L3Cs: A Cure in Search of a Disease

This is a follow up to Kelly Kleiman’s “L3C Spells Caveat Emptor” blog post.

A puzzling phenomenon in the nonprofit sector is the disconnect between legal scholars and the organized bar on the one hand, and selected lawyers and state legislatures on the other, on the subject of L3Cs: low-profit limited liability corporations. These corporations are designed to be the legal structure underpinning so-called “social venture” or “social entrepreneurial” philanthropy—that is, efforts to combine doing good with doing well by securing some profit while working in fields traditionally served by nonprofits.

New York is the latest state to consider adoption of an L3C statute. But here’s the wrinkle: The American Bar Association Business Law Section has long since made clear its disapproval of this form of business organization, describing it as a solution in search of a problem and a system for concealing transactions that should be utterly transparent. Why, then, do state legislatures continue to toy with these statutes like panhandlers discovering gold?

It would be churlish to suggest that lawyers who specialize in creating these unusual (and, as aforesaid, unnecessary) structures are peddling them to state legislators who want to support charitable activities without spending any actual government money. But the truth of the matter is that most social problems now addressed by charities cannot be appropriately addressed by for-profit entities, whether or not those entities pledge to restrict or recycle their profits.

First of all, any corporation might plow its profits back into the business rather than return them to stockholders: Indeed, that’s a complete description of Apple’s business plan. That doesn’t mean that Apple is engaged in philanthropy, social-venture or otherwise; it just means its profits aren’t distributed. An L3C that plows its profits back into the enterprise isn't therefore unprofitable, or even low-profit; it's just a business with retained earnings.

Second, the IRS has not agreed to classify L3Cs as program-related investments, a status allowing foundations to count their involvement with an organization toward their required distribution of income. And it’s not likely that the IRS will do so. Whether an individual L3C is a program-related investment—or whether any other individual entity is such an investment—is decided on a case-by-case basis resting on the work of the foundation, the work of the not-exempt non-charitable business, and the IRS’s discretion. So although enterprising L3C lawyers may suggest otherwise, nothing about the form benefits foundations—meaning nothing about the form allows organizations working in the public interest to attract additional funding.

Look: If the work that charities do—feeding the hungry, housing the homeless, and so on—were profitable, someone would already be doing it. That’s the beauty of capitalism: Profitable niches get filled. But capitalism does not in any way guarantee that every niche is profitable, nor does it answer the question of what niches need to be filled regardless of profit. The L3C doesn’t answer that question either, and every minute a legislature devotes to pretending that it does is a minute that it could be using to figure out how to fill those essential niches.

Read more stories by Kelly Kleiman.