Our first newsletter is written by Jennifer Miller Oertel, a shareholder at the law firm of Jaffe Raitt Heuer & Weiss, PC and coordinator of the Firm’s Tax-exempt Organizations Practice Group where she represents family foundations, public charities, social enterprises and social enterprise investors. (A reminder that Jaffe is offering a $5,000 legal services prize through this year’s Social Entrepreneurship Challenge!)
L3Cs were designed to encourage private foundations to pursue their missions through investments in social enterprises. Private foundations are subject to many restrictions, including that they must: (i) distribute each year at least 5% of their net investment assets for charitable purposes, (ii) exercise additional record keeping and diligence procedures (“expenditure responsibility”) if they make grants to other than U.S. public charities (501(c)(3)), (iii) not invest their assets in such a way that might jeopardize their ability to carry on their charitable activities (“jeopardizing investments”), and (iv) not own more than 20% of the voting stock or beneficial interests in an entity (“excess business holdings”). Failure to comply includes potential foundation-level and personal fines and penalties and the attendant headline risk that family and corporate foundations avoid at all costs.
The Internal Revenue Code does permit foundations to make investments as loans or equity in social enterprises, so long as the primary purpose of the investment is charitable and no significant purpose is the generation of income. If such investments qualify, these so-called “Program-related investments” (PRIs) “count” as a charitable distribution of the foundation, are not deemed a jeopardizing investment, and are exempt from the 20% excess business holdings prohibition. While not required, foundations may seek an IRS ruling that investments in a social enterprise qualify as PRIs, but that process is costly, may take a year or more to secure any action, and the ruling is only specific to the investment described, not follow-on investments. Alternatively, foundations may secure a legal opinion.
Because an L3C must contain language in its operating agreement that tracks the PRI requirements – mainly, that its primary purpose is charitable and that no significant purpose is the generation of income -- it was hoped that the IRS would proclaim that any foundation investment in an L3C would be deemed a per se
PRI so that private foundations could be assured that the PRI counts as a charitable distribution and they would not have to exercise expenditure responsibility or worry about jeopardizing investments. Not only has this not happened, but representatives of the IRS have stated in unofficial conversations that they would “never” support such action. In fact, none of the updated examples issued by the IRS illustrating what might qualify as a PRI included an L3C. Further, state attorneys general have expressed concern over the proliferation of new corporate entities (L3Cs, benefit corporations, flexible purpose corporations) for which there is no body of developed case law, and alarm that nothing in the law prevents an L3C from mission shift and converting into an LLC.
L3Cs are identical to LLCs except for the charitable purposes requirement. That is enough comfort for some social enterprise investors, although until state or federal tax benefits attach to the L3C structure, others are reticent to invest in them given the lack of case law and uncertainty over enforcement. Further, entrepreneurs have found that some potential investors would rather provide a charitable contribution than to invest in the social enterprise. While these ideas are slowly changing, it is a real consideration in deciding upon the form of entity. If a social enterprise otherwise would fit into an L3C structure because its activities are primarily charitable in nature, then it could instead seek 501(c)(3) status as a public charity. Some benefits to charitable status, in addition to the fact that revenues may not be taxable, are the ease by which foundations may make grants or loans to the entity, the availability of other grant funding, and the tax-deductible nature of contributions to the entity. In addition to public oversight of the IRS and state attorney general, a major drawback is that the assets may not inure to the benefit of a private individual, meaning that founders and investors may not take “equity” in the charity, and there is scrutiny over salaries paid. However, certain profit-making activities may be spun off into stand-alone corporations or for-profit subsidiaries in arm’s-length (fair market value) transactions.
Other alternatives by which social enterprises may demonstrate their dedication to social impact are B-Corp. certification and compliance with ISO 26000.
The decision as to whether the L3C is right for your enterprise depends upon many factors, the most salient of which are your expected sources of revenues, financial model, vision and goals. Do not fear if you chose one path and circumstances reveal that another path would have been wiser – in many cases the decision is not set in stone but can be restructured.
Jennifer Miller Oertel
*This article is intended for educational purposes only and does not constitute legal advice.
The Michigan Social Entrepreneurship Challenge offers $60,000 in prizes and an impact investment fellowship for entrepreneurs across Michigan who are committed to addressing challenges across the areas of chronic unemployment, education, urban revitilization, the environment and more. Click HERE
to register for the competition before the deadline of April 30, 2014.