A low-income limited liability company, or L3C, is a relatively new type of business entity designed to pursue a public benefit, make some profits, and attract investment from foundations. However, L3Cs have not gained wide acceptance. They are only available in a few states, and many foundations are reluctant to invest in an L3C due to uncertain treatment of L3C investments by the Internal Revenue Service (IRS).
An L3C is not a nonprofit. It is a special type of limited liability company (LLC), with its primary purpose being the same as a nonprofit but also being permitted to make a profit as its secondary purpose.
Discussions of L3Cs often use the term "social purpose," but state laws do not use that term. State laws typically require an L3C business to meet the IRS requirements for a charitable or educational purpose. The requirements are found in the IRS Code, section 501(c)(3). For more information, see IRS Publication 557, Tax-Exempt Status for Your Organization.
Advantages of an L3C
A nonprofit corporation or LLC is prohibited from distributing profits to equity owners (shareholders of a corporation or members of an LLC). This can limit the organization's viability.
An L3C's ability to engage in profit-making activities can enhance revenues and attract investors who want to both support a charitable goal and obtain some return on their investment.
Also, an L3C has less formal management and record-keeping requirements than a B Corp. This is comparable to the difference between a traditional LLC and a corporation.
Foundations may be attracted to investing in an L3C, but such investments must be what the IRS terms a program-related investment (PRI).
Disadvantages of an L3C
Not all states permit L3Cs. As of 2020, an L3C may only be formed in 10 states:
- North Dakota
- Rhode Island
Unless all members of the L3C are tax-exempt organizations, the L3C will need to pay taxes on its profits. Note also that donations to an L3C are not tax-deductible.
Because of uncertainty about whether a foundation's investment in an L3C will qualify with the IRS as a PRI—thus jeopardizing the foundation's tax-exempt status—foundations may be reluctant to invest in an L3C.
How to Start an L3C
The L3C business structure is the same as for a traditional LLC. Members contribute funds to start the business, and managers run the day-to-day operations. Record-keeping requirements are determined by state law but are generally less burdensome than those required for a corporation.
An L3C must be formed according to the specific requirements of the state in which it is created. This involves filing articles of organization, the same as for any LLC. The filing documents must state that the business is being formed as an L3C.
In addition to each state's formation requirements, state and federal tax laws must also be considered. This includes obtaining a taxpayer identification number and possibly seeking tax-exempt status.
Generally, an L3C is required to pay taxes on its profits. An L3C may only obtain tax-exempt status if all of its members are also tax-exempt organizations. This requires one or more already tax-exempt nonprofits to form an L3C. Or, you can first form your own tax-exempt nonprofit LLC or corporation, then have that entity form an L3C.
In some situations, and in a few states, an L3C can be useful. However, due to the tax uncertainty and complexity that comes with this type of entity, organizing as an L3C can be risky. In many cases, forming a B Corp or for-profit entity in conjunction with a nonprofit may be a better alternative.
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