An L3C is not automatically, and does not seek to qualify as, a tax-exempt entity described in § 501(c)(3)—and it could not
do so unless all the requirements for that status are met, as has been made clear by the IRS. Rather, it is anticipated that
most, if not virtually all, L3C's will be structured to qualify as recipients of equity PRIs, with both taxable and tax-exempt
owners. The L3Cs would, themselves, be taxable entities. In every version of the state L3C legislation that has been
enacted, the definition of an L3C was carefully drafted to encompass the PRI requirements set out in the Treasury
Presently, such taxable L3Cs are subject to the same oversight mechanisms as all other for-profit entities (including
traditional LLCs and corporations) that receive PRIs from foundations. Before making an investment, the foundation
may—but is not required to—secure a private letter ruling from the IRS, or an opinion of counsel, stating that the
investment will qualify as a PRI. Once the PRI has been made, the foundation is required to exercise “expenditure
responsibility” (due diligence) over the investment. This includes obtaining annual financial reports from the PRI recipient,
which account for the foundation’s investment, and a statement that the PRI recipient complied with the terms of the
investment. In addition, the foundation is required to report the PRI to the IRS on its annual information return (Form 990-
Both the state L3C legislation and the proposed federal legislation are exclusively anti-abuse measures. Neither the state
nor the federal legislation creates any legal benefit that does not already exist. To the contrary, both legislation’s create
additional safeguards and enforcement mechanisms to ensure that PRIs accomplish charitable purposes.
- First, by enacting legislation that recognizes the L3C, states are creating a business form with an identifiable
designation— i.e., “L3C.” The presence of the “L3C” designation signals to state regulators that the entity is
organized and operated to accomplish charitable or educational purposes, and regulators may implement
programs or mechanisms to monitor whether these requirements are being met. Indeed, it is virtually impossible
for state regulators to identify taxable entities operating under a charitable purpose unless the organizations have
been formed as L3Cs.
- Second, the proposed federal legislation creates a new mechanism for IRS oversight and approval of PRIs that
consumes fewer IRS and foundation resources than the private letter ruling process by providing that the PRI
recipient (rather than each foundation) requests IRS approval of the proposed PRI. The proposed approval
process, like the current private letter ruling process, is voluntary. However, because the process is streamlined
and because the PRI recipient can anticipate more funding if it has received IRS approval, the regime proposed
in draft legislation should encourage voluntary requests for IRS review of these arrangements.
- In addition, the draft federal legislation creates a mandatory reporting requirement for entities that have been
approved to receive PRIs where none currently exists under either federal or state law. Thus, the federal
legislation should improve both the transparency of the PRI process and the accountability of organizations that
receive charitable funding by establishing a clearly-defined screening mechanism within the IRS.
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