If you’re thinking of starting a business, and you want it to be for-profit but you also have a social purpose in mind, you may want to choose a low-profit limited liability company (L3C). L3Cs are designed for exactly what you have in mind, and are essentially a combination of an LLC and a non-profit.
Social entrepreneurship has been growing in popularity as people look to create businesses that can be profitable while serving some greater social purpose. Essentially, social entrepreneurs want to create economic value and social value at the same time. An example might be a technology that can solve some sort of community or social problem but can also generate revenue.
To be formed as an L3C, a business must meet these requirements:
- Serve at least one charitable or educational purpose within Sec. 170(c)(2)(b) of the Internal Revenue Code and have been formed for the accomplishment of that purpose.
- Production of income or appreciation of property are not a significant purpose.
- The accomplishment of political or legislative goals are not among its purposes.
Essentially, with an L3C the social cause must be the primary purpose of the business, while profit is secondary at best.
Only eight states currently allow the formation of L3Cs: Vermont, Illinois, Maine, Michigan, Louisiana, Rhode Island, Utah, and Wyoming.
Program-Related Investment (PRI)
L3C requirements were designed to match the IRS conditions under which charitable foundations can make a program-related investment (PRI).
Tax-exempt foundations are required to pay 5% of their funds annually to a charitable project or activity and one of the ways they can do so is with a PRI. Normally, these PRIs are made to tax-exempt charitable organizations. IRS rules regarding these investments are strict and have specific requirements, so the intent of L3C requirements is to match the rules to the letter in order to make PRI investments easier.
L3Cs are managed just like an LLC. There are two types of management structures to choose from:
- A Member-Managed L3C is managed by the members of the LLC. This is usually chosen by smaller LLCs with few members who will be involved in various management roles.
- A Manager-Managed L3C is managed by people who are not members of the LLC and are employees of the business. This structure is often used when an LLC is larger and has multiple members.
L3Cs are taxed just like LLCs. LLCs and L3Cs are unique in terms of taxation as their owners have a choice about how the company will be taxed. By default, an L3C is taxed like a sole proprietorship if it has one member and a partnership if it has more than one member.
In both cases, business income “passes through” to the members, while profits and losses are reported on their individual tax returns. The L3C itself is not taxed, which simplifies the process for members. Also, losses and operating costs of the business can be deducted personally by the members. Taxes are paid at the personal tax rate of the members, although the owners may also have to pay self-employment taxes.
Note that a multi-member L3C must also file form 1065 with the IRS, which is the U.S. Return of Partnership Income. Attached to this will be form K-1s for each member showing their share of the business income.
But L3Cs owners can instead choose to be taxed as a corporation. To do so, the L3C must file a document, referred to as an election, with the IRS. The L3C must then decide if it wishes to be taxed as an S corporation or a C corporation.
C-Corp status means profits are taxed at the current rate for corporations (21% as of early 2022), which is significantly lower than the typical individual taxpayer rate. But keep in mind, C-Corp shareholders, which includes members, must also pay taxes on their distributions (but not self-employment taxes). Thus, the C-Corp is subject to what is sometimes referred to as double taxation.
As with sole proprietorship and partnership status, S-Corp taxation considers the L3C a pass-through entity, which means income passes through the company and into the hands of the owners. At this point, taxes are applied at the same rate as those of individual taxpayers.
S-Corps use Form 1120S to file their taxes, which is used to report the income, losses, and dividends of S corporation shareholders. S-Corp shareholders do not pay self-employment taxes, which is the primary advantage of S-Corp status compared to sole proprietorship or partnership.
Generally, S-Corp status is beneficial if the company is profitable enough to pay the owners a salary and at least $10,000 in annual distributions so the owners can be taxed as employees and not pay self-employment taxes. It costs more to run an S-Corp than an L3C due to additional bookkeeping and payroll expenses. Thus, the tax benefits should be more than the additional costs for an S-Corp status to make financial sense.
L3Cs are intended to primarily be funded through PRIs from foundations, but they can also get funding from banks or investors as long as the investors understand that the social mission is of higher importance than the investors’ return on investments.
L3C vs. Benefit Corporation (B-Corp)
A benefit corporation is a type of corporation, but is also similar to an L3C. Benefit corporations are businesses driven by financial profits and making a difference in society.
More states allow the formation of B-Corps than L3Cs. The main difference, however, is that an L3C is a type of LLC, while a B-Corp is a corporation subject to corporate regulations and taxes. L3Cs have pass-through taxation and are more flexible in terms of management.
L3Cs are formed just like LLCs, but they must designate the L3C status in the articles of organization. You’ll file articles of organization with the state where you do business, and should also draft an operating agreement and obtain an EIN. Your L3C will be subject to all the regulations and reporting requirements of LLCs in your state.
If your business has a social purpose, an L3C may be a good option. It provides all the benefits of an LLC, but you can also receive PRI investments to advance your social cause. It’s recommended that you speak with an attorney to determine if an L3C is right for you.