L3Cs (low-profit limited liability companies) are very similar to LLCs. The key difference is that their company purpose, as stated in the L3C’s Articles of Organization, must be a charitable purpose as defined by the IRS for charitable 501(c)(3) purposes. Despite this requirements, L3Cs are not charities and cannot receive tax-free donations or grants. For tax purposes, they are treated the same as LLCs. The L3C’s only other distinguishing factor is that while L3Cs can have a profit motive, an L3C’s principal purpose cannot be to make profit. In practice this limitation has little meaning and L3Cs are generally free to earn as much or as little as they can.
This might lead you to wonder why L3Cs even exist. L3Cs were originally designed to make it easier for private companies to receive certain types of investments from foundations, but this goal relied on certain changes to federal tax law. Unfortunately, those changes never arrived and L3Cs cannot serve their intended function. You can read more about that below, but the thing to know is that an L3C’s primary benefit now, to the extent there are any, is signaling – its a way to tell others who understand social enterprise you intend for your business to operate as a social enterprise ().
Getting into the Weeds – The Social Enterprise Entity that Couldn’t
L3Cs were designed as a vehicle for private foundations to make investments. Private foundations are a type of 501(c)(3) that typically doesn’t do anything itself but that instead gives grants to other 501(c)(3)s that actually do things. These are typically organizations set up by rich families and corporations, like the Bill and Melinda Gates Foundation. Private foundations are required by law to distribute a certain percentage of their assets every year to support organizations that further the private foundations’ exempt purposes. These distributions can be grants or “program related investments.”
Grants are distributions of cash that a foundation gives to another organization for a charitable purpose with no expectation of return. The foundation expects nothing back when it gives a grant.
Program related investments (PRIs), like grants, must be made for a chartable purpose. Unlike grants, the foundation hopes to receive a return on the money distributed. Just like when you invest in a company by purchasing their stock to earn money from that investment, private foundations that make a PRI are hoping to earn a return, the proceeds of which the private foundation will then use to fund other charitable programs.
From a private foundation’s perspective, PRIs sound like a great idea, but in reality they are far less common than grants. The problem historically has been that they are somewhat risky for the private foundation. Because they must be made for a charitable purpose, if the IRS determines that a PRI was made for something other than a charitable purpose, then the private foundation that made the PRI could face various sanctions. Under the existing rules, if the IRS challenges a PRI as non-compliant, the burden is on the private foundation to prove otherwise.
Which finally brings us back to L3Cs. L3Cs were created at the state level in several states as vehicle to allow private foundations to make PRIs at a reduced risk. Under a proposed change in tax law, PRIs made to L3Cs would have been presumptively proper. This would shift the burden to the IRS to prove that the PRI was improper, reducing the risk to the foundation.
Unfortunately the change to tax law was never made, L3Cs did not become the vehicle for a new wave of PRIs, and both L3Cs and PRIs remain fairly rare. It’s worth noting here that because the tax change never occurred, to the extent that foundations make PRIs, L3Cs and LLCs are equally suitable as PRI recipients. As a result, L3Cs have little legal value over normal LLCs. The L3Cs only true benefit now is to signal to others that a business is a social enterprise. This can be helpful for businesses that expect to serve other social enterprises in a business-to-business model, but is probably of limited usefulness for consumer-oriented businesses as very few members of the public know what an L3C is.