Key Takeaways

  • L3C Overview: A Low-Profit Limited Liability Company (L3C) combines aspects of nonprofits and for-profit businesses, prioritizing social impact while still allowing for profit.
  • Comparison with LLC: L3Cs operate similarly to LLCs but must have a primary charitable purpose. LLCs are purely for-profit entities without a social mission requirement.
  • Funding Challenges: L3Cs were designed to attract investment from private foundations through Program-Related Investments (PRIs), but many foundations remain hesitant due to unclear IRS guidance.
  • Tax Implications: L3Cs are taxed like LLCs unless wholly owned by tax-exempt entities, whereas LLCs have flexible tax treatment options based on structure.
  • Legal Recognition: L3Cs are recognized in a limited number of states, whereas LLCs are universally accepted across the U.S.
  • Benefits & Drawbacks: L3Cs offer a structured way for social entrepreneurs to blend profit and purpose but face limitations in funding, tax benefits, and regulatory clarity.
  • Alternatives: Other structures like Benefit Corporations (B Corps) and traditional nonprofits may serve similar purposes with different tax and regulatory implications.
  • Governance & Compliance: L3Cs must adhere to specific social mission requirements and provide oversight through annual reporting, but compliance enforcement varies by state.
  • Real-World Applications: L3Cs are used in industries like healthcare, arts, and education where social impact and financial sustainability are both key concerns.

L3C

L3C combine aspects of a nonprofit and for-profit organizations. It is a relatively new innovation in the United States. Its purpose is to attract capital to commercial ventures that promote some sort of social good. The L3C’s primary purpose is a charitable mission while generating profits is a secondary goal.

What is an L3C?

L3C is a legal structure. It is a hybrid of a 501(c)(3) and an LLC. It was created as a path to encourage and increase social entrepreneurship and self-sustaining charitable missions. Some examples include medical research projects and vehicle safety schools.

L3Cs do distribute its profit to its owners. L3Cs can accept investments like an LLC but also donations for specific purposes like a 501(c)(3). The Gates Foundation has been a leader in investing in L3C organizations. Currently, most foundations do not donate to L3C due to the uncertainty surrounding their status. Additionally, donations are not tax deductible.

L3C organizations:

  • Operate similarly to an LLC
  • Need to keep track of their investors, obligations and do not receive any favorable treatment from the IRS because most do not qualify as tax-exempt
  • Can be tax-exempt only if all members are tax-exempt organizations. Otherwise, the L3C will pay taxes on any income
  • On the state level, only a few states recognize the L3C structure
  • Most states treat L3Cs like LLCs for tax purposes

L3C vs. LLC: Key Differences and Similarities

An L3C is a hybrid entity that merges the financial flexibility of an LLC with the social mission focus of a nonprofit. However, there are distinct differences between an L3C and a traditional LLC:

  • Mission Requirement: An L3C must primarily serve a social purpose, while an LLC has no such requirement and is structured solely for profit.
  • Investment & Funding: L3Cs aim to attract investments from private foundations through PRIs, though many foundations remain hesitant due to IRS uncertainties. LLCs have broader funding sources, including venture capital and private equity.
  • Tax Treatment: Both L3Cs and LLCs are typically taxed as pass-through entities, meaning profits and losses are reported on owners’ personal tax returns. However, an L3C owned entirely by tax-exempt entities may avoid taxation.
  • Legal Recognition: L3Cs are not recognized in every state and are subject to different regulations depending on jurisdiction, whereas LLCs are universally accepted in the U.S.
  • Public Perception & Compliance: L3Cs must demonstrate their commitment to their social mission, often through annual reporting. LLCs do not have this obligation.

Understanding these distinctions helps entrepreneurs choose the best structure based on their goals and funding needs.

Why was L3C Created?

L3Cs were created as a way for businesses to continue operating if they produce a social good but are not commercially viable. For example, a community newspaper may not be able to continue operating, however it does produce a social good by keeping in the community informed of news and events.

The L3C allows people to fund the newspaper in order to keep it running for the social good rather than any return on investment. This can be done through a community-based foundation and may incentivize investors to invest in the newspaper.

How L3Cs Attract Investment: Program-Related Investments (PRIs)

A major goal of the L3C structure was to facilitate Program-Related Investments (PRIs) from private foundations. PRIs are a form of impact investment that foundations can make while still fulfilling their charitable purposes.

However, there are challenges:

  • The IRS has not provided definitive guidance on PRIs for L3Cs, leading many foundations to be hesitant.
  • L3Cs must ensure that their social mission aligns with IRS PRI requirements, which can be complex.
  • Some investors prefer Benefit Corporations (B Corps) due to clearer regulations and higher public trust.

While PRIs remain an attractive funding option, L3Cs often need to seek additional revenue streams or alternative financing.

Precedence, Similarities, and Differences of L3C in Another Country

The L3C concept was first developed in foreign countries. In Great Britain, there are “community interest companies” that are established for the public good. Returns on investment are capped. Any additional profits are reinvested into the company. Companies must apply and be officially recognized before receiving this classification.

What are the pros and cons of obtaining L3C

Some of the benefits of the L3C categorizations are more avenues for social entrepreneurship, easier organization, private foundations can invest without receiving approval, charities can create subsidiary L3Cs in order to pursue profitable ventures, and support for artists.

Some of the drawbacks are that foundations and investors can lose their capital without any tax benefits, limited oversight of how L3Cs use investment funds, and the uncertainty surrounding L3C status with many foundations and investors unsure about how they fit into their investment plans.

Legal Considerations When Forming an L3C

Before forming an L3C, business owners should consider:

  • State Recognition: Only a limited number of states allow L3C registration. Entrepreneurs in states without L3C statutes may need to register as an LLC and operate under an L3C-like model.
  • Regulatory Compliance: L3Cs must comply with state-level filing requirements, including annual reports that demonstrate their commitment to their mission.
  • Conversion Limitations: Converting an L3C into another entity type, such as a traditional LLC or nonprofit, can be complex and require restructuring.

Entrepreneurs should seek legal advice before forming an L3C to ensure compliance and strategic alignment with their mission.

What precedence is there for art companies and creative individuals?

The IRS has always given art schools and art programs tax-exempt status. Examples include dance companies, theater groups, symphonies, musical groups, artist groups, and art activities. L3Cs are a possibility for these art-based organizations to profit from their work while continuing to focus on their core mission of spreading arts appreciation and education.

Who oversees the company’s mission and whether it is fulfilled?

Typically, the L3C is overseen by the state Attorney General’s office. Just like any charity, annual reports should be sent to the Attorney General’s office and posted online. The L3C also has to create an annual report for its investors, detailing operations and how funds are being allocated like an LLC. For L3Cs, there are two sources of oversight - state regulators and its investors.

Do you need a previous track record in social entrepreneurship?

No, you don’t necessarily need a previous track record in social entrepreneurship. More important, you have to find investors who believe in your mission and your ability to execute. Therefore, if you don’t have a track record, you need to develop a detailed plan to show investors and foundations who may want to invest in your L3C.

Why would a nonprofit look into a L3C?

Nonprofits could be looking into L3Cs if setting up a for profit venture can help them achieve their mission. For example, an organization that teaches disadvantaged youth construction skills could open an L3C to buy and repair homes. Once completed, the homes can be sold at a profit. Profits can be used to buy additional homes, fund the nonprofit’s operations, and pay workers.

L3Cs vs. Benefit Corporations (B Corps)

While both L3Cs and Benefit Corporations (B Corps) focus on social impact, they operate under different models:

  • Legal Structure: L3Cs are a form of LLC, whereas B Corps are a specific corporate designation with social and environmental obligations.
  • Tax Status: L3Cs are taxed like LLCs, whereas B Corps are taxed like traditional corporations unless they elect S-Corp status.
  • Public Perception: B Corps often have greater recognition and credibility among impact investors, whereas L3Cs face more skepticism.
  • Reporting Requirements: B Corps must undergo third-party certification (such as B Lab), while L3Cs primarily adhere to state-level oversight.

For businesses prioritizing public trust and broader investor appeal, a B Corp may be a better alternative to an L3C.

Another Reason to Become an L3C

Another reason to become an L3C is that it leads to a better governance structure with oversight from donors and investors. Due to this reason, many are advocating that the L3C structure should be open to all types of nonprofit organizations not only charities.

Frequently Asked Questions

  1. What is the main advantage of an L3C over an LLC?
    The primary advantage of an L3C is its ability to attract Program-Related Investments (PRIs) from foundations due to its legally defined social mission. However, the lack of clear IRS guidance on PRIs remains a challenge.
  2. Can an L3C receive tax-deductible donations like a nonprofit?
    No, donations to an L3C are not tax-deductible unless the donor is a tax-exempt organization. Most foundations require additional IRS approvals before funding an L3C.
  3. How many states recognize the L3C structure?
    As of now, only a handful of states have L3C legislation, including Vermont, Michigan, Wyoming, and others. Businesses in states without L3C statutes often operate as LLCs with a social impact focus.
  4. Can an L3C later convert into a traditional LLC or nonprofit?
    Yes, but conversion can be complex and may involve restructuring the business, reapplying for tax status, and fulfilling state legal requirements.
  5. Should I choose an L3C or a B Corp for my business?
    It depends on your goals. If you prioritize social impact with LLC-style flexibility, an L3C might be better. If you want greater credibility with impact investors and third-party accountability, a B Corp is a stronger choice.
     

If you need help creating an L3C, you can post your legal needs on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.