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Charities rely tremendously on our socially- and community-minded for-profit supporters. They assist us in our work through cash and in-kind contributions, sponsorships, board leadership, influence, business guidance, paying taxes, and the list goes on. Businesses exist, however, to make money and they can do so in socially responsible ways if they choose.
Unlike for-profits, charities exist for a specific, government approved public purpose. As such, we face ever increasing regulatory standards for accountability and transparency designed to demonstrate that our organizations and the individuals involved are not gaining private inurnment.
Why this basic primer on the difference between for-profits and nonprofits? Well, there is a recent national craze that seeks to create a “fourth sector” made up of Low-Profit, Limited Liability Companies (L3Cs) that are legally for-profit businesses, but which are supposed to put their primary focus on social good rather than profit. This movement is both misguided and potentially dangerous.
Vermont was the first state to enact legislation in 2008 establishing L3Cs as a legal business entity. Since then Michigan, Wyoming, Utah and Illinois have followed suit, along with the Crow Indian Nation and the Oglala Sioux Tribe. Several other states are considering similar proposals.
Earlier this year, the New York Council of Nonprofits (NYCON) was surprised to see an L3C bill authored by Senator William T. Stachowski (D-Buffalo), suddenly advance out of its original committee of jurisdiction and proceed through several legislative steps before being passed by a vote of 50-11 on the Senate floor – amazingly, all on the same day. A companion bill AB-10414 introduced by Assemblyman Richard L. Brodsky (D-Westchester) remained under consideration in the Assembly Committee on Corporations, Authorities and Commissions. With the current legislative session at an end and their sponsors leaving office, these bills appear to be dead, at least for the moment.
We at NYCON believe that is a good outcome and we are hopeful that there will be no effort to re-introduce L3C legislation for New York in the future. Here’s why:
Supporters argue that L3Cs innovatively combine the best of both the for-profit and nonprofit worlds. Since they may legally generate a profit – albeit a yet to be defined “low profit” – L3Cs supposedly are capable of attracting new private sector capital in support of ventures with a broader social purpose. Supporters also hope that the IRS will change regulations to allow L3Cs to receive Program-Related Investments (PRIs) from private foundations. Those investments currently are not automatically eligible for inclusion as part of the grants to charities that foundations must make in order to meet their own IRS requirements.
I am sure that the core thinkers and entrepreneurs behind the L3C movement are sincere folks who seek improvements in our society. That said, supporters fundamentally seek three things that are unacceptable to NYCON and many in the nonprofit sector:
1. Access to private foundation dollars for risk leveraging purposes. There are two problems with this. The funding which L3Cs seek comes from resources that would otherwise be available to the good work and achievements of legitimate charities. Secondly, the scheme put forth is that the L3Cs will be take in investments in separate “tranches”, or layers, each with its own level of securitization and risk. Foundation PRI’s, they maintain, would be most helpful in providing the early-round and highest risk financing, thereby attracting for-profit, private sector investors during subsequent rounds when the risk is lower and chances of a return are greater. NYCON believes that any investment model where funds from foundations take on the highest risk in order to protect private investors is totally inappropriate. It goes against the traditional fiduciary responsibility which boards of directors, officers and fund managers of foundations have to safeguard their charitable assets. Since the L3C is a private business, the entrepreneur owners themselves do not have any fiduciary responsibility and, moreover, are personally protected by being in a limited liability corporation.
2. Avoidance from the charitable regulatory and accountability environment. The L3C model is an effort to find a legal and tax “space” with the least amount of public oversight and scrutiny possible. L3C entrepreneurs are accountable first and foremost to their investors and certainly don’t want to be restricted by the federal and state governance, financial, and compensation reporting and rules that charities live by. This accountability to investors who expect a financial return as opposed to donors who solely expect mission return and regulators who are working to protect the public’s interest is a fundamental and fatal flaw in the L3C model. Many of the contemporary regulations concerning nonprofits are due to private inurnment abuse and are critical to maintaining public trust. Currently, a number of State agencies such as the Offices of Mental Health (OMH) and People with Developmental Disabilities (OPWDD) are working hard to prevent such excessive executive compensation through regulation and auditing. Limited liability companies (LLCs) in New York are not required to have Boards of Directors or to make any kind of public disclosure of their organizing documents. Without these and other requirements, there is a high risk that L3Cs will be fertile ground for excessive executive compensation and conflicts of interest, something which is prohibited by the Internal Revenue Code and regulated in charities by the IRS.
3. Intentional “blurring” of the charitable definition and marketplace . The public doesn’t understand the workings of C3’s much less that of an exotic, legal contrivance that is similar in name (L3C) and purports to not be what it appears. Charities are working hard and continually to build the confidence of donors, organized philanthropy, consumers and the public at a time there is growing anger and distrust in the integrity of corporate and government institutions. Creating a so-called fourth sector that relies on blurring, legally and in brand, the historic line separating for-profit from charitable organizations is a dangerous long term threat to the sector and public good will.
Concern with L3C’s is growing. The New York Times recently explored examples of potential conflicts-of-interest at existing L3Cs in other states. (“Hybrid Model for Nonprofits Hits Snags”, October 26, 2010.) Daniel Klienberger, a Law Professor at Mitchell College of Law in St. Paul, MN, has also outlined an extensive series of legal concerns. (“The Fatal Design Defects of L3Cs”, Nonprofit Quarterly, June 21, 2010).
The creation of these entities in New York State will create a regulatory nightmare as there is no regulatory framework for them to operate within at the state or federal level. The Internal Revenue Service has yet to rule on whether PRIs in L3Cs would be viewed as a legitimate use of charitable funds under legal guidelines established for private foundations. Until such a ruling, any legislative action to establish L3Cs clearly would be premature.
Current IRS and State regulations provide ample opportunities for charities to responsibly engage in revenue and mission generating enterprises. NYCON itself is the sole shareholder of a successful for-profit insurance brokerage firm that has served and benefited the charitable sector for a dozen years.
NYCON is fully confident that the legislation passed by the NYS Senate and introduced in the Assembly was intended to promote charitable causes and support the wide range of critically important work that nonprofits perform. Unfortunately, we believe that the passage of legislation creating L3Cs as a legal entity in New York was ill advised and would have precisely the opposite effect.
Doug Sauer is CEO of the New York Council of Nonprofits (NYCON).
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Comments
by Bob Lang
This commentary is reflective of the amount of fuzzy thinking or just plain lack of fundamental knowledge that exists relevant to PRIs and L3Cs. I find it more shocking that many people, and Dog Sauer has joined the ranks, feel it is all right to make all these negative statements without checking the facts. Personal conclusions and opinion are one thing and we are all entitled to those, but to disseminate false or misleading information is totally inappropriate for the leader of an organization that is busy promoting transparency and accountability.
Take this statement: 'Well, there is a recent national craze that seeks to create a “fourth sector” made up of Low-Profit,Limited Liability Companies (L3Cs) that are legally for-profit businesses, but which are supposed to put their primary focus on social good rather than profit. This movement is both misguided and potentially dangerous.' This is stated as if it were some sort of fact but he provides no basis for the conclusion. I resent the implication that I am misguided and certainly do not know how he justifies a word as strong as dangerous. The legislatures of eight states and two Indian Nations have debated this bill and eight governors and two tribal leaders have signed it. This means review by AGs, controllers, secretaries of state etc. Hardly a "craze." Is Doug smarter than all these people or has he just not done his homework? Doug also reflects his lack of research when he lists only five states as having passed the bill. Maybe he does not like Louisiana, Maine and North Carolina. If he had been researching rather than commenting he might have come across the Arkansas Legislative Taskforce on Reducing Poverty and Promoting Economic Opportunity: Final Report 2010 This report was published just prior to Doug’s blog and is the work of a taskforce that included legislators, other government officials, business leaders, nonprofits and amazingly enough foundations. They concluded that Arkansas should pass the L3C bill as one of the ways to solve poverty in Arkansas. More people who did not think it a craze, dangerous or misguided.
Doug makes this statement: "Supporters argue that L3Cs innovatively combine the best of both the for-profit and nonprofit worlds. Since they may legally generate a profit – albeit a yet to be defined “low profit” – L3Cs supposedly are capable of attracting new private sector capital in support of ventures with a broader social purpose. Supporters also hope that the IRS will change regulations to allow L3Cs to receive Program-Related Investments (PRIs) from private foundations. Those investments currently are not automatically eligible for inclusion as part of the grants to charities that foundations must make in order to meet their own IRS requirements." The PRI regulations have been on the books for 40 years and are specifically designed to allow foundations to make loans, equity investments, loan guarantees, leases, etc. to for profit entities for the purpose of furthering a charitable purpose similar to the ones that nonprofits often perform. Foundations must engage in due diligence whether they make a PRI or a grant. Nothing in the L3C laws change that. In fact, Doug ignores a fundamental point of law and that is that no state may make a law which changes the conditions created by the federal laws governing PRIs.
Doug states that supporters also hope that the IRS will change regulations to allow L3Cs to receive Program-Related Investments (PRIs) from private foundations. He makes a statement with no basis in fact. As the creator, I am the leading supporter and I would never make such a statement. First L3Cs already can receive PRIs from private foundations. L3Cs are a variant form of LLC and many LLCs have received PRIs. Again if Doug had been researching rather than blogging he might have come across the March 3, 2010 letter from the Section of Taxation of the American Bar Association to Doug Shulman, Commissioner of the IRS entitled Comments Concerning Proposed Additional Examples on Program-Related Investments. This report clearly states that they see no issues relevant to the IRS accepting PRIs made to L3Cs. As far as automatic eligibility we would never suggest such regulations. To do so would clearly erase any foundation responsibility for due diligence or IRS oversight. But grants to any 501(c)(3) nonprofit are not automatically approved either and if Doug is saying that he is badly misserving his constituency.
In his next paragraph Doug again feels confident putting words in my mouth and those of many supporters when he says: "That said, supporters fundamentally seek three things that are unacceptable to NYCON and many in the nonprofit sector:" Actually I did not know he spoke for NYCON all on his own. But again he shows a total lack of understanding of the fundamental working pieces of the foundation world. First there is nothing in the law that says that foundation resources should be available to the good work and achievements of legitimate charities, whatever legitimate means. Foundations are charged with using their endowments to fund a minimum payout of approximately 5% per year for charitable purposes. This may include grants to individuals (see MacArthur Fellows Program commonly called the MacArthur Prizes) loans or grants to governmental organizations, direct expenditures on studies or to pay for research (see Gates.) So called "legitimate" charities have no legal claims to foundation dollars and have only the right to compete like anyone else. The US, when I last looked, was a free enterprise, capitalistic country in which competition of all kinds is encouraged. Charities even compete with each other for donations. Doug does not even take into consideration the fact that the goal is to perform charitable acts not support organizations. The most effective way at the lowest cost of achieving that goal should be the goal of every citizen. We should not be protecting organizations. To add insult to injury Doug has failed to analyze the fact that by increasing the total pool of dollars brought to bear on an issue the L3C will actually take pressure off the nonprofit sector.
When Doug attacks tranching he again shows a lack of understanding of the PRI regulations. PRIs must, by law, have a profile that is the opposite of the traditional fiduciary responsibility which boards of directors, officers and fund managers of foundations have to safeguard their charitable assets. It is the high risk/low return profile of the PRI which allows a foundation to replace a grant with a PRI. A grant is the ultimate high risk, low return profile. If a PRI were to conform to traditional fiduciary responsibility which boards of directors, officers and fund managers of foundations have to safeguard their charitable assets it would just be another endowment investment which would violate IRS regulations.
As far as management responsibility, Doug would do well to have a conversation with John Tyler the eminently respected Secretary and General Counsel of the Ewing Marion Kauffman foundation who has written several papers in which he has emphasized the fiduciary responsibility to mission that the L3C laws create for the owners and managers. It is built into the law and nothing protects them from possible prosecution by a State's Attorney General for violation of that law.
So now we are promoting avoidance of charitable regulation and accountability. Nothing could be further from the truth. If a foundation makes a PRI it must, by law, execute expenditure responsibility over the PRI and the IRS regulates foundations. The foundation must be sure the L3C is complying with the law and the IRS should check on the foundation. Interestingly the L3C makes this process far more transparent. Presently the PRI process is very opaque. Since there is no unique moniker such as L3C at the end of the company name no one except the organizers knows that an LLC, for instance, has received a PRI and should be performing a socially beneficial purpose. Since the IRS does not separately track PRIs they do not even know how many exist. The use of the L3C moniker would actually open the L3C up to not only public scrutiny but make it apparent to the media, AGs, local law enforcement, etc.
Doug’s use of words like inurement are red herrings and nothing more. First the foundation investors cannot use the L3C to avoid private inurement issues anymore than they can use an LLC or a 501(c)(3). But remember the L3C is not a nonprofit. It does not receive donation dollars in order to operate. IRS regulations make it very clear that the foundation's responsibility ends when they are clearly convinced that the L3C is performing on a mission first, profit second basis. While the IRS states that profit should not be the primary goal of a PRI, they go on to say that profit is perfectly acceptable. In fact, they clearly state that if unplanned high profit results that is fine as are equity kickers and substantial capital gains. High profits and capital gains may actually be a measure of success for the L3C. Take an example of an L3C organized to create jobs in a depressed area such as many sections of Syracuse. The L3C could, because of its higher risk tolerance and lower cost of capital go into a depressed neighborhood of Syracuse and buy an old factory, rehab it, equip it and rent out to entrepreneurs who are willing to start new businesses. They could even be required to hire and train local residents many of whom might be minorities. If those business thrive and the neighborhood revitalizes the project will be a success and the L3C will have "cured its disease so to speak." At that point the foundation could sell out for a capital gain and have more money for its next PRI or grant.
Doug refers to a blurring of the brand. But now there is no identifiable brand. The L3C actually creates one. Again Doug comes to a conclusion that has no basis in fact when he says: "Creating a so-called fourth sector that relies on blurring, legally and in brand, the historic line separating for-profit from charitable organizations is a dangerous long term threat to the sector and public good will." Again where is the evidence?
There is no growing concern there is growing support. All of the material that Doug quotes including the NY Times article is primarily old material and has already been well refuted. That the Internet makes for easy recycling of writings regardless of their validity does not justify including them here.
Doug's references to regulatory nightmares are yet another attempt by him to include material with no basis in fact. As I have previously stated in many places the IRS is charged with judging each individual PRI on a fact and circumstance basis. They cannot make any kind of blanket statement as to the acceptability of L3Cs for PRIs. PRIs can be made to individually owned enterprises, corporations, LLCs, partnerships, etc. The IRS only cares about whether a particular PRI, regardless of the structure of its vehicle, meets their criteria in that unique case. As the Section on Taxation, John Tyler, Elizabeth Minnigh, Marc Owens, and myself have pointed out in our writings, the IRS has previously approved PRIs made to LLCs. Since the L3C is a variant form of LLC it is a non issue.
I save my ultimate criticism for Doug’s last paragraph. He seems to have a total lack of understanding of the US Constitution. He clearly has not read Article IV. This contains the provision normally referred to as full faith and credit. It simply says that each state must give full faith and credit to the laws of the other states. Since all states recognize the LLC and since the L3C is a variant form of LLC the L3C already exists in NYS. So an L3C created in Vermont may register as a foreign LLC in NY and do business the same jas anyone can form a Delaware corporation and operate in Idaho. So Mr. Sauer you are like the little boy with his finger in the dike. L3Cs are here in NY and legally operating. I suggest you figure out how to make peace with them. Your stance only costs NY the prestige and income of having homegrown L3Cs. There are around 300 L3Cs so far and some of them are in your neighborhood.
So what is an L3C really all about? Visit our website http://www.americansforcom munitydevelopme nt.org/" rel="nofollow" target="_blank">http://www.americansforcom munitydevelopme nt.org/ and find out.
Bob Lang, CEO
Mary Elizabeth & Gordon B. Mannweiler Foundation Inc.
914–248–8779
rlang@fabriquecosmeti que.com" rel="nofollow" target="_blank">rlang@fabriquecosmeti que.com
Bob Lang, CEO
L3C Advisors L3C
914–248–8443
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Bob Lang, Founder
Americans for Community Development
914-248-8443
robert.lang@americansforcom unitydevelopmen t.org" rel="nofollow" target="_blank">robert.lang@americansforcom unitydevelopmen t.org
Let me begin by attempting to make this less personal. The views expressed in our NYNP “Point of View” article are not mine alone. They reflect a policy position voted on by the Board of Directors of the New York Council of Nonprofits (NYCON), an 83-year-old membership-base d, mission-driven association of over 2,800 diverse charitable nonprofit organizations throughout New York State.
Mr. Lang argues that because eight states and two Indian nations have debated and passed L3C legislation – and others are considering it -- this is a movement which cannot be described as “misguided” or “dangerous”. NYCON disagrees. We can point to any number of laws, regulatory frameworks, or public policies which have been passed in other states that we believe to be totally “misguided” and absolutely “dangerous”. Take, for example, the relatively worthless scraps of paper which pass for health insurance in many states outside of New York.
Mr. Lang is right when he says that corporations are being created everyday in Vermont, Louisiana, Arkansas, or even off-shore for that matter, and depending on the regulations governing the particular industry, can and are operating here in New York. This is common practice in the private sector, such as insurance, where the intention can be to avoid state regulations designed to protect the public and consumers. In fact, many charitable organizations are created in states like Delaware to avoid coming under the full requirements of New York’s Not-for-Profit Law. His point is so well taken that it is now clear to me that we may need state legislation to protect us from the these unregulated out-of-state L3C entities – in the same way we already prohibit the sale of useless, out-of-state health insurance policies .
With respect to Program Related Investments (PRIs) Mr. Lang argues that IRS regulations already allow foundations to make grants, loans or payments to L3Cs – along with LLCs, partnerships, private individuals and just about anyone or anything else. That is true. However IRS regulations do not automatically allow these expenditures to be counted towards a mandated program-related expenditure equal to 5% of assets. PRIs are subject to individual IRS review and approval if they are to be eligible for inclusion as part of this 5% requirement. NYCON believes this level of review for the investment of charitable assets into privately-owned, for-profit businesses is appropriate.
Amazingly, Mr. Lang says that he would never suggest a change in Internal Revenue Code regulations to make PRIs to L3Cs automatically eligible for inclusion. Yet, Americans for Community Development, an association of L3Cs of which Mr. Lang is a founder, states that it is “actively working to gather sponsors for the proposed Philanthropic Facilitation Act of 2010 and hope to have it passed into law yet in 2010.”
What would this legislation do? “Make the following amendments to the Internal Revenue Code… clarify that a PRI … qualifies as a qualifying distribution under Section 4942 of the Code… (and) provide a rebuttable presumption that investments in entities organized…as low-profit limited liability companies qualify as PRIs.” Who is the contact person at Americans for Community Development for this legislative effort? Robert Lang. That certainly sounds like he is suggesting a change in the IRC to make PRIs to L3Cs automatically eligible.
Mr. Lang’s response to our concerns about the lack of transparency and accountability in L3Cs is equally confusing and self-contradict ory. On the one hand, he argues that “if a foundation makes a PRI, it must, by law, execute expenditure responsibility over the PRI and the IRS regulates foundations.” Yet, he goes on to state that “IRS regulations make it very clear that the foundation’s responsibility ends when they are clearly convinced that the L3C is performing on a mission first, profit second basis.” What does that actually mean again?
After dismissing our concern about the potential for private inurement as “red herrings and nothing more”, he goes on to point out that “while the IRS states that profit should not be the primary goal of a PRI… if unplanned high profit results that is fine as are equity kickers and substantial capital gains.” Excuse us if we feel a certain level of trepidation that this is an invitation for both private foundations and “social entrepreneurs” to play fast and loose with scarce charitable assets.
We find Mr. Lang’s argument that the only good PRI is a “high risk/low return” PRI to be particularly troubling. And, we question whether this is the actual intent of the Internal Revenue Code as he implies – for charitable assets to assume the financial risks that private investors will not.
Very few foundations provide PRI’s and for good reason, because of the associated risks, regulations and management requirements. We believe that may be a good thing.
NYCON is not opposed to PRIs in concept nor are we opposed in any way to responsible social enterprises. We are opposed to L3C legislation which is designed to reduce or eliminate the transparency and accountability that helps to protect tax advantaged, philanthropic assets. When it comes to social problem solving and innovation, there is very little that this scheme can do that can’t be done through existing corporate law. Nothing in Mr. Lang’s response allays any of our concerns.