Michigan’s L3C: Legal Support for Social Entrepreneurs

By Alari Adams on February 25th, 2013 / Comments

Chevrolet Volt.  Toyota Prius.  Michigan L3C.

Two of these products are automobiles and the other is a relatively new Michigan corporate entity known as a low-profit limited liability company (“L3C”).  Nonetheless, all three of these products are considered hybrids and allow their respective user to attain an optimal result via two different components being combined.

Enacted in 2009 by Michigan Legislature, an L3C is a hybrid between a non-profit corporation and a for-profit corporation, therefore an L3C possesses characteristics of each. Similar to a non-profit, an L3C must be formed in furtherance of some charitable or educational purpose.  However, as with a for-profit entity, an L3C may have equity owners who have the right to receive distributions of profits and appreciation in the value of the business entity.  Currently, only nine states permit organizing as an L3C (but L3Cs can operate in all states) and as of this writing there were 162 L3Cs organized in Michigan.

Like most entities, an L3C must be registered with the Michigan Department of Licensing and Regulatory Affairs (“LARA”) in a manner similar to a limited liability company (“LLC”), with articles of organization being filed and execution of an operating agreement.  Since, an L3C is relatively new it requires some strict compliance with Michigan law and the IRS.  Most notably, an addendum needs to be attached to the article detailing the charitable or educational purpose of the respective L3C.

Despite its non-profit characteristics, an L3C is not a tax-exempt organization under Section 501(c) of the Internal Revenue Code, therefore donations and investments to L3Cs are not tax deductible. Additionally, L3Cs operate like standard LLCs for federal tax purposes, so any profits “pass through” to its members and are taxed at individual rates.

Helping Social Entrepreneurship in Michigan

L3Cs are particularly attractive to individuals who are interested in creating a social enterprise.  As you probably know, a social enterprise is focused on improving the quality of their community opposed to increasing the enterprise’s monetary profits.  The attraction to L3Cs, stems from the fact that they permit funding from traditional sources (family, banks, angel investors, etc.) and private foundations.  To maintain tax-exempt status, private foundations are required by the IRS to contribute at least five percent of their assets for a charitable purpose.  Often this is achieved through grants but foundations may also opt to make program related investments (“PRI”).

PRIs, defined in Section 4944 of the Internal Revenue Code, are investments with entities whose primary objective is aimed at a charitable or educational purpose and not attaining a profit (sound familiar?).  A PRI may be structured as an interest-free or below-market loan, loan guarantees, letters of credit, or equity investment.  Therefore, L3Cs and PRIs are perfect for each other – the L3C attains funding and the foundation remains in the good graces of the IRS and any returns can be reinvested for another charitable purpose.

The unique branding opportunities presented by L3Cs are not without any hurdles.  As of now, the IRS does not automatically recognize an investment with an L3C as being a PRI.  And the penalty for making an investment that is later discovered not to qualify as a PRI is large fines and/or loss of a tax-exempt status.  Therefore, foundations must exercise due diligence whether by asking the IRS for a private letter ruling prior to making an investment to ensure compliance.  Or, foundations may examine the nineteen examples provided by the IRS which illustrate investments that qualify as a PRI.

All in all, an L3C may possibly be the answer for social enterprises to achieve creative capitalism.  However, I think that its overall success is contingent on the IRS making a definitive ruling regarding investments to L3Cs.  In the interim, L3Cs create a distinctive entity for those who are passionate about providing a social good within their respective community.

Photo via Trico Charitable Foundation

About the Author

Alari Adams

Alari K. Adams enjoys assisting individuals who are brave enough to live out their dreams. She is founder of ASquared Legal Group, PLC which provides effective legal counsel to entrepreneurs regarding their emerging small businesses or startup. Follow her on Twitter @ASquaredlegal.