Transcript CREATIVE APPLICATIONS FOR CHARITABLE ENTITIES, INCLUDING

CREATIVE APPLICATIONS FOR
CHARITABLE ENTITIES,
INCLUDING FOR-PROFIT LLC’S AND
CORPORATIONS WITH A NON-PROFIT PURPOSE
Presented by:
MICHAEL D. MARTIN
Martin, Stilwell & Jones, LLP
1400 Woodloch Forest Drive, Suite 590
The Woodlands, Texas 77380
281-419-6200
281-419-0250 (fax)
Email: [email protected]
Charitable Giving
Tax Laws Encourage Charitable Giving.
Options for sophisticated giving include:
 Private Foundations.
 Public Charities.
 Private Operating Foundations.
But sometimes “control” and “Hands on
Philanthropy” aren’t enough.

When Tax Benefits & Control simply
aren’t enough. . .
Expanding into Social Enterprise.

The L3C or Low-profit Limited
Liability Company; and

The B Corporation.
Social Enterprise: Defining the Terms
Social Enterprise. A businesslike activity
designed to “do good” and not simply
generate a profit, i.e., a socially motivated
revenue generating activity.
 Social Entrepreneur. One who forms and
leads a Social Enterprise, i.e., society’s change
agent; a pioneer of innovation that benefits
humanity.
 Program Related Investments. Foundation
investments-debt or equity-into socially
beneficial activities.

Social Enterprise: Making the Case

Private Foundation Endowments Increased in 2009 to $583 Bil. USD
Social Enterprise: Making the Case ~ Foundation
Resources; Part of the Private Sector Resource Base
Private sector resources come in two types:
• For-Profit Sector Resources. Market Driven - making
money & building wealth - normally require rate of
return of +5%.
• Nonprofit Sector Resources. Market incentives are
inadequate or non-existent - rate of return of 0 to -100%.
• The Challenge. How to access the vast pools of market
driven wealth to invest in ventures that fall into the gap
between the 0 and +5?
Social Enterprise: Making the Case ~ Foundation
Resources can fund Low Profit Ventures
There are many worthy causes:
• Self-sufficient Under 5%. That can be self-sufficient in
the 0 to + 5% zone.
• Return won’t attract Market Capital. They offer a
return on investment but the return is insufficient to
attract most market driven investors.
• Fall into Low-Profit Zone. They fall into the gap
between the for profit and nonprofit worlds – what we
call the “Low-Profit Zone.”
• The L3C. The L3C lives in the Low-Profit Zone.
Social Enterprise Investing-A Foundation’s
Endowment as a Resource? Making the Case
Foundation Endowments Likely to Increase Dramatically
in the next Few Years. Why? Answer: the “Perfect Storm!”
• The Federal Estate Tax Scheme. At 39.6% and going
higher!
• The Estate and GST Tax Scheme. Likely to return to
the pre-Bush tax cut rates.
• The Charitable Deduction Scheme. Encourages
charitable giving with significant economic benefits.
Query-Where will Wealthy Clients’ money likely go, if they
know its protected, they can control it and get significant tax
benefits, not to mention making a contribution to the
community?
Social Enterprise Investing and Social
Entrepreneurship-Making the Case (Cont’d)
The Current Income Tax Scheme. Rates are 39.6%
and may go higher, due to:



The Deficit. The current deficit & continuing bailouts;
Home Foreclosures and Jobs. House foreclosures and
Joblessness is on the rise; and
Current & Pending Government Reforms. The cost
of Health Care, Immigration and other government
reforms.
Social Enterprise Investing
So What can Private Foundations do?
They can make~
 Minimum

Required Distributions; and
Program Related Investments.
Social Enterprise Investing-What can
Private Foundations do?
What are Minimum Required Distributions and Program
Related Investments.
 Minimum Required Distributions. Private Foundations must
distribute in the current year, five (5%) percent of their average asset
balance for the prior year, for its exempt purposes, typically in the form of
grants to various public charities. IRC § 4942. (NOTE: Grants are
effectively gifts. There is no return on investments. Private Foundations
can do more, however this would begin to erode their endowment base
and investment income). These distributions are called “qualifying
distributions”, id.
 Program Related Investments or “PRIs.” Investments by Private
Foundations, in the form of debt or equity that support socially beneficial
activities. IRC § 4942. These were authorized by the Tax Reform Act of
1968 and are an exception to the “jeopardy investment” rules (i.e., a
Private Foundation can not make investments that jeopardize their exempt
purposes). PRIs are also qualifying distributions. IRC § 4942(g).
Social Enterprise Investing-What have Private
Foundations done ~ The numbers

Assets. $565,000,000,000.00 – The amount estimated in held
in Private Foundations in 2008, id. This amount is expected to
dramatically increase over the near term.

Distributions. The Private Foundation Center reported Private
Foundations
collectively
made
qualifying
totaling
$43,000,000,000.00 in 2008. The Private Foundation Center;
Aggregate Data by Private Foundation type, 2006 [released
2008], at http://privatefoundationcenter.org.

Program Related Investments. Of the foregoing amount, less
than one (1%) percent consisted of Program Related
Investments, despite the fact that PRIs are strong tools of
advancing Social Enterprise. id.
Social Enterprise Investing
Query-Why haven’t Private Foundations stepped up?
There is a Built in Conflict and Tension between ForProfit and Non-Profit entities:
 For-Profit. Must Maximize Profit to Investors;
whereas

Non-Profit. Can only do Program-related Investing
(where income not its “significant purpose”).

PRIs. They complicated, risky and burdensome.
Social Enterprise Investing-So What
Gives with Private Foundations?
Query-Why haven’t Private Foundations stepped up? A
more detailed answer.

PRIs are Complicated. They must meet certain minimum requirements.
– Made solely for exempt purposes. Treas. Reg. § 53.4944-3(a)(1)(i).
– Production of income or appreciation of property not a significant
factor. Treas. Reg. § 53.4944-3(a)(1)(ii).
– No politics or lobbying. Treas. Reg. § 53.4944-3(a)(1)(iii).

PRIs are Burdensome. Private Foundation managers have a fiduciary duty
to do adequate due diligence and provide ongoing oversight once a PRI is
made. Many do not have adequate resources.

PRIs are Risky. While there is no regulatory requirement a Private
Foundation get a “due diligence” legal opinion or Private Letter Ruling, the
consequences of the Service declaring a PRI is not a qualifying distribution
can be economically devastating and potentially carry a “death sentence.”
Social Enterprise Investing; the Roadblocks
to using a Foundation’s Endowment
Limitations on Accessing a Private Foundation’s Resources.
 Limited or Narrow Purpose. Only for Exempt Purposes.
 Required Minimum Distributions. 5% of its assets, as grants.
 No Private Benefit. Except reasonable salaries.
 Significant Restrictions. Restrictions on
Holdings and
Investments.
 Excise Taxes. Onerous penalties in Chapter 42, if they get it
wrong.
 Strong Self Dealing Restraints. Is subject to strict Self Dealing
Rules.
 Strong Government Oversight. Close IRS oversight.
The “Private Foundation Excise Tax Rules”~
Enacted in 1969 to Stop Abuses-The Regulatory
Roadblocks;

Contained in Chapter 42 of the Code. IRC §§4940-4945;

Designed to Prevent Self Dealing. By penalizing & taxing
private use of foundation funds;

Two types of rules.
– Rules to mandate accomplishment of exempt purposes;
– Rules against benefiting related parties;

Penalties and Excise Taxes are Severe. Can be levied against
both the foundation and the managers and can include the
“death penalty.”
The “Private Foundation Excise Tax Rules”;
a Closer Look at these Rules





Mandate Required Minimum Distributions. 5% of assets. IRC
§4942. Failure to distribute generates penalty taxes on
undistributed amounts. IRC §§4942(a)&(b);
Prohibit Jeopardy Investments. Investments that prevent
carrying out the foundation’s exempt purpose. §§4944(a)&(b);
Prohibit Self Dealing. Both direct and indirect, between the
foundation and related parties. IRC §4942;
Prohibit Excess Business Holdings. Investments in entities in
which disqualified persons are also investors. IRC §4943;
Tax Unrelated Business Taxable Income. Income from an
unrelated (to exempt purposes) trade or business. IRC §512.
Social Enterprise Investing: More
Roadblocks
The Inherent Conflict of Interest:

Mission-related investing. Officers and Directors of
for-profit must maximize shareholder value;
V.

Program-related Investing. PRI recipients must not
produce income or property appreciation as
“significant purpose.”
Social Enterprise Investing ~ Can PRIs
mix with For-profit Ventures?
The short answer: Yes, but!!! The LLC as Entity of
Choice. But not without problems:
 Legal Opinion or IRS Approval May be Required.
PLRs or Lengthy legal opinions are expensive, time
consuming and cause delays;
 LLCs are For-profit Entities. No incentive for lowprofit, social enterprise ventures; and
 The LLC Corporate Structure. It requires significant
restructuring to make “user friendly” for PRIs.
Social Enterprise Investing and the
Low-profit Limited Liability Company
The Low-profit Limited Liability Company or L3C; A
response to the “for-profit/non-profit” dilemma.

The LLC. Organized for profit and to attract risk capital; conflicts with. . .

The Private Foundation. Organized for charitable purposes, where tax
exempt benefits are at the core of social enterprise, there are little means to
raise capital and a strong profit motive would jeopardize its exempt status.

The L3C Bridges the Gap. It’s a hybrid, for-profit version of the State
law the LLC, that is: (i) Approved by State Statutes. 9 Jurisdictions so far.
Vermont was the first and others are considering; (ii) User-friendly for
PRIs. State law purpose tracts the PRI rules. It can have no other purpose;
and (iii) L3C Corporate Structure Simplified. State statutes define the
contents.
The Low-Profit Limited Liability
Company or L3C~What is it?
The L3C~
 Is a For-profit LLC. But a special kind.
 Is State-law Defined. Authorized by state LLC rules.
 Provides Asset Protection. The non-corporate form of
doing business limits owners’ liability.
 Is Taxed as a Partnership. Affords flow-through tax
treatment to members.
 Provides Governance Flexibility. Both for-profit and
non-profit personnel participate in management.
Forming an L3C~The Requirements
Establish the Jurisdiction, then
Select Members Carefully. One or more for-profit
“members” and one or more non-profit “members.”

Correctly Develop the Purpose Clause. (i) Charitable or
educational purposes; (ii) Would have not formed, except to
accomplish those purposes; (iii) No significant purpose to
produce income or property appreciation (but may produce
significant income or property appreciation); and (iv) No
political or legislative purpose.

Otherwise Governed by State’s LLC Rules. Just like
any other LLC.
Forming an L3C~The Benefits; In
General
An L3C
Bridges the Gap between Non-profits and Forprofits.

Signals Foundation Managers. L3C can hold PRIs.

Alerts State and Federal Regulators. The “L3C
brand” signals regulators it contains PRIs, making
oversight easier.
The L3C and Federal Legislation~
How Will it Help?
The IRS has not yet ruled on the L3C, however any ruling
would only be a “facts and circumstances” ruling on
whether a foundation’s investment was a PRI.
Federal legislation would:



Create a Qualification Process.
Create Safe Harbors.
Update the Code and Regulations to require
disclosure and annual reporting.
The L3C~When is it Indicated?

As a Startup.
– Two Member LLC ~ Investment Scenario.
– As a Foundation Sub ~ Loan Scenario.

Expand a Foundation’s PRI.

Leverage a Foundation’s Financial Resources.

Better Business Oversight.
The L3C~How it’s Done

Formation & Organization. Select jurisdiction of choice and
follow the rules (NOTE: Local counsel may be necessary).

Governance. L3C Managers will include non-profit
representatives (for continuing oversight and to assure that a
PRI is used for exempt purposes) and for-profit members (or
representatives).

Tax Implications & Compliance. The L3C is taxed as
partnership

Exit Strategy. A Private Foundation must always have the
unilateral right to withdraw, as a Member, and get its PRI back.
The L3C~Sounds Great!
Have any Really Been Implemented?
Examples..........
Literally hundreds of L3Cs have been formed since April of 2008 (when
Vermont passed the first state law). See outline, Part III, Section H, paragraph
6 for L3Cs in formation or currently operating and two success stories, below.
–Moo
Milk CO
(Westbrook, ME).
http://moomilkco.com
The L3C~Sounds Great!
Have any Been Really Implemented?
–
–
More Examples..........
The Endless Sky Project (Deer Lodge, MT).
In our Firm. Two projects; one under
discussion and one on the “drawing board.”
The B Corporation ~ Another Social
Venture Hybrid

For-profit Corporation with a Social Mission.

Designed to Receive PRI Funds.

Not Presently State or IRS Sanctioned. But, the process
has started. Maryland passed B corporation on May 1, 2010.*
*(See Fifty State Series: L3C & B Corporation Legislation
Table,
tracking
legislative
developments
at
http://ssrn.com/absract=1561783)

The B Corporation Designation. A brand name developed by a nonprofit called B-Labs. This group, for a fee, does extensive due diligence on
corporate structure, purpose, activities and personnel and issues a
“Certificate” which, for a fee, is renewable.
Thank you!
Questions?
I hope that this presentation on L3Cs and their
potential use with Foundations has been helpful. If
you would like more information, please do not
hesitate to call me!
Michael Martin,
Martin, Stilwell & Jones LLP