January 14, 2013
Brewer: Strengthening the L3C
The raison d’être for the low-profit limited liability company (“L3C”) is to encourage program-related investments (“PRIs”) by private foundations. PRIs are special types of investments that can be both charitable and profitable. PRIs have been embraced by knowledgeable scholars, practitioners, foundation managers, and even the U.S. Treasury Department. Further, the L3C and PRIs are associated with the growing “social enterprise” movement. The L3C thus would seem to be in the right place at the right time and should have the full support of the charitable sector, practitioners, and lawmakers.
Yet, after a fast start, adoption of L3C legislation across the U.S. has stalled. In fact, several states recently have considered L3C legislation and have either rejected it outright or deferred its passage indefinitely. Many highly-regarded scholars and practitioners adamantly oppose the L3C, even though those scholars and practitioners generally endorse PRIs. This slow pattern of adoption and strong opposition to the L3C contrasts sharply with the rapidly increasing acceptance of another type of “social enterprise” entity, the benefit corporation.
Why is L3C legislation languishing? Because the L3C suffers from the following fundamental defects: (i) except in name, the L3C is indistinguishable from a regular LLC; (ii) without any type of statutory enforcement mechanism, the L3C lacks accountability and transparency; and (ii) because the L3C promises more than it can deliver absent new federal legislation, the L3C fails of its essential purpose of encouraging PRIs. Given these defects, the L3C’s opponents maintain that the L3C is a well-intentioned but nonetheless failed experiment that should be abandoned.
This article argues that even though the L3C in its current form is defective, the L3C should not be abandoned. Instead, the L3C can be a viable tool for tax-exempt organizations and PRIs if the current statutory framework is strengthened and improved. With the foregoing premise in mind, this article proposes seven relatively simple but impactful changes that would strengthen and improve the L3C statutory framework. If the L3C becomes more than just a brand, then perhaps the L3C can fulfill its raison d’être.
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Americans for Community Development is totally opposed to the suggestions of Cass Brewer. Papers like this work against the L3C and will hurt not help its chances for expansion. The L3C is not broken nor do we feel we need more complicated government regulation to fix what is not broken. The following response is based on a new paper The L3C - Background and Legislative Issues by Robert Lang, the creator of the L3C and available on our website - americansforcommunitydevelopment.org. Cass Brewer's comments are in quotes, ACD response follows.
"The passage of L3C laws does not seem to be moving as rapidly as it once did. Does this mean the law is flawed or states should reconsider adoption"
No. The legislative process moves in spurts. There are always the early adopters who understand the promise of a new idea and then there are those who want to wait to see what everyone else does. Robert Lang remembers testifying before a legislative committee before any state had adopted the law and at the end of his testimony he said, “...and you can be the first state to adopt this law.” Whereupon one legislator promptly said, “I don’t cotton much to number one. I prefer to be number 25.” The first state law was passed in 2008 just before the beginning of the Great Recession. That recession has made it challenging to finance any venture let alone a new and untried one. It is way too early to judge the L3C. There are many happy users and some who are disappointed because they thought organizing as an L3C would bring foundations to their door with bundles of cash. Unfortunately, or maybe fortunately, no form of business organization eliminates the need for a good business plan and as a new idea the L3C will undoubtedly take a while to gain widespread acceptance.
Mr. Lang is proud to have created the L3C and hopes more and more states will pass the enabling legislation and that more and more people will find value in its use every year. The L3C reflects the desire of many Americans to follow our free enterprise system and operate without a lot of government regulation and reporting requirements. According to the World Economic Forum’s 2012 - 2013 Global Competitiveness Report the US is now only 7th in a world ranking of economic competitiveness. Canadian think tank Fraser Institute ranks the US 7th in its ranking of most to least free countries for 2013. We already have enough burdensome regulations. Lets create opportunities for individuals and groups to do good without a government regulator looking over their shoulder.
"1. First and foremost, require every L3C to have at least one bonafide economic member that is a qualified tax-exempt charitable or educational organization within the meaning of IRC § 501(c)(3)."
"2. Related to the first change suggested above, make a technical but important correction to the L3C statutes to clarify that only “one or more limited liability company interests” must be charitable in nature, not the entire company as currently stated in the existing L3C enabling legislation."
The advocates of these changes miss the point of the L3C law. Our attempt is to create an entity which is first and foremost a for profit venture but one whose primary job is fulfill a charitable mission. But these questions miss the mark because they fail to recognize that the present law permits an L3C to engage in one or more businesses that are not directly related to its mission. Endless Sky L3C is being formed in Montana for the express purpose of processing food for the food banks and soup kitchens in Montana. In order to do so it will create and market a high end iconic branded retail line of food which it will sell at market price. But the revenues from that line, will support the food bank line. The revenue from the retail line will cover the entire overhead and profit not used to repay investors will also go to support the food bank line. In fact Endless Sky could not function except for its non charitable product line. The point here is that everything the L3C does must support the charitable mission but everything it does does not have to be charitable.
These suggestions also eliminate the entrepreneurial structure of the L3C. Most of the L3Cs that have been formed were formed by entrepreneurs who liked the simplicity and low cost of entry.
"3. Similar to reporting obligations imposed by federal law upon IRC § 501(c)(3) organizations, require L3Cs to report their PRIs (including detailed financial information) on an IRS-approved informational return that must be made public."
"4. Similar to requirements imposed by state law upon many nonprofits, require L3Cs to register under state charitable solicitation acts."
"5. Similar to requirements imposed by state law upon many nonprofits, require L3Cs with certain minimum revenues or assets (e.g., $1 million) to obtain annual, audited financial statements and provide those statements to the state agency responsible for regulating nonprofits."
Americans for Community Development cannot endorse any of these points no matter how well meaning Cass may be. These proposals fail to grasp the idea that L3Cs do not use publicly donated charitable dollars. In the sense they use charitable dollars it is money from foundations or DAFs (Donor Advised Funds) which are already regulated and required to monitor their investments. The L3C, unlike a nonprofit does not solicit public funds and does not use charitable dollars to subsidize its operations. The investments made in the form of PRIs into L3Cs are a form of subsidization of capital not operations and support the L3C by reducing its cost of capital and hence its operating expenses.
Interestingly enough the L3C designation significantly improves transparency. And the L3C statutes create a fiduciary responsibility on the part of the owners and managers to perform the designated charitable purpose. The PRI regulations have been law since 1969 and during that time it has been generally impossible for either the states or the IRS to track all the PRIs that have been made, know who they were made to, or have any idea of the outcomes. The only mechanism for over forty years for reporting PRIs has been as a line item on the 990-PF of a foundation making a PRI. The L3C as a branding mechanism will serve to announce an organization that promises charitable purpose and flag the possibility that a PRI is in place here. The mechanism for tracking L3C performance is via a foundation investor if there is one. If there is not there is no reason that public examination should be required since there is no charitable investor. The purpose of most charitable laws is to insure that the donor can be confident that the donated dollars will be used for charitable purposes. It is up to the foundation to be sure its PRI is being used properly and to this end the foundation is responsible to the IRS.
Reporting requirements are also unfair to L3Cs of any size which choose to operate with only private investment. The L3C is a for profit that happens to do good but so what. As for public perception, if a toy company says its toy will make a child happy for hundreds of hours there are no toy police that go out and check on child pleasures. This is a matter of free enterprise response. Dozens of companies claim to give all or some portion of their profits to charity. Others claim a portion of revenue goes to a cause. We seem to be locked into the misguided idea that we all have the right to know how an organization that claims to do good is performing. We don’t. It runs entirely contrary to our basic free enterprise, capitalist system. We make our own independent decisions every day among the thousands of goods and services in front of us. We may look to others for advice or recommendations but the decisions are ours. If we do not think the L3C museum is offering enough value for its purported claims then we will not go there.
"6. Provide a “free transferability” default rule for L3Cs so that a tax-exempt member may assign its membership interest at any time, with the exempt member’s transferee being automatically admitted as a substitute member with full economic and membership participation rights in the L3C."
"7. Provide a default rule so that at any time and for any reason a tax-exempt member unilaterally may withdraw from an L3C, whereupon the L3C must repay the exempt member’s unreturned capital contribution (unless the L3C is simultaneously liquidated, in which case the exempt member would participate in the liquidating proceeds)."
These provisions are available to all L3Cs. They all are organized via an operating agreement. The parties to the operating agreement are free to put these provisions in the agreement but requirement by law is a very bad idea. Number 7 is sure to scare off most market rate/commercial investors unless it is very carefully worded, project specific and only available if actions of the L3C jeopardize the status of the tax exempt member. By giving the exempt member special privilege by statute we essentially kill the LLC advantages of the L3C since the members are now constrained in structuring the deal. It is up to the exempt member to look at the specific situation and decide what provisions they need for protection in that particular deal. These provisions would essentially destroy the L3C.
We are proud of the L3C and hope more and more states will pass the enabling legislation and that more and more people will find value in its use every year. Any suggestions regarding changes to the law should not be based on theoretical discussions but come from a consensus after several years of use. Anyone who wishes to further discuss this issue is invited to contact Robert Lang, the creator of the L3C and the founder of ACD at firstname.lastname@example.org or 914-248-8443.
Posted by: Janice Lang | Jan 16, 2013 1:33:06 PM