Vermont Law Authorizing L3C Business Entities Supports Vermont’s Economy and Social Infrastructure

 

My blog posting on "Vermont's Thriving Nonprofit Sector..." (May 26, 2008) discusses how Vermont’s robust nonprofit sector enhances our state’s economy both directly, by providing good jobs and attracting dynamic people to Vermont, and indirectly, by enhancing the social infrastructure which is critical to economic growth. The new L3C law passed by the Vermont Legislature makes it easier for private foundations to directly invest in Vermont’s economy without jeopardizing their favorable tax-exempt status. The L3C law is another avenue for cross-pollination between the nonprofit sector (including private foundations) and our for-profit economy.

Private foundations are tax vehicles for individuals and companies to set aside their own funds for charitable purposes.  Private foundations are 501(c)(3) organizations, but unlike "public charities" that receive contributions from a broad segment of the general public, private foundations generally are funded by a limited universe of donors, often from either a single family or company.  Private foundations are afforded special tax treatment under state and federal law but must avoid investments that involve substantial risk unless those investments are “program-related investments” ("PRI"), meaning that the investments further charitable or educational purposes of the private foundation. If a private foundation invests in a for-profit enterprise that involves substantial investment risk (a so-called “jeopardizing investment") the foundation and each of its managers may be subject to punitive excise taxes.

One of the benefit of L3Cs for private foundations relates to the fact that private foundations are required to spend 5% of a running average of their net asset value every year on certain administrative costs and grants.  A PRI may substitute for all or some of those grants. By making these PRIs in an L3C not only do private foundations fulfill this legal requirement but also, as members of the L3C, they have a degree of control over how the L3C operates.  Also, if at some point in the future the private foundation recovers its investment with or without appreciation, it then has more money to make further grants or PRIs, thereby increasing the potential to perform socially beneficial activities. 

Low-profit Limited Liability Companies, referred to as “L3Cs”, are a new entity authorized under Vermont law.   Click HERE for a brief overview of L3Cs from the Vermont Secretary of State; click HERE to read the new L3C law (one page in length).  The idea is that investment in an L3C, by definition, qualifies as a "program-related investment" under federal tax rules because the conditions for organization under the Vermont l3C law are consistent with the IRS regulations for PRIs.  As such, no significant purpose of the L3C is the production of income or the appreciation of property.  An L3C is designed to be self sufficient and generate a low profit for its owners and investors, and even if one of its investors is a private foundation, the private foundation will not be exposed to excise tax liability based on the profit generated by the L3C.

For example, a farm may re-organize as an L3C and generate a small profit. The L3C farm could accept investment from a private foundation seeking to support businesses maintaining Vermont’s working landscape and preserving valuable open space, and could pay a modest rate of return (“low profit”) to the private foundation. The L3C farm also could accept investment from other investors seeking a market rate of return. If the L3C farm generates a profit and pays a market rate of return to a standard investor, that fact would not adversely affect the tax status of the private foundation, a co-investor, as long as the private foundation did not originally structure the L3C to provide the foundation more than a “low profit” from the farm. Also, the L3C law allows private foundations to own more than 20% of an L3C business enterprise, whereas the general rule is that ownership of more than 20% of a business by a private foundation constitutes an “excess business holding,” which can result in substantial excise taxes.

Proper use of the L3C under IRS regulations is in situations where private, normal for-profit investment would not be made although such investment would bring about desired social purposes.  For example, an L3C can be used to create jobs in a depressed area if businesses are not providing adequate opportunity.  Just because the L3C creates one or more jobs does not mean it is positioned to compete effectively with private business or generate profits that a for-profit investor would find adequate.

My law partner Brian Murphy served a key role as a volunteer helping the Vermont Legislature analyze the L3C proposal. As a fellow member of the Vermont Bar Association’s Business Section, he studied the L3C proposal with an objective eye and testified in the Legislature about its features. The law was proposed by a private foundation seeking to advance the L3C concept in one state as a testing ground, hopefully to be replicated in other states. This approach is similar to how limited liability companies (LLCs) were introduced state by state a number of years ago, starting with Wyoming in 1977 and eventually authorized in other states, including Vermont in 1996. Just as a Delaware corporation may be used anywhere in the United States, a Vermont L3C now may be used anywhere in the United States.

L3Cs are being touted in Vermont as an improved way to engage in socially responsible investing. This is true . . .  but to a limited extent. L3Cs only make things easier for private foundations – the L3C law changes nothing for individuals and companies who seek socially responsible investments. Individuals and companies always have been, and remain, free to invest in any business enterprise (high profit, low profit or no profit), and take any percentage of ownership in a business without jeopardizing their current tax status – only private foundations need to worry about “jeopardizing investments” and “excess business holdings.” L3Cs are a useful tool to enable private foundations to invest in businesses and use for-profit businesses to perform socially beneficial goals without setting up layers of legal documentation to avoid a “jeopardizing investment" or “excess business holding” that would adversely affect the foundation or its managers.

Another point that has not been raised in recent discussions about L3Cs is the fact that the Internal Revenue Service has not "blessed" the L3C concept. There definitely are some misconceptions regarding the IRS role.  The IRS has published regulations and examples as to what constitutes a PRI and requires no pre-approval of the investment.  However, without a defined vehicle for the investment, many foundations were reluctant to make these investments without prior IRS approval via a tool known as a "private letter ruling."  the danger has been that there are penalties for the foundation and its managers if the IRS in a later audit finds fault with the investment.  the sponsors of the L3C statute believe that the vehicle as structured eliminates this uncertainty.  The same national interests who lobbied for the L3C law in Vermont are contemplating lobbying in Washington, D.C., seeking either a federal law or IRS guidance ratifying the L3C concept as an additional security blanket.  It is important to note that there are additional requirements under the federal tax rules that every private foundation making an investment in an L3C must meet, which are separate and apart from the legal requirements of the L3C itself (such as exercise of "expenditure responsibility" by the foundation, alignment of charitable or educational objectives of the L3C with the tax-exempt objectives of the foundation, and so forth). 

Brian is preparing a set of Frequently Asked Questions on L3Cs. We are collecting questions asked by our clients and anticipating other questions that probably are on people’s minds. If you would like to submit a general question about the new L3C law, please post your question as a comment on this blog, and we will incorporate your questions and our answers into the FAQs to be posted on our firm’s web site shortly. IMPORTANT: Do not send confidential information to me or any other lawyer unless you have engaged the lawyer for legal representation – sending an email to a lawyer does not create an attorney-client relationship or trigger attorney-client privilege and confidentiality. If you have a question that is targeted to a specific set of facts, you should request a consultation with an attorney.

Post your general questions on L3Cs on the journal page of this blog (click HERE to return to the journal page, then scroll down to the "L3C" item and post your question as a comment) and we will address them soon in our upcoming FAQs.