The article "The L3C: A new business model for socially responsible investing" in the November 2009 issue of Community Dividend speaks enthusiastically about "[t]he low-profit limited liability company, or L3C…a newly developed form of business that blends attributes of nonprofit and for-profit organizations in order to promote investment in socially responsible objectives."
We understand the enthusiasm; proponents of the L3C have predicted dramatic benefits. However, after careful study of the relevant law, we have concluded that the enthusiasm is misplaced. The L3C concept is fundamentally flawed, needlessly risky, and at best counterproductive.
We also understand that our skepticism may make us seem like a pair of Grinches. We want, therefore, to briefly describe our experience in this realm of law and outline the legal issues we have considered. We have each been involved in the law and practice of limited liability companies (LLCs) for more than 20 years. One of us (Bill) has a full-time practice that includes substantial amounts of work with low-income housing and community development financing transactions and extensive work with nonprofit organizations. The other of us (Daniel) is a professor of law who was the reporter for the Uniform Limited Partnership Act (from the National Conference of Commissioners on Uniform State Laws) and co-reporter for the Revised Uniform Limited Liability Company Act. Each of us has taught and written extensively about LLCs. In our assessment of the L3C concept, we have considered the arguments and claims of the L3C's proponents (including statements made in state legislatures), and also the laws providing for LLCs, regulating charitable foundations, and governing the sale of securities.
The promoters of state L3C legislation describe three principal benefits from the L3C form: (1) the L3C complies or "dovetails" with Internal Revenue Service (IRS) program-related investment (PRI) rules, thereby enabling private foundation investment in qualifying business enterprises that operate according to for-profit metrics (but nonetheless for socially beneficial purposes); (2) the L3C permits "tranched investment" through which foundations can make high-risk/low-return investments to enable profit seekers to make low-risk/high-return investments, thereby bringing market-rate capital into socially beneficial enterprises; and (3) the L3C creates a "brand" to enable easy comprehension and use of the PRI tool. Our research shows that none of these benefits exists.
First, the Congress, Treasury Department, and IRS have not created any special category of PRI treatment for the L3C, and it is not likely that they will ever do so. Indeed, they could not do so without turning the PRI concept upside down. To be a program-related investment, a foundation's investment must fit the program of the investing foundation. Therefore, each time a foundation considers making a PRI, the foundation must make a situation-specific determination that carefully takes into account the foundation's mission, the purpose of the organization receiving the investment, the relationship of the receiving organization's purpose to the foundation's mission, and how the governance and financial structure of the receiving organization ensures that the receiving organization will operate within the PRI requirements.
Thus, contrary to the hopes and assertions of L3C proponents, private foundation investments in L3Cs will not have any PRI-related advantage over investment in ordinary LLCs. Moreover, due to the substantial excise taxes imposed on foundations (and in some circumstances their managers) for failing to distinguish correctly between PRIs and non-PRIs, foundations will continue to be conservative in these determinations. Thus, devising a PRI arrangement will continue to require careful and individualized investigation, deliberation, negotiation, and drafting, and foundations will continue to need to ensure, through rulings, legal opinions, and other due diligence, that their investments meet the PRI rules.
We submit that this result is just as Congress intended when it authorized PRIs—i.e., a narrow channel through which tax-exempt, nonprofit organizations might divert assets into the for-profit world. We therefore caution that it would be misleading—both to foundations and to people who might set up L3Cs in expectation of foundation investment—to promote the L3C as enabling PRIs.
Second, "tranched investment" raises very serious policy concerns and is dangerous as a tax matter. Foundations have the privileges of tax-exempt status and the ability to receive deductible contributions. Tranched investing runs the risk of exporting these privileges to benefit non-charitable businesses, managers, and investors. Tax law has a term for this sort of private benefit—private inurement—and transactions that create private inurement cause large and potentially debilitating problems for charitable organizations. Properly constructed, a tranched investment arrangement might well survive IRS scrutiny, but it is risky and misleading to advocate tranched investing by foundations as a generic, easily designed, and readily available device for social progress.
Third, given our first two points, we question whether there is any branding value to the L3C label. Branding properly occurs when the market perceives substantive value behind the brand. As we have shown, the L3C's two principal "claims to fame" lack legal substance. Moreover, the very idea of a brand in this area creates a false sense of security for foundations. Brand connotes simplicity, templates, even (as one proponent predicted in a recent presentation) "L3Cs for Dummies." But, if an L3C is to receive PRIs, simplicity and templates are hazardous impediments, not facilitators.
Finally, we note that the L3C legislation enacted to date contains a technical but nonetheless fundamental error in drafting. Extrapolating from language in the federal regulations on PRIs, the typical L3C statute provides that: "no significant purpose of the company [can be] the production of income or the appreciation of property." (Emphasis added). How could tranched investing possibly work under these constraints? (As a chart in the November 2009 Community Dividend article illustrated, the final tranch is for investors seeking "a competitive market rate of return.") More generally, how is it possible to have a low-profit limited liability company when no significant purpose of the company is the production of income or the appreciation of property?
The PRI is an important tool for foundations willing to devote the thought, care, and time to look wisely for "social investment" opportunities. However, the existing forms of business organizations (including the "regular" LLC) are perfectly suitable for PRI arrangements. In our judgment, the L3C adds nothing and risks much.
For further reading we suggest:
- Carter G. Bishop, "The Low Profit Limited Liability Company (L3C): Program Related Investment Proxy or Perversion," University of Arkansas Law Review (forthcoming 2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1552056.
- J. William Callison, "L3Cs: Useless Gadgets?" Business Law Today, Volume 19, Number 2, November/December 2009.
- Daniel S. Kleinberger, "A Myth Deconstructed: The 'Emperor's New Clothes' on the Low Profit Limited Liability Company," Delaware Journal of Corporate Law (forthcoming 2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1554045.
- David Edward Spenard, "Panacea or Problem: A State Regulator's Perspective on the L3C Model," Exempt Organizations Tax Review, Volume 65, 2010, page 131.
Daniel S. Kleinberger is a professor of law at William Mitchell College of Law in St. Paul, Minn.
J. William Callison is a partner at Faegre & Benson, LLP, in Denver.