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L3Cs: A Cure in Search of a Disease

Most social problems now addressed by charities cannot be appropriately addressed by for-profit entities, whether or not those entities pledge to restrict or recycle their profits.

10th Anniversary Reflections

A series of reflective posts by regular Stanford Social Innovation Review bloggers in honor of SSIR’s 10th anniversary.

This is a follow up to Kelly Kleiman’s “L3C Spells Caveat Emptor” blog post.

A puzzling phenomenon in the nonprofit sector is the disconnect between legal scholars and the organized bar on the one hand, and selected lawyers and state legislatures on the other, on the subject of L3Cs: low-profit limited liability corporations. These corporations are designed to be the legal structure underpinning so-called “social venture” or “social entrepreneurial” philanthropy—that is, efforts to combine doing good with doing well by securing some profit while working in fields traditionally served by nonprofits.

New York is the latest state to consider adoption of an L3C statute. But here’s the wrinkle: The American Bar Association Business Law Section has long since made clear its disapproval of this form of business organization, describing it as a solution in search of a problem and a system for concealing transactions that should be utterly transparent. Why, then, do state legislatures continue to toy with these statutes like panhandlers discovering gold?

It would be churlish to suggest that lawyers who specialize in creating these unusual (and, as aforesaid, unnecessary) structures are peddling them to state legislators who want to support charitable activities without spending any actual government money. But the truth of the matter is that most social problems now addressed by charities cannot be appropriately addressed by for-profit entities, whether or not those entities pledge to restrict or recycle their profits.

First of all, any corporation might plow its profits back into the business rather than return them to stockholders: Indeed, that’s a complete description of Apple’s business plan. That doesn’t mean that Apple is engaged in philanthropy, social-venture or otherwise; it just means its profits aren’t distributed. An L3C that plows its profits back into the enterprise isn't therefore unprofitable, or even low-profit; it's just a business with retained earnings.

Second, the IRS has not agreed to classify L3Cs as program-related investments, a status allowing foundations to count their involvement with an organization toward their required distribution of income. And it’s not likely that the IRS will do so. Whether an individual L3C is a program-related investment—or whether any other individual entity is such an investment—is decided on a case-by-case basis resting on the work of the foundation, the work of the not-exempt non-charitable business, and the IRS’s discretion. So although enterprising L3C lawyers may suggest otherwise, nothing about the form benefits foundations—meaning nothing about the form allows organizations working in the public interest to attract additional funding.

Look: If the work that charities do—feeding the hungry, housing the homeless, and so on—were profitable, someone would already be doing it. That’s the beauty of capitalism: Profitable niches get filled. But capitalism does not in any way guarantee that every niche is profitable, nor does it answer the question of what niches need to be filled regardless of profit. The L3C doesn’t answer that question either, and every minute a legislature devotes to pretending that it does is a minute that it could be using to figure out how to fill those essential niches.

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COMMENTS

  • Christian Smith-Socaris's avatar

    BY Christian Smith-Socaris

    ON March 5, 2013 11:35 AM

    I think you ignore a small but growing reason for going with an L3C - to be relieved of the fiduciary responsibility of maximizing profit.  Much of what ills the business world when it comes to being a “responsible” company is the perverse dynamic where maximizing shareholder value becomes the entire purpose of the business.  Many businesses that do not fill some need currently only filled by charitable institutions are being created by people who want to make decisions about how to operate the business and what to do with profits that include non-financial considerations.  An L3C opens up the space for these companies.

  • There’s a strong debate, though, over whether that fiduciary duty to maximize profit exists to the extent that L3C proponents believe. If that were true, would any publicly traded company ever run a corporate giving program, or establish a corporate foundation? But those things happen all the time, and the company is not taken to court as a result. See the (very vigorous) arguments over the Ben and Jerry’s article that was in SSIR not long ago.

  • Steve Wernet's avatar

    BY Steve Wernet

    ON March 8, 2013 02:02 PM

    An interesting blog (and its predecessor is equally as interesting). I agree it raises the ‘storm warnings’ pertaining to L3Cs. I do not see the last paragraph being a logical conclusion evolving from the preceding material. Preferred organization form – L3C or not - has nothing to do with capitalism. It has everything to do with the will of ‘the community’ – if ‘the community’ wants to address a problem then it decides to invest in a solution. Direct allocation of dollars as well as tax incentives are some of those solutions. The community will also stipulate preferred organization form for addressing a common issue. Every solution assumes a position on ‘start-up capital’, risk, reward and return. Traditionally individuals provide these resources for ventures in the marketplace with ‘the profit’ going to those assuming the risk; volunteer labor and tax advantage is provided by ‘the community’ to those ‘risky ventures’ addressing common problems that are unlikely or unable to survive in the marketplace but are seen as necessary by the community, and thus ‘the profit’ returns to the community. Rather than being ‘the beauty of capitalism’ this is ‘the beauty of community’. To the cynic, the L3C might be “the worst” of both worlds – the risk is borne by the community or investor and the return goes to ‘the social entrepreneur’.

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