LLC vs L3C
I am frequently asked if the new business organization called a Low-Profit Limited Liability Corporation (L3C) is a suitable structure for a business incubator. Like all things in life, there is no one simple, easy answer. I always reply, “It depends.” First of all, you need to know what an L3C is and how it functions.
An L3C is a legal form of business entity in the United States that was created to bridge the gap between non-profit and for-profit investing by providing a structure that facilitates investments in socially beneficial, for-profit ventures while simplifying compliance with Internal Revenue Service rules for Program Related Investments (PRIs). PRIs are IRS-approved investments made by foundations, often into for-profit ventures, to support charitable activities, which may involve the return of capital within an established period of time, kind of like a low- or no-interest loan. So, in a nutshell, an L3C is a for-profit entity that can deliver not only a return on investment to stakeholders but can also provide non-profit benefits to its non-profit partners. An L3C organization is able to access capital in situations where the profit potential of a business is too low to warrant the risk of investment by traditional investors. For a business incubator program, especially one that takes an equity stake in its client companies, this could be a very good thing. It opens up the door to sources of funding that may have been closed before. It also allows for the management of any financial returns resulting from a successful exit of a client company without endangering the incubator’s non-profit status.
An L3C uses its for-profit efficiencies along with fewer regulations from the IRS to achieve socially beneficial goals. Unlike a standard LLC, the L3C has an explicit primary charitable mission and only a secondary profit concern. But unlike a charity the L3C is free to distribute after-tax profits to owners or investors. It can bring together foundations, nonprofits, trusts, pension funds, endowment funds, individuals, corporation, other for-profits, and government entities to address common social concerns. An L3C is a taxed organization that operates with a stated goal of achieving a social goal while making a profit is a secondary goal. One possible use of an L3C structure might include the development of a business incubator for the commercialization of cutting-edge technology or the development of new business in an economically distressed area.
To authorize the L3C as a business structure, each state must pass legislation amending the General Limited Liability Company Act (LLC). Vermont was the first state to adopt the L3C legislation in April 2008. To date, legislation has been passed in Illinois, Louisiana, Maine, Michigan, North Carolina, Utah, Vermont and Wyoming. Legislation has also passed in the federal jurisdictions of The Crow Indian Nation of Montana and the Oglala Sioux Tribe. Additionally, legislation has been written in California, Florida, Iowa, Minnesota, Nebraska, Ohio, Texas, Washington, and Wisconsin but has not been introduced yet.
There are several benefits to the L3C structure for both the L3Cs as well as the foundations that may invest in them. Because foundations can only directly invest in for-profit ventures qualified as PRIs, the L3C structure can significantly simplify the process.1 The L3C operating agreement specifically outlines its respective PRI-qualified purpose in being formed, making it easier for foundations to identify social-purpose businesses as well as helping them ensure their tax-exemptions remain secure. In addition, L3Cs can attract outside investors. Investment in a L3C can be layered, delivering returns according to the needs of the investor (low or no return to a foundation, greater returns for a market-driven investor). Foundations can serve as early-stage investors by taking on more financial risk, in exchange for a high social return. Further, early foundation investment will pave the way for more market-driven investment from individuals who don’t want to make charitable gifts but might “give” in return for a minimal rate of return. Lastly, L3Cs can satisfy the philanthropic mandate of a foundation. Investment in a L3C would allow a foundation to invest in an organization that is meeting community needs, while providing an opportunity for a foundation to generate a modest return.
In this early stage of the movement, however, L3Cs have some concerning aspects that cannot be overlooked. At this time there is no universally agreed upon definition of “low-profit.” Until this is clarified, any L3C stands on shaky ground as it amasses profit and distributes it to investors. When does “some profit” become “too much profit,” if ever? Also, there is no standard qualifying criteria for “social benefit,” leaving the door open for the establishment of L3Cs that simply want funding without community accountability. What would prevent a coffee shop (community building), a soap company (health), or an insurance company (disaster protection) from becoming an L3C? At this time, nothing. And on a macro level, there is some concern that the diversion of foundation funding from non-profit support to for-profit investment may result in the declining health of the nonprofit ecosystem. In other words, there may be more organizations competing for a piece of an ever-shrinking funding pie. Lastly, a business incubator that forms as a L3C cannot also be a 501(c)(3) entity.2 This might impact the incubator’s ability to secure money from certain funders, including the federal and/or state governments. Existing nonprofits can utilize the L3C structure in two ways: reincorporating as a L3C or establishing a subsidiary. If a nonprofit generates enough earned income to qualify as “low profit,” it could reincorporate as a stand-alone L3C. However, the most likely scenario for existing nonprofits is the establishment of subsidiaries to conduct qualifying activities.
So, is a L3C structure appropriate for a business incubator? Perhaps. In addition to having a socially beneficial mission, strong candidates for the L3C structure are organizations that:
Have cash flow. Since investors will be seeking a return on their investment in a L3C, the organization must consistently generate revenue.
Are entrepreneurial in finding ways to generate revenue. Organizations that are willing to supplement their current services with additional revenue-generating activities will be more attractive to investors.
If your business incubator program has cash flow and is entrepreneurial in generating revenue, the L3C structure may be feasible. The best recommendation at this time is to talk with an attorney who is very knowledgeable in this new corporate structure. Only after a thorough examination of the specific situation and how corporate structure may impact the incubator program can a decision be made. But it is worth having the conversation.
In Michigan, the L3C legislation has resulted in the creation of 80 approved L3C entities as of April 25, 2011. (http://www.intersectorl3c.com/site_images/pageimage_1625_104300_8_1.png). Anyone thinking of forming an L3C in Michigan can find more information at Citizen Media Law Project (http://www.citmedialaw.org/legal-guide/forming-l3c-michigan). The Michigan Department of Licensing and Regulatory Affairs has all the required forms posted online at http://www.michigan.gov/lara/0,1607,7-154-35299_35413_35429---,00.html.
1 Note that a private foundation that is seeking to make a PRI in an L3C still has to obtain a PLR – which is very expensive. Also note that public charities can make “mission-related investments” in a for-profit entity, including an L3C and private foundations that are not seeking to have the distribution qualify for the 5% distribution requirement can also make an investment in a L3C without seeking the approval of the IRS.
2 It can invest in a 501(c)(3) entity or have a 501(c)(3) as an investor.
Special thanks to Linda A. Wasserman, Department Head of Trusts and Estates at Honigman Miller Schwartz and Cohn LLP, for her assistance in helping me research material for this blog posting.