If your business has a socially beneficial mission but wishes to operate with a for-profit model, then you may be interested in forming a hybrid entity.
Low Profit Limited Liability Company (L3C)
An L3C functions like an LLC with a socially beneficial business purpose. While L3Cs operate like LLCs, they benefit from a tiered capital structure that permits the L3C to raise capital through both the Program Related Investments (PRIs) of private foundations as well as commercial investments.
Like an LLC, an L3C benefits from flexible ownership structure and pass-through taxation. Unlike an LLC, an L3C may implement a tiered capital structure through which private foundations effectively subsidize commercial investments. The lowest tranche of this tiered L3C capital structure is allocated the highest risk and the lowest rate of return. This tranche is reserved for PRIs made by private foundations. PRIs allow foundations to contribute to for-profit businesses without incurring negative tax-penalties. To qualify as a PRI, the use of a foundation’s investment must correspond with the foundation’s charitable purpose and the funds are prohibited from inuring as a benefit to other private parties. The restriction on private inurement means that a foundation’s investment cannot be used to make excessive distributions to L3C insiders or its other investors. The mezzanine tranche is reserved for socially responsible investors who may be willing to take on below-market returns because of their commitment to the L3C’s social or charitable goals. Finally, private commercial investors are relegated to the upper tier where returns are highest and risk is lowest. Through this tiered capital structure, an L3C may be able to attract both profit-driven and charity-driven investors.
Moreover, while many commercial investors are hesitant to invest in social businesses, investors and customers who share similar convictions may be drawn to the commitment to a particular cause evidenced by the choice of the L3C entity.
First, only Vermont, Michigan, Wyoming, Utah, Illinois, Louisiana, Maine and Rhode Island have L3C statutes, limiting L3Cs to those states. Second, L3Cs must be organized in accordance with three principles: 1.) an L3C must be organized around the primary goal of achieving a charitable, educational or socially-beneficial purpose, 2) the production of income or appreciation of property may not be a significant purpose of the L3C, and 3) an L3C may not seek to accomplish any political or legislative purpose.
Attracting PRIs may pose particular difficulty and risk. In order for a private foundation’s investment to qualify as a PRI, the L3C must further the foundation’s charitable goals. If the IRS rules that an investment in an L3C jeopardizes the tax-exempt purpose of a particular private foundation, then that foundation will be subject to an automatic 10% excise tax and the potential for additional penalty taxes. Further still, even if a private foundation’s investment qualifies as a PRI, if any part of the foundation’s investment inures to a private individual, such as a commercial investor in the L3C, the private foundation may lose its tax-exempt status. To mitigate these risks, private foundations will typically negotiate for management rights.
Furthermore, the L3C structure is risky because it is extremely new. The IRS has not designated private foundation investments in L3Cs as automatically qualifying as PRIs, nor have they articulated that such investments are entitled to a rebuttable presumption of PRI qualification.
Finally, the L3C is risky because it is built on the competing interests of profit and social benefits. It remains to be seen how courts will interpret that combined mandate. How venture capitalists and angel investors will treat L3Cs in the long-term remains equally unclear.
The Benefit Corporation is a status available in 30 U.S. states. That status accords legal protection to corporate directors and officers who wish to balance financial and social interests when making corporate decisions.
The primary advantage of a Benefit Corporation is that its officers and directors may simultaneously seek to maximize profit and social impact. Unlike the standard corporate form where directors and officers have a duty to its shareholders to maximize profit, directors and officers of a Benefit Corporation have the freedom to balance the Corporation’s profit motive with the achievement of its social mission. This Benefit Corporation structure thus permits socially minded entrepreneurs to protect their social mission as a critical part of their business. Furthermore, stockholders have the increased power to hold directors and officers accountable in their duty to pursue that social mission. The Benefit Corporation’s accountability structure thus may be attractive to socially conscious investors who want to ensure that their investment is impactful.
A Benefit Corporation must hold a public benefit as part of its stated mission and assign a benefit director to oversee the progress towards achieving that mission. Benefit Corporations are subject to heightened reporting requirements, namely the requirement to release a benefit report to the public (in Delaware the report need not be public). The benefit report is meant to facilitate transparency so as to inform the public of the corporation’s social performance, inform directors so they are better able meet their duties in pursuit of the public mission, and inform shareholders of the Corporation’s progress towards its social mission so that they might exercise their rights to hold the directors and officers accountable.
Finally, like the L3C, Benefit Corporations are fairly new and how courts will interpret the combined mandate of seeking profit and social benefits remains unclear. Likewise, how venture capitalists and angel investors will treat Benefit Corporations in the long-term is equally uncertain.
A B Corp is a for-profit company that has been certified by the nonprofit organization, B Lab, to meet rigorous standards of social and environmental performance, accountability, and transparency. Such designation is meant to signal customers, investors, and other corporations that the entity satisfies certain desirable benchmarks of corporate responsibility.
All entity types are eligible to apply for B Corp status. In applying, entities must subject themselves to a rigorous assessment and review of their goals and practices. In addition, 10% of B Corps are subjected to random on-site review each year. Each B Corp is required to resubmit the majority of its assessment every two years for reevaluation.
The easiest road to B Corp status is to first become a Benefit Corporation. In states where Benefit Corporations are not available, or if your entity is an LLC, C Corp, S Corp, or Partnership, you may amend your articles of incorporation or organization to permit officers or members to weigh the environmental and social effects of the company’s operations alongside the interest of the shareholders. Introducing a social or charitable mission into your business purpose is the best way to shape your entity and its practices to qualify for B Corp status before applying.