“L3C” Spells “Caveat Emptor”

Here’s something strange: a concept thrown around routinely and casually in conversations among nonprofits and philanthropies is simultaneously the subject of fierce debate and sometime disapproval by the Internal Revenue Service, a committee of the American Bar Association, and other experts. What is going on?

The notion of Low Profit Limited Liability Corporations (L3Cs, for short) is that they’re a vehicle for doing well by doing good and therefore an improvement over the typical nonprofit structure. L3Cs are permitted to earn profits, but proponents claim that their praiseworthy intentions—to end hunger or provide clean water or whatever—make those who lend to them eligible for the special tax benefits attached to program-related investments. In other words, this is a legal structure presented as a technique for gaining access to capital (always a struggle for nonprofits) by providing a tax benefit to lenders.

Of course, foundations already get a tax benefit for program-related investments in regular nonprofits, so what, exactly, is the appeal? In theory, foundations might be more interested in program-related investments that generate a reliable flow of capital (in the form of profit) than in program-related investments that generate nothing but additional nonprofit programs and services. Likewise in theory, regular venture capitalists outside of foundations will be more interested in making investments in profit-making entities than in pure nonprofits. This—the notion goes—will increase the amount of capital available to support general good-guy behavior.

However, a number of scholars and lawyers (Daniel Kleinberger of William Mitchell College of Law prominent among them) see the L3C as, at best, redundant and, at worst, an invitation to fraud. They point out that regular limited liability corporations can be organized for any purpose, including public-spirited and low-profit ones. They point out that the IRS has not yet issued (and does not seemed inclined to create) a rule awarding automatic program-related investment status to any investment in an L3C. So anyone who invests in an L3C on the basis that it provides a higher return than a regular nonprofit with the same tax benefits will find out to his/her sorrow that this is not the case.

What strikes me as peculiar, though, is that in the many discussions I’ve heard and read about L3Cs, only one mention (specifically, Professor Kleinberger’s Nonprofit Quarterly article) has ever surfaced of this opposition from the bar and Federal regulators. Not until my tax lawyer Stuart Levine asked about the (successful) efforts in Illinois to create L3Cs did I realize there was anything controversial about the phenomenon. After bringing me up to speed, Levine wisely said:

“L3Cs don’t work unless there is a change in federal tax law. In other words, L3Cs are a little like the wonder drug for which there is no known disease. L3Cs raise difficult issues of fiduciary duty and the inherent conflict between ‘charitable’ purposes and ‘business’ purposes. At the least, these conflicts cannot be dealt with via a quick-fix state statute.”

Doubtless I space out on frequent occasions and miss aspects of what’s said or done in the sector. But I suspect there’s also a significant disconnect between what nonprofit executives and L3C promoters expect and describe and what lawyers and regulators understand.

So if you’re considering investment in an L3C, be the aware buyer of whom you’ve heard.

Read more stories by Kelly Kleiman.