Chevrolet Volt. Toyota Prius. Michigan L3C.
Two of these products are automobiles and the other is a relatively new Michigan corporate entity, known as a low-profit limited liability company (“L3C”). Nonetheless, all three of these products are considered hybrids and allow their respective users to achieve optimal results by combining different components.
Enacted in 2009 by the Michigan Legislature, an L3C is a hybrid between a non-profit corporation and a for-profit corporation, possessing characteristics of each. Similar to a non-profit, an L3C must be formed in furtherance of some charitable or educational purpose. However, as with a for-profit entity, an L3C may have equity owners who have the right to receive distributions of profits and appreciation in the value of the business entity. Currently, only ten states permit organizing as an L3C (although L3Cs can operate in all states).
Like most entities, an L3C must be registered with the Michigan Department of Licensing and Regulatory Affairs (“LARA”) in a manner similar to a limited liability company (“LLC”), with articles of organization being filed and execution of an operating agreement. Due to the unique nature of the L3C, some additional compliance is required with Michigan law and the IRS. Most notably, an addendum needs to be attached to the article, detailing the charitable or educational purpose of the respective L3C.
Despite its non-profit characteristics, an L3C is not a tax-exempt organization under Section 501(c) of the Internal Revenue Code. Therefore, donations and investments to L3Cs are not tax deductible. Additionally, L3Cs operate like standard LLCs for federal tax purposes, so any profits “pass through” to its members and are taxed at individual rates.
L3Cs are particularly attractive to individuals who are interested in creating a social enterprise. As you probably know, social enterprises are focused on improving the quality of their communities, as opposed to solely achieving monetary profits for the organization. The attraction to L3Cs stems from the fact that they permit funding from traditional sources (family, banks, angel investors, etc.), as well as private foundations. To maintain a tax-exempt status, private foundations are required by the IRS to contribute at least five percent of their assets for a charitable purpose. Often, this is achieved through grants but foundations may also opt to make program-related investments (“PRI”).
PRIs, defined in Section 4944 of the Internal Revenue Code, are investments with entities whose primary objective is aimed at a charitable or educational purpose, rather than seeking a profit. A PRI may be structured as interest-free or below-market loans, loan guarantees, letters of credit or equity investments. Therefore, L3Cs and PRIs are perfect for each other — the L3C attains funding and the foundation remains in the good graces of the IRS. Any returns can be reinvested for other charitable purposes.
However, the unique branding opportunities presented by L3Cs are not without some hurdles. Currently, the IRS does not automatically recognize an investment with an L3C as being a PRI. And the penalty for making an investment that is later discovered not to qualify as a PRI can be severe — large fines and/or loss of tax-exempt status. Therefore, foundations must exercise due diligence by asking the IRS for a private letter ruling, prior to making an investment to ensure compliance. Alternately, foundations can examine the nineteen examples provided by the IRS, which illustrate investments that qualify as a PRI.
Keeping potential pitfalls in mind, the L3C may be an appropriate solution for many social enterprises seeking to achieve creative capitalism. However, the designation's longterm success may be contingent on the IRS making a definitive ruling regarding investments to L3Cs. In the interim, L3Cs create a distinctive entity for those who are passionate about providing social benefits to their communities.
Alari K. Adams is the founder of ASquared Legal Group, PLC which provides legal counsel to entrepreneurs and startups. Follow her on Twitter @ASquaredlegal.