Why L3Cs Will Change Grant-making in the United States

When Senate Bill 308 was signed into law on August 3, 2010, North Carolina became the ninth state to create a legal designation for Low-profit Limited Liability Companies (L3Cs). The relatively new L3C designation (Vermont was the first state to pass L3C legislation on April 30, 2008) is a remarkably innovative and effective method for allowing social enterprises to legally operate as for-profit entities with non-profit missions. An L3C is just like a conventional LLC except that it has demonstrated that (1) its primary purpose is social in nature and (2) it is not primarily interested in the generation of profit or the appreciation of property. One of the L3C designation's most significant advantages for social enterprises is that it will help attract increased investment from private foundations in the form of program related investments (PRIs).

Federal law permits private grant making foundations to engage in program related investments (PRIs), which are investments that support socially beneficial activities. The law, which was passed under the Tax Reform Act of 1968, is of great potential benefit to social enterprises because it permits foundations to make PRIs regardless of whether the socially beneficial activities are performed by a non-profit or a for-profit entity. Moreover, foundations can benefit from PRIs because, like grants, they count towards the Internal Revenue Service's (IRS) requirement that private foundations spend 5% of their net worth annually, but, unlike grants, they promise modest financial returns on investment.

PRIs are rare, however, because they are burdensome and risky for foundations. Foundations that seek to invest through the PRI provisions have faced two unappealing choices. First, a foundation can choose to exhaustively screen a potential PRI recipient to ensure that the PRI is legal. In order to qualify as a PRI, a private foundation's investment must be (1) motivated solely by a desire to accomplish its social mission, (2) be able to demonstrate that the generation of income or the appreciation of property are not significant factors motivating the investment, and (3) prove that no electioneering purposes are served by the investment. Once the investment is made, however, the IRS is authorized to intervene and retroactively declare that the investment failed to qualify as a PRI, which can disrupt the foundation's long term fiscal plans or, worse, jeopardize the foundation's tax exempt status. As a result, foundations almost always avoid this method of engaging in PRIs because it is prohibitively risky.

The second method for foundations considering a PRI is to seek a private letter ruling from the IRS, which effectively acts as pre-approval for the PRI. Private letter rulings are not mandatory, but they are often more attractive to foundations who seek to eliminate the risk of a retroactive declaration of ineligibility by the IRS. Unfortunately, private letter rulings can cost over $50,000 in legal fees, require an $8,700 fee to be paid to the IRS and typically take 12 to 18 months to process. As a result, foundations are loath to pursue private letter rulings because they are a costly and inefficient method of solving social problems.

The L3C designation is designed to make it significantly easier for foundations to engage in PRIs. Marc Owens, former Director of the Exempt Organizations Division of the IRS, made a significant contribution to the L3C project by figuring out how to make the L3C an attractive vehicle for private foundations' PRIs. Instead of building an entirely new parallel legal form (such as the B Corporation or the Socially Responsible Business Company), Owens proposed to draft model legislation that mirrored the language of the PRI requirements stipulated in the Internal Revenue Code. Thus, a social enterprise that qualifies for L3C status should automatically qualify for PRIs under IRS Code. This way, private foundations can be confident in their ability to make PRIs to L3Cs without having to seek private letter rulings or fear retroactive reprisals from the IRS.

The L3C remains relatively new and untested, but Americans for Community Development, the organization which promotes the L3C designation, is currently working to pass federal legislation authorizing the L3C. If this were to happen, the relationship between private foundations and social enterprises may change as foundations alter their activities to include more PRIs and less grant making.

Tomorrow I'll publish an article in which I will describe the additional advantages of the L3C. Stay tuned!