A recent court ruling underscores an important point for L3Cs: Be careful about your charitable purpose.
On the other hand, it doesn’t mean much for other social enterprises.
The ruling came earlier this month from the Ninth Circuit Court in Zagfly, Inc. v. Commissioner of Internal Revenue. Zagfly, a company selling flowers online at market rates, wanted to be considered a non-profit 501(c)(3), because it would donate profits to charity. That, it argued, made the company a charity, too. The IRS disagreed.
Basically, the Court of Appeals would have none of it, affirming the idea that donating profits doesn’t make you a nonprofit.
“The ruling is entirely consistent with prior law,” wrote Marc J. Lane, a Chicago-based attorney specializing in social enterprise, in an email to me. “To be tax-exempt an organization must be operated exclusively for charitable purposes. The test is how the money is earned no matter where its eventual profits are deployed.”
Of course, there are a great many social enterprises that donate profits to charity. Doing so, in fact, is the primary social mission of a lot of such companies. This ruling doesn’t mean much of anything for them, because they’re for profit.
But the decision does have implications for L3Cs, or Low -Profit Limited Liability Companies. Just to review, this structure is aimed at for profits with a social mission at their core. It was created with the idea that the companies could serve as Program Related Investments (PRIs), which are entities with a charitable or educational purpose that can receive foundation money. Basically, foundations must direct 5% of their assets every year to charitable or educational purposes to maintain their tax exempt status. One way they can do that is to invest in PRIs–and an L3C can serve as a PRI, according to proponents of the structure. And if foundations were to put money into an L3C, that conceivably would encourage other investors to follow suit.
What does this mean for L3Cs? According to Lane, the decision underscores how careful such companies must be about their mission, particularly when it comes to donating profits to charity. “L3Cs, which are obligated to significantly pursue a charitable or educational purpose, should understand that their charitable purpose cannot derive from the donation of their profits to charities,” Lane wrote. “Many that pursue such a strategy may otherwise satisfy the charitable or educational test by virtue of their workforce development, community revitalization or other activities which themselves are revenue-producing.”
By the way, foundations, so far, haven’t been rushing to making such investments–specifically, using L3Cs as PRIs –because they fear the IRS won’t like it. There is the option of getting a private letter ruling from the IRS or an opinion of counsel, of course, but that still isn’t enough for many organizations. Still, a trickle of small foundations have started to make PRI investments in L3Cs, which I wrote about here.
The world's first social impact bond, or SIB, was introduced in 2010 to fund innovative social programs that realistically might reduce recidivism by ex-offenders in Peterborough, England, and, with it, the public costs of housing and feeding repeat offenders. Prudently building on the strengths of that initiative, Illinois Gov. Pat Quinn is rolling out SIBs to help solve some of the state's most vexing social problems.
A SIB isn't a traditional bond where investors are guaranteed a fixed return but a contract among a government agency that agrees to pay for improved social outcomes, a private financing intermediary and private investors. SIBs shift the risk of experimenting with promising but untested intervention strategies from government to private capital markets, with public funds expended only after targeted social benefits have been achieved.
Peterborough's problem was daunting: Sixty percent of prisoners serving short-term sentences historically had gone on to re-offend within a year after their release. But policymakers were confident that a solution was within their reach. They attracted private investment to pay experienced social service agencies to provide intensive, multidisciplinary support to short-term prisoners, preparing them to re-enter society and succeed outside the penal system.
The government decided which goals would be supported, but exactly how those goals would be achieved was left to the private sector. It was the investors, through a bond-issuing organization, who ultimately endorsed the allocation of investment proceeds — how much would be invested in job training, drug rehabilitation and other interventions.
If the Peterborough plan eventually shrinks recidivism rates by 7.5 percent or more, the government will repay the investors' capital and share the taxpayers' savings with them, delivering up to a 13 percent return. If the target isn't hit, the investment will have failed and the government will owe the investors nothing.
Illinois' SIB effort was spearheaded by the state's Task Force on Social Innovation, Entrepreneurship and Enterprise — the governor's think tank on social issues, which I am privileged to chair — with support from Harvard University's John F. Kennedy School of Government, the Rockefeller Foundation and the Aurora-based Dunham Fund. A request for information issued by the Office of Management and Budget on May 13 yielded responses from service providers eager not only to reduce recidivism here but also to create jobs, revitalize communities, improve public health outcomes, curb youth violence, cut high school dropout rates and alleviate poverty.
Now the governor has issued a request for proposals intended to spur better outcomes for Illinois' most at-risk youth — by increasing placement stability and reducing re-arrests for youth in the state's Department of Children and Family Services, and by improving educational achievement and living-wage employment opportunities justice-involved youth most likely to re-offend upon returning to their communities.
Kudos to Mr. Quinn for bringing SIBs to Illinois. May they soon start delivering on their promise.- See more at: http://www.chicagobusiness.com/article/20131007/OPINION/131009850/a-new-kind-of-futures-contract-for-illinois#sthash.ThgxeiFt.dpuf
Reprinted from Anne Field's May 31, 2015 editorial which appeared on Forbes.com. 2015 Forbes.com LLC™ All Rights Reserved