able to discuss them civilly.
BY Kelly Kleiman
ON March 21, 2011 07:39 PM
@ Rob Bryan: I’m familiar with Mr. Lane’s work and in fact look forward to discussing these issues face to face with him at a meeting on the subject sponsored by Chicago’s Philanthropy Club. The fact that my choice of experts isn’t the same as yours proves only that this is a field in which a breadth of opinion is acknowledged. And yes, my blog posting was an opinion piece; I didn’t think there was any need to highlight that fact, which was patently clear.
I also note that Mr. Lane’s critique of my opinion is far less heated than yours, and in fact acknowledges many of the concerns I raise. My concern is precisely for those in the charitable trenches, who don’t spend all their time reading law review articles and ABA Committee resolutions and therefore may be unaware that there’s anything to be concerned about with respect to L3Cs. Those emptors stand to benefit from my caveat.
BY Kelly Kleiman
ON March 21, 2011 07:42 PM
@Mazarine: Your point is well-taken that we in the charitable sector grow more and more desperate to separate the super-rich from their money on behalf of those we serve. But a far simpler technique for doing that is to raise taxes, and that’s where I think our legislative advocacy efforts belong—not in the creation of a superfluous form of business organization.
I look forward to having the opportunity to read your piece, and will send along any comments I might have that could be useful.