Frequently Asked Questions
BASIC OVERVIEW OF THE L3C
EXAMPLES OF L3C BUSINESSES
L3C’s would typically involve businesses that serve socially beneficial purposes and have some economic viability — but have difficulty attracting capital because of the high risk or low return (or both) integral to their operation. A few examples:
- A hotel in a deteriorating business district would have some ability to generate revenue, but not enough to attract sufficient capital to begin operations.
- Historic buildings could be preserved and converted into office and retail property, but the costs of renovation may be so steep that the projected rents can not support market-rate debt incurred to finance those renovations.
- A factory that has employed much of a town’s work force may need to replace obsolete equipment at great cost, leading its owners to explore relocation of manufacturing operations to a lower-cost foreign jurisdiction.
- A nonprofit hospital with unsustainable debt from significant charity care opts to reorganize as an L3C, with the primary benefit of continued care for paying and charity patients, but with the added empowerment of for profit business practices.
In all of these situations, an L3C could undertake the low-return, high-risk business activity involved in these situations, with a view to combating economic deterioration, destruction of historic property, or job loss.
We ask existing L3Cs to contact us so we may list your operation as an example here.
FINANCING AN L3C
Attracting capital is the key to this innovative business vehicle. Under the federal tax laws, private foundations must distribute 5% of their capital each year for charitable purposes. Usually, foundations do this by making grants. However, foundations are permitted to make program-related investments (PRI) instead, and to count funds so invested in determining compliance with the five percent requirement.
The L3C vehicle is designed to attract PRI investments (although PRI investments from foundations are not a requirement. Under the L3C operating agreement, the foundation investor would have the last claim on the assets of the enterprise upon dissolution while accepting a rate of return well below the market rate. By absorbing excess risk and accepting less than market rate returns, the foundation investment provides a base of capital that makes the subsequent senior tiers of capital less risky and more profitable.
The most senior tier could generate market rates of return. With the PRI capital in place, the model L3C can potentially offer market rates of return at acceptable levels of risk to investors such as pension funds, community banks, etc.
PRIs were intended to facilitate joint investments by foundations and commercial interests in a way that accomplished charitable purposes, and have been permitted since 1969.
When describing approved PRIs, the Ex.s in the regulations use phrases such as:
- “conventional sources of funds are unwilling or unable to provide funds.…” Treas. Reg. § 53.4944-3(b), Ex. (1);
- “conventional sources of funds are unwilling to provide funds…at reasonable rates.…” Treas. Reg. §53.4944- 3(b), Ex. (3);
- “conventional sources of funds are unwilling or unable to provide funds …at reasonable rates.…” Treas. Reg. § 53.4944-3(b), Ex. (4);
- “Y, a private foundation, makes a loan to X [a business enterprise] at an interest rate below the market rate for commercial loans of comparable risk.” Treas. Reg. § 53.4944-3(b), Ex. (4);
- “Y, a private foundation, makes a loan to X [described as a business enterprise which is financially secure and the stock of which is listed and traded on a national exchange] at an interest rate below the market rate to induce X to establish a new plant in a deteriorated urban area which, because of the high risks involved, X would be unwilling to establish absent such inducement.” Treas. Reg. § 53.4944-3(b), Ex. (5); and
- “Y, a private foundation, makes a high-risk investment in low-income housing…” Treas. Reg. §53.4944-3(b), Ex. (10). In fact, all of the Ex.s of approved PRIs in the Treasury Regulations involve risk levels that are unacceptable to normal financial investors, and all of the examples involve highly capital intensive projects such as the construction of manufacturing plants and low-income housing.
Moreover, current economic conditions suggest a need for greater deployment of foundation funds in PRIs in order to help alleviate economic and social distress.
TAXATION AND IRS–RELEVANT ISSUES
- First, the draft federal legislation creates a new oversight and approval process at the IRS that enables entities seeking to receive PRIs (such as L3C’s) to request an IRS determination that foundation investments in the entity will qualify as PRIs. Once an entity has received an IRS determination that it qualifies as a PRI recipient, foundations would be entitled to rely on the determination when making PRIs. Although the proposed determination process, like the current private letter ruling process, is not mandatory, we believe that L3C’s and other PRI-seeking entities will voluntarily seek IRS review andapproval because foundations will be more likely to make PRIs in entities that have been approved by the IRS as PRI-qualified.
- Second, the draft federal legislation creates a mandatory reporting requirement for entities that receive PRIs where none currently exists.
- Finally, the federal legislation does not relieve foundations from their existing obligation to exercise due diligence and expenditure responsibility when making PRIs that have not been reviewed in advance by the IRS.
Treas. Reg. § 1.501(c)(3)-1(d)(2) provides that the term “charitable” includes the promotion of social welfare by organizations designed to (1) lessen neighborhood tensions, (2) eliminate prejudice and discrimination, (3) combat community deterioration, or (4) combat juvenile delinquency. As the following examples illustrate, the
IRS generally draws on these criteria when evaluating whether jobs creation and economic development activities qualify as “charitable” under § 501(c)(3) of the Code.
In Rev. Rul. 70-585 (1970-2 C.B. 115) a community organization was formed to plan the rehabilitation and renewal of an area in a deteriorated urban area where the median income level was lower than in other sections of the city. The organization purchased an apartment house that it planned to rehabilitate and rent to low- and moderate-income families, with preference given to residents of the area. The IRS ruled that “[since the organization’s purposes and activities combat community deterioration by assisting in the rehabilitation of an old and run-down residential area, they are charitable within the meaning of § 501(c)(3) of the Code.” In the same ruling, the IRS considered an organization that was formed to construct housing facilities that would help families to secure safe and affordable homes in an area where the high cost of land, increased interest rates, and the growing population had produced a shortage of housing for moderate income families. In contrast to the first example, the IRS ruled that this organization did not qualify for exemption because its “program is not designed to provide relief to the poor or to carry out any other charitable purpose within the meaning of the Treasury Regulations applicable to § 501(c)(3).”
In Rev. Rul. 74-587 (1974-2 C.B. 162 ) the IRS considered whether an organization formed to stimulate economic development in high-density urban areas inhabited mainly by low-income minority or other disadvantaged groups qualified as charitable. The organization provided funds and working capital to corporations or individual proprietors who were not able to obtain conventional financing because of the poor financial risks involved in establishing and operating enterprises in communities or because of their membership in minority or other disadvantaged groups. The IRS ruled that the organization was exempt under § 501(c)(3) because it (1) demonstrated that the disadvantaged residents of an impoverished area can operate businesses successfully if given the opportunity and proper guidance, (2) assisted local businesses that would provide a means of livelihood and expanded job opportunities for unemployed or underemployed area residents, and (3) helped to establish businesses in the area and rehabilitated existing businesses that had deteriorated. The IRS specifically explained:
Although some of the individuals receiving financial assistance in their business endeavors under the organization’s program may not themselves qualify for charitable assistance as such, that fact does not detract from the charitable character of the organization’s program. The recipients of loans and working capital in such cases are merely the instruments by which the charitable purposes are sought to be accomplished.
Thus, even though the organization did not provide financial support directly to members of a traditional charitable class, its activities still were deemed “charitable” since they benefited the disadvantaged community as a whole. It is worth noting that the preceding IRS rulings have been in place and operating as effective guidance for more than 35 years.
The proposed federal legislation provides for a voluntary process wherein an entity seeking to receive PRIs (e.g., an L3C) may request an IRS determination that foundation investments in the entity will qualify as PRIs. This process is analogous to the IRS determination process for entities seeking to qualify as tax-exempt under § 501(c)(3) of the Code and should ensure that the structure and proposed activities of the entity comply with the PRI requirements. In addition, the proposed federal legislation requires each PRI-qualified entity that has received an IRS determination to file an information return with the IRS for any taxable year in which it receives or retains one or more PRIs. The return must contain the following information about the entity:
- its gross income for the year;
- its expenses attributable to such income incurred within the year;
- its disbursements within the year for the exempt purposes of organizations holding PRIs in the entity, together with a narrative statement describing the results obtained from the use of those assets for charitable purposes;
- a balance sheet showing its assets, liabilities, and net worth as of the beginning of such year;
- a statement of the portion of its liabilities and net worth that represent capitalization obtained by means of program-related investments as of the beginning of such year;
- a statement of any interest, dividends, or other distributions paid with respect to any program-related investments during the year; and
- any other information that the IRS may require.
This information, together with the information disclosed on the foundations’ Forms 990-PF, should enable the IRS to verify an L3Cs compliance with the PRI requirements and facilitate oversight over the entity by state regulators. Thus, the proposed federal legislation provides a mechanism for regulatory oversight of PRI recipients where none currently exists. Aside from the Form 990 and Form 990-PF disclosures the IRS does not currently have another method for tracking information concerning PRIs in any entity. Further, absent a congressional amendment to the Code, the IRS could not publicly disclose – or require an L3C to disclose – the L3Cs partnership or corporate tax filings
The L3C legislation at the state level provides the initial basis for state regulatory oversight by creating a mechanism—that is, the “L3C” designation—through which to identify the organizations. Currently, state regulators have no systematic way to even identify commercial entities with a charitable purpose, much less to develop legally sustainable procedures for reviewing them.
Such oversight procedures would be most effectively addressed through the legislative process; however, under current law, L3C entities may be required to register with state regulators in some states on the grounds that the entities are making “charitable appeals.” Certainly, the public information return requirement set out in the proposed federal legislation would provide a substantial amount of organizational and operational information to assist both federal and state regulators in addressing any inappropriate situations.
The L3C concept provides that the primary purpose of the organization must be charitable, with the production of income permitted to be a secondary purpose. As with a tax-exempt charity that must have a charitable purpose by law, yet also must, from an economic standpoint, have sufficient revenue to conduct operations, institutional decisions must be made with the L3Cs overarching charitable purpose in mind. Thus, the L3C brings together foundations’ PRIs and investments by nonexempt parties to accomplish L3Cs primary charitable purpose through a business that, because of its inherent risk and low likelihood of profit, simply would not be attractive solely to for-profit investors.
Precisely the same analytic framework that applies under current law to assess the purpose and fiscal operations of a tax exempt charity will apply to an L3C. When assessing whether a “significant purpose” of a foundation’s proposed investment is the production of income for purposes of the PRI rules, Treas. Reg. § 53.4944-3(a)(2)(iii) states that is is “relevant whether investors solely engaged in he investment for profit would be likely to make the investment on the same terms as the private foundation.” However the fact that an investment produces significant income or appreciation in the absence of other factors, is not conclusive evidence of a significant purpose involving the production of income or the appreciation of property. In fact, Treas. Reg. § 53.4944-3(b), Ex. 1, states, in analyzing an investment by foundation “Y,” that the investment “is a program related investment even though Y may earn income from the investment in an amount comparable to or higher than earnings from conventional portfolio investments.”
ACCOUNTABILITY AS AN L3C
The IRS, state regulators, and private foundations would utilize the same oversight mechanisms currently used to evaluate and monitor existing PRIs. In addition, the oversight mechanisms proposed in the proposed federal legislation—the determination process and annual reporting requirement for PRI recipients (such as L3C’s) —also could illuminate private benefit and self-dealing issues. Finally, if there were a change of circumstances whereby an L3C began to serve an illegal purpose or the private purpose of its managers, such entity would cease, under the terms of the state’s L3C statute, to qualify as an L3C and would cease, by operation of the federal tax law, to qualify as a PRI. In addition, it is important to remember that any foundation or charity investment in an L3C or other PRI is still governed by the restrictions in § 4941 of the Code, addressing self-dealing, or § 4958 of the Code, addressing excess benefit transactions.
Treas. Reg. § 1.501(c)(3)-1(d)(2) provides that the term “charitable” includes the promotion of social welfare by organizations designed to (1) lessen neighborhood tensions, (2) eliminate prejudice and discrimination, (3) combat community deterioration, or (4) combat juvenile delinquency. As the following examples illustrate, the IRS generally draws on these criteria when evaluating whether jobs creation and economic development activities qualify as “charitable” under § 501(c)(3) of the Code.
In Rev. Rul. 70-585 (1970-2 C.B. 115) a community organization was formed to plan the rehabilitation and renewal of an area in a deteriorated urban area where the median income level was lower than in other sections of the city. The organization purchased an apartment house that it planned to rehabilitate and rent to low- and moderate-income families, with preference given to residents of the area. The IRS ruled that “[since the organization’s purposes and activities combat community deterioration by assisting in the rehabilitation of an old and run-down residential area, they are charitable within the meaning of § 501(c)(3) of the Code.” In the same ruling, the IRS considered an organization that was formed to construct housing facilities that would help families to secure safe and affordable homes in an area where the high cost of land, increased interest rates, and the growing population had produced a shortage of housing for moderate income families. In contrast to the first example, the IRS ruled that this organization did not qualify for exemption because its “program is not designed to provide relief to the poor or to carry out any other charitable purpose within the meaning of the Treasury Regulations applicable to § 501(c)(3).”
In Rev. Rul. 74-587 (1974-2 C.B. 162 ) the IRS considered whether an organization formed to stimulate economic development in high density urban areas inhabited mainly by low-income minority or other disadvantaged groups qualified as charitable. The organization provided funds and working capital to corporations or individual proprietors who were not able to obtain conventional financing because of the poor financial risks involved in establishing and operating enterprises in communities or because of their membership in minority or other disadvantaged groups. The IRS ruled that the organization was exempt under § 501(c)(3) because it (1) demonstrated that the disadvantaged residents of an impoverished area can operate businesses successfully if given the opportunity and proper guidance, (2) assisted local businesses that would provide a means of livelihood and expanded job opportunities for unemployed or underemployed area residents, and (3) helped to establish businesses in the area and rehabilitated existing businesses that had deteriorated. The IRS specifically explained:
Although some of the individuals receiving financial assistance in their business endeavors under the organization’s program may not themselves qualify for charitable assistance as such, that fact does not detract from the charitable character of the organization’s program. The recipients of loans and working capital in such cases are merely the instruments by which the charitable purposes are sought to be accomplished.
Thus, even though the organization did not provide financial support directly to members of a traditional charitable class, its activities still were deemed “charitable” since they benefited the disadvantaged community as a whole. It is worth noting that the preceding IRS rulings have been in place and operating as effective guidance for more than 35 years.
The IRS does not identify a set of factors to determine whether the production of income is a significant purpose of a PRI. However, the Treas. Reg. § 53.4944-3(a)(2)(iii) explains that the IRS finds it “relevant whether investors solely engaged in the investment for profit would be likely to make the investment on the same terms as the private foundation.”
For example, in Priv. Ltr Rul. 199910066, a private foundation interested in assisting in the revitalization of blighted communities entered into a limited partnership with a limited liability company as the general partner. The partnership raised funds to use as seed capital and first stage financing for start-up high technology ventures. Some of the companies in which the partnership invested would have been unable to obtain conventional financing. The funds invested by the foundation, as a limited partner, were used to invest in technology businesses that agreed to place their operations in areas of the community determined by a governmental body to be blighted or depressed. The companies had to agree that the investment could be redeemed or repaid if they failed to maintain operations in the community. Because these restrictions were imposed on the use of the foundation’s invested funds, the IRS concluded that the purpose of the investment was not the production of income or the appreciation of property and that the investment qualified as a PRI.
The L3C legislation at the state level provides the initial basis for state regulatory oversight by creating a mechanism—that is, the “L3C” designation—through which to identify the organizations. Currently, state regulators have no systematic way to even identify commercial entities with a charitable purpose, much less to develop legally sustainable procedures for reviewing them.
Such oversight procedures would be most effectively addressed through the legislative process; however, under current law, L3C entities may be required to register with state regulators in some states on the grounds that the entities are making “charitable appeals.” Certainly, the public information return requirement set out in the proposed federal legislation would provide a substantial amount of organizational and operational information to assist both federal and state regulators in addressing any inappropriate situations.
Rather than increase the burden on state and federal regulators, the proposed federal legislation is an anti-abuse measure designed to prevent and detect the “noncompliance” to which is referred to:
- First, the draft federal legislation creates a new oversight and approval process at the IRS that enables entities seeking to receive PRIs (such as L3C’s) to request an IRS determination that foundation investments in the entity will qualify as PRIs. Once an entity has received an IRS determination that it qualifies as a PRI recipient, foundations would be entitled to rely on the determination when making PRIs. Although the proposed determination process, like the current private letter ruling process, is not mandatory, we believe that L3C’s and other PRI-seeking entities will voluntarily seek IRS review and approval because foundations will be more likely to make PRIs in entities that have been approved by the IRS as PRI-qualified.
- Second, the draft federal legislation creates a mandatory reporting requirement for entities that receive PRIs where none currently exists.
- Finally, the federal legislation does not relieve foundations from their existing obligation to exercise due diligence and expenditure responsibility when making PRIs that have not been reviewed in advance by the IRS.
Additionally, the proposed federal legislation should assist state regulators in exercising their oversight function. State regulators, if they desired, could require L3Cs to submit copies of their IRS determination and information return, much as some states require charities to provide copies of their IRS determination letters and Forms 990. Thus, rather than increasing the burden on state regulators, the federal legislation should increase the transparency of the PRI process and the accountability of organizations that receive charitable funding, thereby facilitating regulatory oversight.
Yes. The incorporation of the L3Cs concept into LLC statutes at the state level provides a consistent legal structure for socially beneficial enterprises and a means, through the “L3Cs” designation, for the public, regulators and grant-makers to identify them. Without such statutes in place, regulators would have no ability to identify such enterprises and determine whether or not they should register under state charitable solicitation rules or other regulatory regimes.
Section 4941 of the Code imposes tiered penalty excise taxes on each act of “self-dealing” between a disqualified person and a private foundation. Section 4946(a)(1) of the Code provides that a foundation’s “disqualified persons” include its substantial contributors, foundation managers, their family members (spouses, children, grandparents and grandchildren), and any entity that is more than 35% controlled by these individuals. Section 4941(d)(1) of the Code lists six transactions as acts of self-dealing, including a prohibition against the payment of compensation by a foundation to a disqualified person, unless the compensation is for “personal services which are reasonable and necessary to carrying out the exempt purpose of the private foundation,” and a broad catch-all prohibition against the transfer or use of foundation assets to it for the benefit of disqualified persons.
It bears emphasis that § 4941 imposes penalty taxes on disqualified persons that participate in direct, as well as indirect self-dealing transactions. The IRS has never provided any precise definition of what it might consider “indirect” self- dealing; rather, the applicable Treasury Regulations provide five categories of transaction which are not indirect self- dealing. Many of these categories address transactions involving entities controlled by the foundation or its disqualified persons. For these purposes, the Treasury Regulations provide a very detailed definition of “control.” Specifically, an organization is controlled by a private foundation where:
- the foundation can require the organization to take certain action solely by virtue of the foundation’s voting power or positions of authority held by its foundation managers (acting only as such), or
- disqualified persons may require the organization to take certain action solely by aggregating their votes or positions of authority with those of the foundation. Treas. Reg. § 53.4941(d)-1(b)(5).
Further, an organization will be considered to be controlled by a foundation or by a foundation and its disqualified person if they are able, in fact, to control the organization (even if they have less than 50% of the total voting power of the organization’s board of directors) or if either the foundation or one or more disqualified person has veto power over the potential self-dealing transaction.
The first category of transaction specifically excepted from the definition of indirect self-dealing introduces an important limiting principle. Under the regulations, a transaction between a private foundation and an organization that (1) is not controlled by the foundation, and (2) is not itself a disqualified person because disqualified persons have no more than a 35 percent interest in the organization, is not treated as an indirect act of self-dealing between the foundation and the disqualified persons solely because disqualified persons have an ownership interest in the organization. The IRS has cited this safe harbor as allowing foundations to invest in investment vehicles where disqualified persons will also be investors but at less than the 35 percent level. E.g.,
- Priv. Ltr. Rul. 200551025 (private foundation’s investment of 56% of its assets in an investment fund that is comprised of, and managed by, disqualified persons of the foundation, will is not an act of self-dealing under § 4941(d)(1)(E))
- Priv. Ltr. Rul. 200420029 (private foundation’s investment in investment partnerships in which the foundation’s disqualified persons were the co-investors was not an act of self–dealing)
- Priv. Ltr. Rul. 199905025 (investments by a private foundation in mutual funds in which the foundation’s trustees also invest are not acts of self-dealing under section 4941(d))
- Priv. Ltr. Rul. 9844031 (investments by private foundations in LLCs in which investment funds managed and advised by disqualified persons of the foundations also invest are not acts of self-dealing under § 4941(d)(1)(E))
- Priv. Ltr. Rul. 9448047 (private foundation’s co-investment with disqualified persons in certain investment limited partnerships was not an act of self-dealing under § 4941(d)(1)(E)). The IRS will scrutinize such investments, however, for any special benefits to the disqualified person created by the foundation’s participation. Cf., e.g.,
- Priv. Ltr. Rul. 200420029 (noting that provisions in the investment fund’s operating agreement (i) gave the foundation veto rights with respect to certain decisions; (ii) prohibited the partnership from taking actions or making investments that could be detrimental to the foundation; and (iii) prevented any benefit from accruing to a disqualified person by reason of the fact that the foundation was also an investor in the partnership)
- Priv. Ltr. Rul. 9844031 (noting that the funds’ investment return would not be dependent upon the foundations’ participation in the LLCs, that the costs to the funds of investing in the LLCs would be based on a set percentage of the amount invested, and that the foundations’ participation in the LLCs would not be advertised by the funds in their memoranda to investors)
- Priv. Ltr. Rul. 9448047 (noting that the disqualified person did not benefit as a result of the foundation’s co- investment in an investment partnership and the foundation could withdraw its investment on short notice).
In several of the rulings cited above, the entity (partnership, limited partnership, or LLC) in which the foundation and its disqualified persons co-invested was managed by a disqualified person of the foundation, and the disqualified person received a fee for providing management services. The IRS’s analysis of whether the management fees were a “payment of compensation . . by a private foundation to a disqualified person” and, thus, an act of self-dealing varied with the facts and circumstances of the management services arrangement.
- For example, in one ruling, the entity paid the disqualified person a management fee equal to one percent of the contributions made by all investors, including the foundation. Because the fee was paid by the entity, and not the foundation, the IRS concluded that there was no “direct or indirect payment of compensation” by the foundation, and thus no act of self-dealing. (Priv. Ltr. Rul. 9844031).
- In another ruling, the entity’s operating agreement provided that the disqualified person would waive the foundation’s share of any management and performance fees collected from the entity, to avoid any act of self-dealing. See Priv. Ltr. Rul. 200551025.
The IRS approved this arrangement, but noted that, to the extent such services were “in the nature of ‘brokerage and portfolio services,’” they would be considered “personal services” and compensation for such services would not be considered an act of self-dealing under the exception described in § 4941(d)(2)(E). - In a third ruling, the IRS determined that the fees related to “certain services in the nature of brokerage services performed by [the disqualified person] for [the foundation],” and, accordingly, came within the exception from self-dealing for compensation for “personal services which are reasonable and necessary to carrying out the exempt purpose of the private foundation.” (Priv. Ltr. Rul. 9448047.)
Based on the foregoing, it stands to reason that a foundation’s valid PRI or portfolio investment in an L3C that is not 35% controlled by disqualified persons would not be considered an act of self-dealing, provided that the disqualified persons did not receive special benefits as a result of the foundation’s participation. Conversely, a foundation’s PRI or portfolio investment in an L3C that is 35% (or more) controlled by disqualified persons would raise self-dealing concerns. Thus, under certain circumstances, the Foundation, like all foundations, would be permitted to co-invest in an L3C together with its disqualified persons, provided that the Foundation’s investment did not confer a special benefit on its disqualified persons and provided that the L3C itself was not a disqualified person of the Foundation.
FOUNDATIONS, PRIs AND L3Cs
The decision whether to make a grant or a PRI is a “business” decision of the foundation, and neither form of charitable distribution is favored or disfavored over the other under either federal or state law; it is simply that grant-making is traditionally more common and thus more familiar to state regulators and the public. Whether a private foundation makes grants to charities or PRIs in L3Cs, charities, or other entities, the funds must be used to accomplish charitable purposes. If the PRI is in the form of a loan, the foundation eventually recovers its principal and perhaps earns interest. If the PRI is in the form of an equity investment, then the foundation may earn a return on that investment and eventually recover its capital contribution. Unlike a grant that is never recovered, PRIs may be repaid and then used by the foundation to make additional grants or PRIs. Thus, PRIs actually increase the funds available to accomplish charitable purposes over time.
Although it is impossible to project how foundations might array their charitable activities in the future, a significant shift away from grants is unlikely to occur, simply because of the traditional focus of many foundations on grant-oriented charity. However, this question suggests an economic analysis focused on a variation of “opportunity cost.” Viewed from that perspective, it may make more sense for a foundation to invest—rather than give away—its charitable funds because the foundation will be able to recover and redeploy the funds to accomplish additional charitable purposes in the future.
Foundations will be in the best position to determine whether their funds will have the most impact if granted or invested in a PRI. Based on the above considerations, if a foundation’s charitable portfolio consists of a thoughtful mix of grants and PRIs, the foundation could actually increase its funds available to accomplish charitable purposes over time.
If an L3C was not organized or operated to satisfy the requirements for qualifying as a PRI, the foundation’s investment in the L3C would not qualify as meeting the foundation’s distribution requirement and might be treated as a jeopardizing investment if the investment, in fact, jeopardized the foundation’s ability to carry out its exempt purposes. The “jeopardizing investment” rules evaluate an investment in the context of the foundation’s entire portfolio, and require “the foundation managers, in making the investment, [to] have failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long- and short-term financial needs of the private foundation to carry out its exempt purposes.” Under Treas. Reg § 53.4944-1(a)(2)(i). examples of types or methods of investment that will be closely scrutinized by the IRS to determine whether the foundation managers have met the requisite standard of care and prudence include “trading in securities on margin, trading in commodity futures, investments in working interests in oil and gas wells, the purchase of ‘puts,’ ‘calls,’ and ‘straddles,’ the purchase of warrants, and selling short.”
One can envision hypothetical scenarios under which a particularly large investment fails to qualify as a PRI because of, for example, massive self-dealing, which could theoretically trigger the so-called “third tier” termination excise tax under § 507 of the Code. However, from a practical perspective, absent connivance or gross dereliction of responsibility by a foundation board, a failed PRI would not be expected to jeopardize the overall tax-exempt status of a foundation. Nor should a foundation’s exempt status be threatened merely because the L3C was not structured to meet the requirements for qualifying as a PRI. Rather, the consequences to the foundation would depend on the circumstances of the investment. For example:
- If the L3C failed to qualify as such because it was organized for a commercial purpose or had real profit potential, the foundation could retain its LLC interest as part of its portfolio.
- If the L3C failed to qualify as such because it was organized to accomplish a political or legislative purpose described in §170(c)(2)(D) of the Code, then the foundation’s investment could be treated as a “taxable expenditure,” subjecting the foundation to penalty taxes under § 4945 of the Code.
Insofar as the L3C’s investors are concerned, if the L3C was not structured to qualify as such, the investors would be members in an LLC, rather than an L3C, and their investments would be treated in accordance with the LLC operating agreement.
The tax policy, which has been in place since 1969 and that underlies the concept of a PRI—namely, that private interests will benefit, but in the course of deriving that benefit, a far greater public benefit will be attained though the overarching charitable purpose of the PRI. Under federal tax law, such private benefit is deemed “incidental” and regularly occurs in many charitable relationships. For example, when a student receives a scholarship to attend college, the student receives a benefit that will result in life-long personal financial return, yet the act of granting the scholarship assistance is a traditional charitable act.
The state L3C legislation does not create a new opportunity for foundations to make PRIs instead of grants. Foundations already utilize PRIs in LLCs, partnerships and corporations to accomplish charitable goals. However, these entities may not—and, under state law, generally are not required to—articulate a commitment to charitable purposes in their governing documents. By enacting legislation that recognizes the L3C, states are creating a business form with an identifiable designation—i.e., “L3C.” This designation signals to state and federal 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 regulators to identify taxable entities operating under a charitable purpose unless the organizations have been formed as L3C’s. Thus, the state L3C legislation provides a new way for the public, the IRS, and state charity regulators to identify more easily organizations that seek charitable funding and purport to do charitable work.
IS L3C LEGISLATION NECESSARY?
PRIs have existed since 1969 and there are numerous examples in the Treasury Regulations and rulings of approved PRIs—including PRIs in traditional LLCs. Thus, as a technical matter, one could create the “effect” of an L3C by forming up an LLC and ensuring that its operating agreement and activities satisfy the requirements in Treas. Regs. § 53.4944-3. However, there would be no IRS screening mechanism or public information return filing requirement in the absence of the proposed federal legislation. These procedures would help ensure that foundation and charity investments in PRIs are appropriate and accomplish charitable purposes.
In addition, the proposed legislation is designed to help facilitate PRIs and, accordingly, the flow of capital from foundations to organizations providing charitable services to the community—a particularly important objective in the current economy. While the question assumes that foundations (in particular, “the big guys”) make significant PRIs, recent data reveal that the opposite may be true. According to a survey of more than 72,000 independent, corporate, operating, and community foundations, qualifying distributions in 2006 were approximately $43 billion. PRIs accounted for only $310.5 million (0.72%) of these qualifying distributions. (The Foundation Center, Aggregate Fiscal Data by Foundation Type, 2006 (published in 2008), available at http://foundationcenter.org/findfunders/statistics/pdf/01_found_fin_data/2006/02_06.pdf). 88% of the 2006 PRIs were made by independent and corporate foundations. However, even for these organizations, PRIs accounted for only 0.81% of their total qualifying distributions. These statistics demonstrate that foundations of all sizes are simply not using the full array of tools available to them under federal and state law to accomplish their charitable missions, and, in particular, are not utilizing the PRI concept to enlist resources from the taxable sector to leverage charitable dollars in furtherance of those goals.
We are not aware of any statistics showing how many of these PRIs are made with, or without, out a private letter ruling; however, we note that all private letter rulings involving PRIs must be publicly released under § 6110 of the Code, and relatively few such rulings have been so released. According to our research, the IRS has released between 20 and 25 rulings addressing PRIs during the past 10 years.
We do understand, however, that the disproportionately low number of PRIs relative to grants is caused in part by foundations’ perception that the transaction costs associated with making PRIs are quite high. Given the fiduciary obligations imposed on foundation managers by state and federal laws, it is highly improbable that a foundation would deliberately avoid seeking a private letter ruling because it feared that its proposed investment would not be approved by the IRS as a PRI. It is far more likely that the time and expense associated with seeking a private letter ruling (time spent by counsel preparing the request, plus an $8,700 IRS user fee, plus a wait of up to a year to receive the ruling) deter foundations from making PRIs.
Disclaimer:
Any legal information provided on this website, including (without limitation) any model operating agreements, is not legal advice, but rather provided for general informational purposes.
ACD is not a law firm, and its employees or representatives are not acting as your legal counsel. An attorney-client relationship with ACD cannot be formed by reading the information on this website or by using a model legal form provided by ACD on this website.
The legal information, including (without limitation) any model operating agreements, provided on this website are not a substitute for the advice of a competent attorney. Because the law constantly changes and varies from jurisdiction to jurisdiction, and is subject to varying interpretations, you should consult a licensed attorney in your jurisdiction regarding the applicability any points of law discussed on this website to any specific situation.
While the ACD member directory, biographies of advisory board memers and working group leaders and certain advertisements on this website may include listings for legal counsel, ACD does not warrant the validity of the information, nor does it guarantee the quality of the work product. The determination of the need for legal services and the selection of an attorney are extremely important decisions and should not be based solely upon advertisements, professional affiliations or self-proclaimed expertise. ACD is not responsible for reviewing the contents of the listings thatare provided by the listees or any linked websites, and ACD is not responsible for any material or information contained in the linked websites or provided by listees. A description of practice by an attorney does not mean that any agency or board has certified such attorney as a specialist or expert in any indicated field of law practice, nor does it mean that such attorney is necessarily any more expert or competent than any other attorney. You should make your own independent investigation and evaluation of any attorney being considered.
The information provided on this website is not guaranteed to be correct, complete, or current. ACD makes no warranty, express or implied, about the accuracy or reliability of the information on this website or at any other website to which this site is linked. If you use any links to websites not maintained by ACD, you do so at your own risk. ACD is not responsible for the contents or availability of any linked websites. These links are provided only as a convenience to you.
Any information that you send us in an e-mail message might not be confidential or privileged, and ACD may use any information provided to us for any legal purpose.
ACD is not responsible for any loss, injury, claim, liability, or damage related to your use of this website or any website linked to this website, whether from errors or omissions in the content of our website or any other linked websites, from the website being down or from any other use of the website. Your use of the site is at your own risk.