Effective January 1, 2010, Illinois will begin allowing the organization of low-profit limited liability companies or L3Cs. An L3C is a hybrid business structure that offers an alternative to for-profit and nonprofit companies by combining the pass-through tax advantages of a traditional limited liability company with the social advantages of a nonprofit. Michigan, Vermont, Wyoming, Utah and North Dakota have also adopted statutes allowing the organization of L3Cs.
The L3C structure also provides a vehicle for attracting investment in companies founded by social entrepreneurs who may be more interested in promoting social, cultural or environmental changes than making a profit. Moreover, the L3C structure is intended to facilitate program-related investments (PRIs) by private foundations in for profit companies. A PRI is an investment:
- The primary purpose of which is to accomplish one or more of the foundation's exempt purposes;
- For which the production of income or appreciation of property is not a significant purpose; and
- In which the influencing of legislation or taking part in political campaigns on behalf of candidates is not a purpose.
These criteria are nearly identical to the statutory requirements for setting up an L3C in Illinois and the other states that have adopted the L3C structure. Thus, the L3C structure was intended to offer some assurance to a private foundation that the investment it makes in a for-profit company (to further the private foundation’s exempt purpose) qualifies as a PRI. PRIs are sometimes made as an alternative to grants with the goal of preserving some foundation assets. The Internal Revenue Service (IRS) has identified the following as “typical” examples of PRIs:
- Low-interest or interest-free loans to needy students;
- High-risk investments in nonprofit low-income housing projects;
- Low-interest loans to small businesses owned by members of economically disadvantaged groups, where commercial funds at reasonable interest rates are not readily available;
- Investments in businesses in deteriorated urban areas under a plan to improve the economy of the area by providing employment or training for unemployed residents; and
- Investments in nonprofit organizations combating community deterioration.
For its part, the IRS has recently urged caution about using the L3C structure in comments at the June 11, 2009 conference of the American Institute of Certified Public Accountants. Ron Schultz, a senior technical adviser in the IRS’s Tax Exempt and Government Entities Division, warned that it may be premature to use L3Cs as a vehicle to make PRIs because the tax consequences may be unclear. Specifically, Mr. Schultz noted that if a foundation failed to exercise ordinary business care and prudence in providing for the short-term and long-term financial needs of the foundation in carrying out its exempt purpose, then the foundation manager could be subject to the 10% excise tax on investments under the jeopardy investment rules of Section 4944 of the Code. Such could be the case where an investment by a private foundation in an LC3 failed to qualify as a PRI.
Even if the IRS has been slow to warm to the LC3 structure, the IRS has previously approved PRIs by private foundations in the usual LLC structure, which does not offer the same statutory restrictions that are offered in the L3C structure. The Illinois L3C statute requires that an L3C “at all times significantly further the accomplishment of one or more charitable or educational purposes,” that no significant purpose of the L3C be the production of income or the appreciation of property, and that the L3C not have the purpose of accomplishing one or more political or legislative purposes. Under the statute, the L3C is required to promptly amend its articles of organization if it no longer satisfies those requirements. Furthermore, the L3C and its chief operating officer, director or manager is to be referred to as a “trustee.”
In any event, private foundations that are contemplating PRIs and/or persons who wish to organize an L3C to attract investment capital from private foundations would be well advised to consult competent legal counsel to ensure that they do not run afoul of the jeopardy investment rules.
For more information about the LC3 structure, program-related investments, or the jeopardy investment rules, please contact Douglas Pessefall at (414) 978-5534 or email@example.com or another member of the Tax Exempt Organization Practice Groups.