March 12, 2008

New Business-Charity Hybrid Sought

As the lines between the nonprofit and for-profit worlds blur, social-enterprise leaders continue to look for new legal structures that are better suited to such blended activities than current designations.

The topic was one of many discussions here at a meeting of more than 530 charity and business leaders gathered this week for the Social Enterprise Alliance’s annual summit. The conference focused on ways in which nonprofit groups can diversify their sources of revenue by charging fees for the services they provide and starting businesses related to their charitable activities.

One proposed legal structure discussed at the meeting — the low-profit, limited liability company, or L3C — is designed to increase the number of program-related investments, or PRI’s, that foundations make in social-purpose businesses by making those enterprises easier to find. Proponents hope that foundation investment in those ventures would, in turn, would spur an influx of private capital.

To gain the proposed designation, which would be a new type of limited-liability corporation, the venture would have to state in its organizing document that its primary mission was charitable, and that making money was a secondary concern.

The entity would have to pay taxes on profits, but, unlike a charity, it would be free to distribute those profits to owners or investors.

Vermont’s House of Representatives has passed a bill that would create the new designation, pending approval by the state senate. Backers are also trying to get legislation passed in Georgia, Michigan, Montana, and North Carolina, said Robert M. Lang, Jr., chief executive of the Mary Elizabeth & Gordon B. Mannweiler Foundation, in Cross River, N.Y.

Mr. Lang believes that only one state has to approve the new designation for it to be available for businesses across the country.

If, for example, L3C’s become legal in Vermont, “you can be in Idaho and you can form a Vermont L3C and do business in Idaho,” he said. “Just like now, how many people have Delaware corporations?”

Mr. Lang and others hope that having a designation for social-purpose businesses will encourage foundations to make program-related investments in such ventures.

IRS guidelines offer examples of program-related investments that foundations can make in businesses that offer a significant social benefit — such as a factory in a depressed inner-city neighborhood that employs local workers, said Marc Owens, a Washington lawyer who from 1990 to 2000 was head of the IRS division that oversees tax-exempt groups. But, he said, of the relatively few PRI’s that foundations make, almost all are loans to nonprofit groups.

Identifying Mark

Because there is no designation for business projects that qualify for PRI’s, similar to the tax-exempt status that charities receive, searching out potential recipients is a lot harder, said Mr. Owens.

“If you as a foundation are interested in program-related investments to relieve poverty in a particular geographic area or to have a positive environmental impact, there’s no list you can go to,” he said. “You’ve got to do a lot of research upfront to make that program-related investment, far more than it would cost you to make a grant.”

For a foundation’s investment in a company to be considered a program-related investment and counted toward the 5-percent payout requirement, the investment must be made to accomplish a charitable purpose and without a substantial expectation of gain, said Mr. Owens.

But, he said, “that doesn’t mean that other investors in the L3C can’t have different objectives.”

Proponents hope that L3C businesses would be able to leverage foundation PRI’s, which would pay a relatively low rate of return, to attract private investors, who could then be offered a higher rate of return.

Mr. Lang and Mr. Owens said that the proposed designation’s strength is as an identifying mark, and that its simplicity and the fact that it would only be a small modification of a limited liability corporation would help get it passed whereas other proposed hybrid structures have faltered.

“You could form the equivalent of a L3C now by simply taking an LLC and in the organizing document saying, ‘Our purpose is the following charitable purpose, and we’re really not intending to make money as our primary purpose,’” said Mr. Owens. “The problem is there would be no branding effect. You would be out in the wilderness looking for support, just like every other potential program-related investment.”

More information about the L3C concept is available online.