For years, the only option for starting a new venture in the United States was binary: for-profit or non-profit. This all changed in April 2008 when a new form of business legislation was enacted in Vermont. The low-profit limited liability company, or L3C, was established as an alternative to the more traditional LLC. Options were further expanded in April 2010, when Maryland enacted the first legislation creating a Benefit Corporation. Luckily for Louisiana entrepreneurs and residents, the state has been a pioneer in this social business arena, enacting L3C legislation in 2010 and B Corp legislation in 2012. There are currently 137 L3Cs registered in the state of Louisiana, one of only nine states to offer this corporate form.
So what is an L3C?
Think for-profit meets non-profit, or 501c(3) married to LLC. An L3C is similar to an LLC, but its main purpose is to attain a socially-beneficial goal, and its secondary purpose is to make a profit. “Low-profit” is a bit misleading as a title because although the main goal of the organization cannot be to make a profit, there is in fact no limit to the amount of revenue, and subsequently profit, that can be generated.
Why form an L3C?
Instead of playing for both teams, why not just pick a side? In other words…
Why not just be a for-profit corporation?
1. Social Mission
Because for-profit corporations like LLCs, S-Corps, or C-Corps are legally obligated to make business decisions that maximize profit for shareholders, founders of traditional corporations may feel constrained in their desire to pursue a philanthropic goal. An L3C allows a company to pursue a social mission without the fiduciary duty to shareholders to maximize profit.
2. Program-Related Investments
One major benefit of an L3C is its ability to collect investment dollars from foundations and private donors who have difficulty investing in traditional for-profit businesses. By law, foundations must allocate 5% of their assets to charitable purposes each year in order to remain tax-exempt. Foundations can achieve this through grant making to 501c(3)s, but also through program-related investments (PRIs). A foundation can make these investments if the business it funds has a charitable purpose and profit is not the primary goal. It is generally difficult for a foundation to prove this charitable purpose for a for-profit entity, and so a large percentage of U.S. foundations don’t take advantage of this opportunity. However, the L3C makes it easier for foundations to prove to the IRS that their investment is going to a charitable purpose. These PRIs may also have a lower interest rate than traditional lenders, creating a mutually beneficial relationship with the L3C as they are able to access capital at a lower cost.
Why not just be a non-profit?
1. Access to Private Capital
Many non-profits find it too difficult and risky to rely on philanthropic donations and grants for operating cash flow. The L3C format provides a vehicle for a company to raise private capital that is usually unavailable to non-profits. Furthermore, an L3C can easily target socially conscious investors who aren’t looking to give straight donations, but are willing to sacrifice somewhat of a return in order to achieve a social mission. The popularity of impact investing has greatly increased in the past few years, and an alternate corporate form allows companies to differentiate themselves to these impact investors.
Non-profits are often constrained by a bureaucratic approval process for making strategic decisions. However, many corporate leaders don’t want every decision to be taken to a board of directors for approval. The L3C format allows the organization to bypass approval from a hierarchical board and subsequently allows the company to stay nimble.
3. Unrestricted Ability to Earn Revenue
Although non-profits are legally allowed to earn revenue, there are restrictions on the sources of revenue they can earn tax-free. A non-profit corporation may earn Unrelated Business Income (UBI as it is termed by the IRS), but it will be taxed at the corporate tax rate, therefore losing some of the tax-exempt benefit. In cases when too much of a non-profit’s revenue is not directly related to charitable activities, the non-profit could lose its 501c(3) status.
So far everything about an L3C sounds great. But what are the disadvantages?
1. PRI is Not Guaranteed
Although an L3C makes it easier to attract program-related investments from foundations, this source of funding is not guaranteed. In order to make a PRI in an L3C, the foundation must still prove the charitable nature of the company, and it must align perfectly with its mission. Therefore, this type of investment is still seen as risky to a foundation, because if the IRS deems a PRI invalid, the foundation can be stripped of its tax-free status. Plus, only a small portion of foundations actually engages in PRI. So if this is the primary reason for forming an L3C, probably not a good idea. But if it is seen as an added perk, great.
2. Limited Profit Potential
Perhaps made obvious by its name, the low-profit limited liability corporation has limited profit potential, and therefore limited long term earnings potential for the owners. While there is no profit maximum in place, profit cannot be the primary purpose of the business venture, and therefore is not the ideal vehicle if high revenue generation is the end goal.
3. Difficulty Attracting Investors
Because an L3C does not have the fiduciary duty to maximize profit for its shareholders, L3C entrepreneurs must be flexible in their funding sources, often leaning on impact investors for funds. Traditional investors concerned only with the bottom line and a high return may be dissuaded from this type of investment. Although an L3C’s ability to attract private capital is greater than that of a non-profit organization, L3Cs may still find it more difficult than LLCs to find investment.
4. No Federal Tax Benefits
At this point in time, the IRS does not award any special tax status to an L3C. This is not a disadvantage over a traditional LLC, but rather provides no additional incentive for entrepreneurs.
The adoption of social businesses like the L3C can be a strategic choice by management to help the company gain a competitive advantage in its industry. Not only is the L3C format beneficial for public relations and marketing, it is a comprehensive way to engage with all stakeholders and ensure satisfied consumers. Consumers have already started to push for businesses that align profit goals with community and environmental benefit. Louisiana’s decision to emerge as a pioneer helps keep our state’s entrepreneurs ahead of the curve.
To learn more about alternate corporate forms, please reach out to us at email@example.com and stay tuned for an upcoming blog article about Benefit Corporations. Please note that EMH is not providing tax advice. You should consult your CPA to determine if this business form could be appropriate for you.