L3C: Pot of Gold or Space Invader?

Blue Avocado Investigates [1] • By Rick Cohen • September 30, 2009 • forward article

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For-profit companies continue to seek ways to obtain two benefits that are usually reserved for nonprofits: foundation grants and government tax exemptions. These efforts are led by both well-meaning individuals as well as those that simply want funding without community accountability. Regardless, they present risks and challenges to the nonprofit sector as we know and celebrate it. Rick Cohen tells us of one such effort that appears -- in the absence of opposition -- to be headed for adoption.

The hot topic in foundation circles is the L3C: the low profit limited liability corporation, the latest development in social enterprise. Several states are legalizing L3Cs and accompanying tax and philanthropic benefits, and its backers are pitching them for federal approval.

L3Cs are profit-making corporations, but their owners don't identify profit as their primary purpose. The mission of an L3C is a social benefit, doing socially productive and useful things, and only then earning a profit.

At the national level, the Council on Foundations has been actively promoting L3Cs, [4] on Capitol Hill for the past two years. Already in four states and two tribes, individuals can form L3Cs and attract various types of investors, and, because of their charitable missions, tap into foundation loans and guarantees. At least they will be able to if Congress passes legislation giving blanket approval for such loans, or if the Internal Revenue Service (IRS) issues a ruling authorizing them.

There may be some sound reasons for the creation of hybrid models melding features of nonprofits and for-profits, hopefully helping localities and states attract new sources of capital for critical economic and environmental ventures. But states, Congress, and the nonprofit sector might want to be cautious about this social enterprise innovation.

Foundations funding for-profits

Foundations that see nonprofits as vehicles for meeting the foundation's goals have been using the term "sector agnostic" to describe grantmaking that should look only at a grantee's ability to meet those goals rather than at the charitable status of a prospective grantee.

L3Cs are part of a movement to expand the scope of charity, eventually including foundation grants and individual donations beyond 501(c)(3) public charities. An increasing number of commentators such as bike ride fundraiser Dan Pallotta [5] advocate changing the tax code so that contributions to (or purchases from) socially minded for-profits would be tax deductable. Opening up private foundation PRIs (Program Related Investments) to L3Cs is part of a dynamic of ostensibly public or social benefit businesses, including B Corporations [6], to expand the scope of charitable thinking and ultimately charitable support for for-profit corporations as well as nonprofit charities. In the public's mind and in some of the press commentary, the various states passing L3C laws are seen as conferring something like nonprofit status on for-profit business entities. It isn't true, but it's hard not to imagine this as the direction that the movement is headed.

And foundations can already fund for-profits. They can already make Program Related Investments (PRIs), low- or no-interest loans and loan guarantees to entities other than nonprofits if they either get an IRS letter ruling or take "expenditure responsibility" for the investment. They can hire for-profit firms through contracts the same way they "hire" nonprofit organizations through grants. And in the same way that they can invest their capital in less-than-socially-minded companies through the stock market, they can make "mission-related investments" (MRIs) in socially-minded for-profits.

So if foundations can already make loans to nonprofits (including their subsidiary business ventures) through PRIs and can make investments in socially responsible companies through MRIs (getting market returns), why are foundations pushing so hard for the ability to make PRIs to L3Cs?

Why are foundations promoting L3Cs?

Notwithstanding the economic development potential of the L3C model, we think there are two superordinate reasons relating to legitimizing and expanding the "charitable" interactions of foundations with for-profit entities:

First, foundations are looking for more ways to invest in alternatives to the nonprofit sector. Sadly, some foundation executives and social entrepreneurs express, often sotto voce, limited belief in or frustration with nonprofits, despite their public statements to the contrary. One foundation and association leader recently challenged the "assumed exclusive" relationship [7] between foundations and nonprofits. Ralph Smith and his colleagues believe they are in the "solutions" business, eager to find and fund groups with solutions to social problems, with no predisposition that nonprofit foundations ought to be obliged to support nonprofit organizations.

Second, it's complicated to do PRIs for for-profit businesses (because of the need for IRS letter rulings), but PRIs do count toward required foundation 5% payouts. On the other hand, if a foundation wants to invest in a for-profit, an MRI is easier to do than a PRI, but the MRI doesn't count toward payout. The L3C innovation, if the IRS gives its blessing, means that a PRI to an L3C would count toward foundation payout.

L3Cs versus 501(c)(3)s

Social entrepreneurs will come through the walls at criticisms of the L3C model and the suggestion that foundation interest in L3Cs isn't entirely unanimously high-minded and benevolent. They cite instances where the spigots of foundation investments in for-profit ventures may be crucial for economy recovery in areas of high unemployment and desperate economic conditions.

Such a place is Michigan. Michigan's new L3C statute has resulted in 14 approved and 3 pending L3Cs [8] which see themselves as alternatives to automobile production in struggling areas of the state. In North Carolina, a state senator has been promoting L3C legislation aimed at shoring up the state's faltering furniture building companies.

At the national level, a big interest of L3C promoters is to attract major foundation investments into the faltering newspaper industry. Senator Benjamin Cardin of Maryland introduced S.673 to make newspapers federally tax exempt if the newspaper is seen as achieving an "educational purpose" and "follows methods generally accepted as educational in character." There has been plenty of positive commentary within journalism circles of commercial (failing) newspapers as candidates for L3C status.

The upshot for nonprofits

First out of the gate in 2008, Vermont has already recognized 68 L3Cs [9]. Utah has approved only one (the Salt Lake City Ballet Conservatory) with one more pending (the Full Curl Society, a sheep-hunting program reportedly with initial capitalization from former Utah Jazz star Karl Malone). Wyoming has approved one L3C. Illinois just enacted its L3C law. Legislation is moving toward approval in a half dozen other states.

On the positive side, L3Cs could be formed by nonprofits to attract support from people who don't want to make charitable gifts, but might "give" in return for a minimal rate of return. In an era of declines in charitable giving, low-return investments might be a useful substitute revenue source for some nonprofits.

Maybe L3Cs could get private foundations, normally skittish about mission-related investing, to do so by counting their MRIs toward required foundation payout. For example, an alternative energy program that is having difficulty finding investors in the conventional capital market might be able to get foundation investments.

But the noisy cheerleading for L3Cs may lessen the attention paid to the cautionary issues about these new social enterprises:

There is no "ceiling" on profit in these "low-profit" entities as one advisor to the L3C movement has commented [10], or even any real definition of "low profit." Is it appropriate to have no controls on profit margin? When does some profit become too much profit, if ever?
What would keep a coffee shop (community building), a soap company (health) or an insurance company (disaster protection) from becoming an L3C and thereby potentially getting tax exemption benefits?
An L3C requires a profit-making business model, regardless of its socially beneficial goals. While some nonprofits could form L3Cs, many are nonprofits precisely because their activities and functions do not lend themselves to profit.
In states where L3Cs have been authorized, the state agencies in charge appear to be simply registering them without digging into their bona fides. As a result, the L3C lists, which include remarkably creative and witty corporate names (such as Peace Meals, Coolpass, Explorience, Ecozoic, the Vermont Haunters Club, Badasset, Tails on Trails, and many more), include a number of registered entities whose social missions and programs look, at first glance, somewhat dubious.
Some foundations might find it easier or more attractive to make PRIs to profit-minded entities than their usual nonprofit partners. Will nonprofits end up competing against L3Cs for PRI dollars?

Pardon us, but we're not sold on L3Cs. Community nonprofits -- arguably the most critically needed and the most innovative segment of the nonprofit sector -- will be largely left out of these new financing schemes. Diversion of foundation funds from nonprofits to for-profits is likely to result in declining health of the nonprofit ecosystem. And notwithstanding their interesting potential for attracting capital investments to struggling newspapers, faltering furniture makers, and new environmental and energy companies, the L3C scheme feels ideologically geared to expanding for-profit options for foundation loan-makers and, potentially in the long run, to foundation grantmakers as well.

Editor's note: Have the state or national nonprofit associations to which you belong taken up this issue for study and potential advocacy? We need our leadership organizations to be raising debate and making sure that the voices of nonprofits -- not just those of foundations and entrepreneurs -- are heard in that debate.