Published November 1, 2009 | November 2009 issue
Proper adoption and use of the low-profit limited liability company (L3C) as legislation and a form of choice in the right circumstances depend on appropriate understanding of its features. Unfortunately, but not surprisingly given the newness of the form, misunderstanding of certain of the L3C's core features has inhibited its broader adoption and use. This essay is an attempt, within limited space, to present certain of those features and in doing so address some criticisms and correct some misapplications. To that end, we first present the essential framework of the L3C and explain two of its critical characteristics. We then consider the effect of success and converting to for-profit status, the L3C's innovation in fiduciary duties and enforcement, and how foundations may (but need not) be part of this new form.
The L3C statutes adapt and broaden a strategy that Congress enacted 40 years ago and that the Internal Revenue Service (IRS) has regularly reaffirmed. The strategy, called "program-related investments" (PRIs), allows private foundations to engage in otherwise prohibited profit-related transactions that meet three conditions, the first two of which we discuss below. The third, which is not as relevant for this essay, is that an L3C's purpose may not be lobbying or political activity.
The first relevant condition mandates that the L3C's primary purpose be exempt under the Internal Revenue Code—that is, be charitable, educational, scientific research, etc. Examples include offering specialized training programs, combating community deterioration, assisting in economic revitalization, or commercializing results of certain scientific research. Note that so-called "social" benefit is not enough. Creating jobs, expanding the tax base, spurring economic growth, and other benefits that for-profit enterprises contribute to society would not satisfy this condition unless in a charitable, exempt context as discussed above.
Second, no significant purpose of the L3C can be pursuing and distributing profit. Contrary to some assertions and consistent with longstanding guidance from the IRS regarding PRIs, this condition does not require that profit be "low" or that L3Cs cannot make and distribute profit that may reach market or even above-market levels in certain instances. Instead, this condition recognizes that their primarily charitable nature makes L3Cs financially risky, as demonstrated by an unwillingness of participants to engage fully on market terms.
If the enterprise consistently generates market or better returns or if the market changes, an L3C may be at risk of profit becoming a significant purpose—not a bad outcome, considering the charitable purposes being fulfilled along the way. Like the PRI, the L3C permits such success by allowing the L3C to convert to for-profit status. For instance, an L3C working to revitalize an economically distressed area should be able to convert if the area is no longer distressed. Or, an L3C that is developing a treatment for a rare medical condition for which there is no ready commercial market should be able to convert if broader commercial applications are discovered. An inability to evolve and then convert, or impediments to doing so, has the paradoxical and irrational effect of perpetuating the charitable status quo targeted for alleviation—in effect, an institutional bias toward failure.
Some have complained that allowing conversion to for-profit status inappropriately allows people to profit from charitable purposes. Such complaints are unfounded for at least two reasons, in addition to the paradox noted above. First, investors have put their capital at risk and, while prepared to endure market losses, presumably intend some return. Investors have not made a gift or grant and no charitable deduction is available, although a PRI by a foundation may count toward its payout obligation. Moreover, distributions to nonexempt investors are taxed at the investor rate. Second, the IRS has long recognized the validity of combining charitable purpose and economic gain through its support of PRIs, joint ventures between for-profit and charitable entities, and for-profit companies operating in realms traditionally deemed charitable (e.g., health care and education). As such, allowing the L3C to evolve to for-profit status should be encouraged when undertaken in good faith and consistent with fiduciary duties.
One of the L3C's most significant innovations is the clarity it provides to fiduciary duties in an enterprise that embraces charitable purpose and permits profit distribution. Notwithstanding constituency statutes, for-profits ultimately seek to maximize owner value, although charitable or social tactics may be deployed for doing so. Exempt organizations must exclusively honor charitable, exempt purposes, which allows them to earn profit but not distribute it. The L3C's properly ordered priorities require that charitable, exempt purposes have primacy and that economic gain to investors, while permitted, may not be a significant purpose. If there is irreconcilable conflict between these principles, the L3C's managers must choose charity as a fiduciary matter.
The L3C provides a nontraditional ordering of these priorities under a fiduciary umbrella, instead of relying solely on limited rights, claims, and remedies available under contract. Moreover, unlike limited liability company statutes that generally permit broad waiver and modification of fiduciary duties, the ordering of L3C priorities cannot be waived or modified. Of course, there also must be practical means for ensuring accountability to these priorities.
Those who may do so could include other members and managers (even if in the minority), creditors, and state attorneys general. Among causes of action are (1) civil and criminal prosecution for fraud in misrepresentations made in raising capital; (2) the doctrine of ultra vires acts; and (3) piercing the veil of limited liability for those who willfully or knowingly fail to adhere to the priorities or are grossly negligent in doing so. Remedies may include disgorging profits, covering expenses, potential punitive damages, and possibly even excise tax liability under certain circumstances. These strategies are not infallible, but they are more expansive than those available under traditional contract law.
Returning full-circle to the foundation tool that inspired the L3C, the properly ordered fiduciary priorities, notably primacy of charitable purpose, can help foundations that make a PRI in an L3C satisfy certain procedural obligations regarding due diligence and accountability in part because charitability should be inherent and enforcement opportunities should be broader. Due diligence on other issues may still be appropriate and a foundation may still want certain contractual rights but, contrary to some suggestions, it is not necessary (and may be undesirable or even unwise) that a foundation control the L3C's governance or operations.
Finally, there is no requirement that L3Cs have foundations involved. In fact, most L3Cs are likely to be without such involvement, and the L3C's nonfoundation-specific benefits should still apply without regard to such involvement. Consequently, critiques of the L3C premised on foundation involvement understate the form and its potential and, in doing so, cause unnecessary confusion.
The L3C is not a panacea for all of society's ills, but properly deployed it could be a useful tool to help revitalize economically distressed areas, advance scientific research and its results, and achieve other charitable, exempt purposes. The L3C's properly ordered fiduciary priorities afford opportunities that do not exist with such clarity in other forms, and its approach to success can inspire innovative efforts to enhance our society, whether foundations are involved or not. With these features properly understood and applied, hopefully the L3C can be more broadly adopted and used.
John Tyler is General Counsel for the Ewing Marion Kauffman Foundation in Kansas City, Mo.
Marc Owens is an attorney in the Exempt Organizations area of Caplin & Drysdale in Washington, D.C.