In the News

IRS Rules Could Help the Fledgling L3C Corporate Form

Friday, May 4, 2012 11:32 am
by Anne Field

In what could be big news for not only for profits, recently released proposed rules from the IRS could give a major boost to a fledgling corporate form called the L3C.

The regulations relate to program-related investments (PRIs), a type of investment foundations are allowed to make. Just so you know, the L3C is a type of LLC for for-profit companies focused on a socially beneficial mission. (They're low- profit limited liability companies).

More background about the IRS rule. By law, foundations have to direct 5% of their assets every year for charitable purposes to keep their tax-exempt status. They can do that through grants, of course. But they also can make investments, as long as the entity they're putting their money in primarily is aimed at a charitable or educational purpose and making a profit isn't a significant goal. Those investments are called  PRIs.

While they've been around for more than 40 years, however, foundations have been slow to make such investments. That's because they've been afraid of being socked with a big excise tax by the IRS for engaging in speculation if the agency finds the organization they've invested in isn't kosher. Foundations can protect themselves by getting what's known as an opinion of counsel, according to Marc J. Lane, a Chicago lawyer and a leader in developing the L3C concept. Or they can ask for a private letter ruling from the IRS, which is a lot more time-consuming, expensive and risky.

Nonetheless, most foundations have been wary of taking the step.  (That's not to say there haven't been some significant exceptions. About a year and a half ago, the Gates Foundation set up a $100 million PRI fund).

And that reluctance hasn't been great for L3Cs. Why? The idea behind these entities is that  they can be treated as legitimate PRI investments for foundations.  And, according to Lane, if foundations were to pour money into these companies, then that could serve as an incentive for other investors to take the plunge.  While there are about 600 L3Cs in existence–nine states have passed laws allowing the form since 2008–a lot more could take off were PRIs to become more accepted.

What's been needed, then, is more guidance from the IRS about just what constitutes an acceptable RIA. And that's what's happened with the new proposed regulation.

In the 1970′s, the Treasury Department published examples of entities that would qualify as PRIs. They focused on organizations involved with the hot issues of the time, like addressing deteriorating urban areas. (Not that those aren't big problems now. They just aren't the issues du jour).

The new regulations broaden the landscape considerably by adding nine new examples of investments that would qualify, along with some general principles.

Some noteworthy principles: The existence of a potentially high rate of return on an investment does not, by itself, prevent the investment from qualifying as a PRI;  an investment that funds activities in a foreign country may further the accomplishment of charitable purposes and qualify as a PRI;   a PRI may accomplish a variety of charitable purposes, such as advancing science, combating environmental deterioration, and promoting the arts.

Some of the examples:

  • an equity investment in a for-profit drug company made for the purpose of developing a vaccine to prevent a disease that predominantly affects poor individuals in developing countries
  • an investment in a new recycling business in a developing country that will recycle solid waste currently being disposed of in a manner that contributes significantly to environmental deterioration
  • a loan to a business that purchases coffee from poor farmers in a developing country

InterSector Partners is one company that could benefit from a new  embrace by foundations of not only PRIs, but using the L3C as a vehicle in which to make those investments. The Longmont, Col., consulting firm, which works with profits, nonprofits, and government agencies around social and environmental issues, has been an L3C since 2009. Co-founder Rick Zwetsch says the firm is gearing up for a major new project and he's hoping to garner some PRI money to help make it happen.

Why did he go the L3C route to begin with? “We have to make a profit or we go out of business,” he says. “But we want to have our social purpose in front of everything we do.”


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