When the Law is Understood - L3C No
6 Pages Posted: 13 Mar 2010
The November, 2009 issue of Community Dividend, included an article entitled “The L3C: A new business model for socially responsible investing.” The article spoke 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, potentially dangerous, 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 to outline the legal issues we have considered. We have each been involved in the law and practice of limited liability companies 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 limited liability companies, 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 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 exist.
First, the Congress, Treasury Department and IRS have not created any special category of PRI treatment for the low profit limited liability company, and it is not likely that they will ever do so. Indeed, they could not do so without turning the PRI concept upside down.
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 appropriately conservative in these determinations.
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 dangerous 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 is dangerous 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 dangerous 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.” How could tranched investing possibly work under these constraints? 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?
Keywords: limited liability company, LLC, low profit limited liability company, L3C, program related investment, PRI, tax exempt organizations, socially beneficial investing, tranch, foundations, charities, private foundations, hedge funds, leverage
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