An L3C company - hard to say at first, since it’s easily confused with 501(c)(3) - is a “low-profit limited liability company” that is established according to state law. Similar to LLCs, L3Cs have members and are governed by an operating agreement. While an L3C exists as a for-profit company, it must be formed with a charitable or educational purpose or mission, within the meaning of the Internal Revenue Code. Unlike a public charity under Code Section 501(c)(3), an L3C has equity owners who may receive profit distributions. Also unlike the profits of a public charity’s exempt activities, the profits of all L3C activities are subject to income tax. However, the production of income or the appreciation of property may not be a significant purpose of an L3C. Also, L3Cs are prohibited from pursuing political or legislative purposes.
The L3C is a free-standing business that also exists as an investment vehicle to promote the social causes for which it was formed. Individuals, businesses, governmental entities, and public charities may all have reasons to invest in an L3C. However, for private foundations, the ability to invest in an L3C is particularly attractive since private foundations generally have a requirement to distribute 5% of their net investment assets (their minimum investment return) on an annual basis. Funding Program Related Investments (PRIs) into an L3C by a private foundation will meet this requirement since L3Cs must be organized for charitable or educational purposes. These PRIs must: a) primarily accomplish a charitable purpose of the private foundation; b) not have any political or legislative purpose; and c) not be primarily for the production of income or the appreciation of property. Since the private foundation can continue distributing to the L3C, this can be a catalyst to attract other investments to further its purposes.
If your nonprofit is not a private foundation, but is a public charity, there may be other reasons to operate closely with a for-profit entity, such as an L3C. If your public charity is considering a tandem structure in which the nonprofit has ownership in an L3C or a joint venture with an L3C (or a similar for-profit business), you will need to be very careful in how your organization goes about this. First and foremost, the nonprofit must be able to demonstrate that it is not operating solely to further the purposes of the for-profit L3C, but acts and operates independently. Secondly, if the L3C’s activities are unrelated to the mission of the nonprofit, these activities can be attributed to the nonprofit if the nonprofit holds equity in and makes management decisions for the L3C. This is especially worrisome if the L3C is a pass-through entity for tax purposes and files its annual tax return using Form 1065 (partnership) or Form 1120S (S Corporation). If the unrelated activities of such a pass-through entity generate taxable income, this may not only trigger unrelated business income tax exposure to the nonprofit, but it could easily endanger the nonprofit’s public charity status. The preferential ownership structure is to have the L3C file as a C Corporation (Form 1120) since activities of a company treated as a C Corporation (for tax purposes) are generally not attributable to public charities that hold equity ownership or stock in these companies. It should also be noted that if your nonprofit is a private foundation and not a public charity, it cannot own a majority interest in a for-profit company (some limited exceptions to this rule do exist for certain program-related businesses and investments).
As of the date of this writing, only eleven states have passed legislation that allow for L3Cs to operate: Illinois, Kansas, Louisiana, Maine, Michigan, North Carolina, North Dakota, Rhode Island, Utah, Vermont, and Wyoming. In January 2014, North Carolina repealed the legislation allowing L3Cs to form. However, North Carolina continues to allow existing L3Cs to operate. Currently, approximately 1,000 L3Cs exist in the United States, including Federal jurisdictions. The first L3C was formed in Vermont when that state became the first to recognize the L3C as a separate legal structure in April 2008. The intent of those initial L3Cs was to attract private investments and philanthropic capital in ventures created to provide a social, educational, or charitable benefit. Since then, the other states to adopt legislation allowing for the existence of L3Cs have done so with this same intent.