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L3Cs: What are They and What Should Private Foundations Know About Them?

Tax-Exempt Organizations Law Update Norah L. Jones

On August 4, 2009, Illinois Governor Pat Quinn signed into law an amendment of the Limited Liability Company Act allowing for the formation of low-profit limited liability companies ("L3Cs") as of January 1, 2010. Illinois is now one of a handful of states that authorize L3Cs. L3Cs are designed for social enterprises that combine a social mission and a profit motive, but are not designed to maximize profits for their owners. They are for-profit entities that advance certain charitable purposes and have been promoted as attractive recipients of program-related investments (or "PRIs") from private foundations. Private foundations wishing to make program-related investments in L3Cs should realize, however, that an investment in an L3C does not automatically qualify as a program-related investment. Failure to approach the L3C investment with the due diligence and formality required of all program-related investments could result in costly penalty taxes.

L3C Legal Requirements

In Illinois, to be organized as or converted to an L3C, an entity must significantly further the accomplishment of one or more charitable or educational purposes within the meaning of Internal Revenue Code Section 170(c)(2)(B) and affirm that it would not have been formed but for the accomplishment of these charitable and educational purposes. An L3C may not have the production of income or the appreciation of property as its primary or significant purpose. It also may not seek to accomplish political or legislative purposes.

An L3C generally cannot qualify for tax exemption under Code Section 501(c)(3) because of its private ownership. Depending on how it elects to be treated, an L3C will be taxed either as a corporation or as a partnership. Under the new law, any company operating or holding itself out as an L3C in Illinois is a "trustee" for purposes of the Illinois Charitable Trust Act. Accordingly, an Illinois L3C or a foreign L3C operating in Illinois must register with the Attorney General's Charitable Trust Bureau and be subject to the regulatory authority of the Illinois Attorney General.

Program-Related Investments

A stated goal of creating the new L3C entity is to encourage private foundations to make equity investments that qualify as "program-related investments."  Private foundations generally must spend an amount equal to five percent of their net investment assets each year for charitable purposes. Private foundations sometimes make program-related investments to satisfy part of this annual spending requirement. An investment will qualify as a program-related investment, and count towards a private foundation's annual distribution requirement, if:

  1. The primary purpose of the investment is to further the foundation's tax-exempt activities and the investment would not be made but for the relationship between the investment and those tax-exempt activities;

  2. No significant purpose of the investment is the production of income or the appreciation of property; and
  3. No purpose of the investment is to accomplish one or more lobbying or political campaign activity purposes.

In addition, the foundation must exercise expenditure responsibility[1] with respect to the investment, if the investment is made in an entity other than a public charity.

These requirements do not prevent an investment from qualifying as a program-related investment simply because it in fact produces significant income or appreciation. The analysis instead focuses on whether an investment on the same terms would be attractive to investors solely engaged in the investment for profit. In general, this means that the risk-to-reward ratio of the investment is such that the investment would not normally be considered a prudent investment for a foundation.

An investment that does not qualify as a program-related investment could result in a "jeopardizing investment" by the private foundation, which is subject to an excise tax equal to ten percent of the amount of the investment. A jeopardizing investment is an investment of the foundation's assets that jeopardizes its ability to carry out its tax-exempt purposes and generally would include an investment made without exercising ordinary business care and prudence. Any foundation manager who knowingly, willfully, and without reasonable cause participates in making a jeopardizing investment also may be subject to a ten-percent excise tax.

Further, if a private foundation does not exercise expenditure responsibility, the investment likely would be a taxable expenditure. A private foundation that makes a taxable expenditure will be subject to an excise tax at the rate of twenty percent of the amount of each taxable expenditure. Additionally, any foundation manager that agrees to make a taxable expenditure knowing that the expenditure would be taxable and without reasonable cause may be subject to tax at a rate of five percent of the amount of the taxable expenditure.

IRS Comments on L3Cs

Although the due diligence for a program-related investment may be easier with respect to an L3C because of the L3C's charitable focus and other statutory features, private foundations should be aware that an investment in an L3C is not automatically a program-related investment for federal tax purposes. The IRS previously has recognized certain private foundation investments in for-profit entities as program-related investments, so it is possible that an appropriate investment in an L3C could qualify as a program-related investment. In each of the IRS approved scenarios, however, the private foundation documented its compliance with each of the program-related investment requirements.

In public statements, the IRS has said that "no one has really signed off on" L3Cs yet at the federal level. The IRS continues to investigate internally how to treat private foundation investments in L3Cs but has not issued any guidance or rulings. Proposed federal legislation would permit the IRS to determine that a below-market investment in a particular L3C would qualify as a program-related investment, but the legislation is still being developed. If that proposed legislation became law, it could be very helpful as to PRI qualification. As it is currently envisioned, however, expenditure responsibility would still be required.

Quarles & Brady Comments

Private foundations interested in investing in an L3C should either (1) take steps to ensure that the investment complies with each of the program-related investment requirements and to exercise expenditure responsibility over it or (2) determine whether the investment is appropriate as part of the Foundation's overall investment strategy. The latter likely would be a tough argument, as an L3C statutory characteristic is that it has no significant profit purpose. Without clear guidance from the IRS, private foundations should not presume that investments in L3Cs will qualify as program-related investments. Private foundations that want to invest in an L3C should undertake a standard program-related investment analysis and adhere to expenditure responsibility so as to avoid making a jeopardizing investment or taxable expenditure, which would subject it and possibly its managers to penalty excise taxes.

This update is intended as a general summary of legal matters and not as specific advice to any particular client. If you have any questions concerning the subject matter of this update, please contact one of the authors of this update, Norah L. Jones, at 312-715-5052 / [email protected], or Krupa Shah, at 312-715-5027 / [email protected], or your Quarles & Brady attorney.

[1] To meet the expenditure responsibility requirements when making a program-related investment, a private foundation must engage in a pre-grant inquiry and make each investment subject to a written commitment that specifies the purpose of the investment and is signed by an appropriate officer, director, or trustee of the recipient organization. The written commitment must contain an agreement by the recipient organization to adhere to certain specified terms as outlined in the relevant Treasury Regulations. The private foundation also must obtain full and complete reports from the grantee organization on how the funds are spent and make full and detailed reports to the IRS on its own Form 990-PF. Further details are in the Treasury Regulations.

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