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American Bar Association

ABA Section of Business Law


Business Law Today

Nonbinding opinion
By J. William Callison
L3Cs: Useless Gadgets?
When I was a kid, I had a knife with many tools, and I used it frequently and for all kinds of tasks. It had a large blade, a small blade, several screwdrivers, tweezers, a can opener, a bottle opener, scissors, and other devices. It also had something that was marketed as a fishhook remover and fish scaler. I took it fishing, and even tried the hook remover and scaler—they were pretty much useless. I think of such a knife as very useful, adaptable for many purposes, with a few useless gadgets tossed in so that it can be promoted as a tool that does nearly everything one can want.

Limited liability companies are the multipurpose knives of the business organization world. They can be used well for many different tasks. It is this multiplicity of uses, all within one statutory form, that gives LLCs their value and their allure.

One trick with LLCs is to keep from burdening them with useless gadgets. Inclusion of such gadgets is dangerous since some people will attempt to use them, creating risk that should not be created. The well-advised will just use the good tools, and stay away from the gadgets. When my combination hook remover/fish scaler did not work, I folded it back into the knife's body and used a regular scaler. If an LLC gadget does not work, there will be costs incurred by those who attempt to use it to solve a real problem.

Low-profit limited liability companies (L3Cs), adopted in six states with numerous other states considering adoption, are, in the author's view, dangerous gadgets. They add nothing to the LLC package, and might give the unsuspecting user the unfounded belief that difficult tax problems have been solved. Before discussing the risk posed, this article will discuss concepts underlying L3Cs generally.

If a private foundation makes investments in a manner that jeopardizes its exempt purposes, Internal Revenue Code § 4944(a) can subject the foundation and its management to a 10 percent tax on the amount invested. If the investment is not removed from jeopardy in a timely fashion, additional penalty taxes attach. These taxes do not apply to "program-related investments." A program-related investment (PRI) is one in which the primary purpose is to accomplish a charitable purpose "and no significant purpose of which is the production of income or the appreciation of property." Thus, private foundations are capable of making PRIs, and they may not make other investments in profit-seeking business enterprises.

In 1968, the Ford Foundation pioneered the PRI field by making direct, below-market charitable loans to organizations that were part of its focus. Congressional recognition of PRIs came in the Tax Reform Act of 1969. From a foundation's perspective, even beyond the expected financial return, PRIs are valuable tools since they count toward the foundation's 5 percent annual distribution requirement. PRIs also allow foundations to "evergreen" their money for future charitable spending and investments. Below-market loans are the most common PRI investment, but PRI investments can be accomplished through mission-related linked deposits, loan guaranties, lines of credit, asset purchases, recoverable grants, and equity investments.

The L3C is intended to facilitate the making of program-related investments. An L3C is an LLC, formed under state LLC law, that is organized for a business purpose and that satisfies the following requirements: (1) the LLC significantly furthers the accomplishment of one or more charitable or educational purposes; (2) the LLC would not have been formed but for its relationship to the accomplishment of such purposes; (3) no significant purpose of the LLC is income production or property appreciation; and (4) the LLC does not have legislative or political purposes. The L3C's name must include the abbreviation "L3C" or some derivative thereof. The promoters of L3C legislation intend to create an entity form that dovetails with PRI requirements, thereby allowing form to govern substance—the form being an L3C, then the substance of PRI treatment follows.

At the same time, L3C promoters attempted federal tax legislation to make the Code's PRI definition match the L3C structure. The legislative vehicle was the Program-Related Investment Promotion Act of 2008, which would have
A good discussion of PRI use in the context of charter school development can be found on the Annie E. Casey Foundation website:
www.aecf.org/~/media/Pubs/Other/
P/ProgramRelatedInvestingandthe IndianapolisChar/accion.pdf
.

amended Code § 4944(c) to provide a process through which entities seeking PRIs could receive a determination that below-market foundation investments in the entity qualify. Importantly, entities organized as L3Cs would have been entitled to a rebuttable presumption that below-market foundation investments are PRIs. Unfortunately for the L3C industry, the legislation went nowhere.

The problem with attempting a parallel approach of creating a form to match a substance, while also creating the substance that matches the form, is that the concept fails when either the form or the substance is not created. In the case of the L3C, Congress failed to pass the requisite tax legislation and LLCs formed as L3Cs are not entitled to any special presumption concerning PRI treatment. Thus, L3Cs are in no better position to receive PRI treatment than the LLCs out of which they emerged. LLCs are already flexible entities, and nothing prevents an LLC from receiving a PRI when its articles of organization and operating agreement provide for the LLC to significantly further a charitable or educational purpose and for no significant purpose of the LLC to be income production or property appreciation. Indeed, there have been several IRS private letter rulings that LLCs can receive PRIs. Further, unlike statutory formulations of low-profit concepts, LLC law does not lock into specified formalities and allows adaptation to changing IRS approaches to PRI investment. Using the knife analogy, the tool is already there, and it probably works better than the proposed additional gadget.

Perhaps the larger problem with L3Cs is that the form's existence can give rise to the delusion that it has use, and therefore the risk that ill-advised people will use it believing that the form itself gives rise to PRI treatment. It does not, and until Congress determines to give some special treatment to them, L3Cs are like a multipurpose knife's fish scaler, only in a world where their failings count for something.

Callison is a partner at Faegre & Benson LLP in Denver. His e-mail is wcallison@faegre.com.

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