The traditionally rigid view of society as structured in three distinct sectors—business, government, and nonprofit—has failed to adequately address the social problems of modern times. People tend to think that the nonprofit sector and its “IRS-sanctioned philanthropy is the only way to solve social problems.” There is a growing recognition, however, that to achieve the type of social impact that is now required, philanthropy needs a new approach that incorporates resources typically unavailable to the nonprofit sector. Indeed, a new “fourth sector” is emerging, as a hybrid between the for-profit and nonprofit sectors, with a “double bottom line” of providing social benefit and earning a financial return. Commonly referred to as “social enterprise,” the reasons for this development are the nonprofit sector’s general lack of market efficiency in raising capital and the restrictive duty on for-profit businesses to maximize profits for shareholders. New models of legal entities have been devised to help solve the problem of attracting and accessing capital for charitable purposes by merging key attributes of both the nonprofit and for-profit sectors.
One particular model that has gained significant momentum over the last few years is the low-profit limited liability company (L3C). The L3C aims to solve the capital formation problem by utilizing the substantial assets held by private foundations. According to the Foundation Center, the combined assets of all private foundations in the United States totaled about $565 billion at the end of 2008. Yet, foundation leaders find it difficult to align their charitable work with their financial resources, and the effectiveness of foundations’ traditional grantmaking strategies has been questioned. To take advantage of foundation resources and provide for more efficient charity, the L3C is designed to tap into the potential of program-related investments (PRIs) as “social enterprise vehicles.” Specifically, the L3C blueprint uses a PRI to leverage a market return for profit-seeking investors in a tranched, that is, multi-layered, investment strategy.
One of the primary issues in using this strategy is whether a foundation’s participation in the L3C’s tranched investment structure violates fundamental rules regarding nonprofit operations, thereby threatening the foundation’s exempt status. Congress and the IRS are particularly concerned about the provision of private benefit, both to the “insiders” of a charitable organization as well as to “outsiders.” In that respect, the private inurement rule “serves to prevent anyone in a position to do so from siphoning off any of a charity’s income or assets for personal use.” Additionally, under the private benefit doctrine, the IRS balances public versus private benefit to ensure that exempt organizations are operating primarily for charitable purposes. If foundation leaders perceive either the inurement or private benefit risks to be too high, and thus decline to make PRIs, the L3C model will find it more difficult to obtain the leveraging capability that is necessary to attract for-profit investors.
This Comment suggests that the private benefit doctrine poses a greater risk than private inurement for a foundation that makes a PRI in an L3C. It then contends that the expenditure responsibility requirements that private foundations must follow when making PRIs are sufficient to satisfy the control standard of the private benefit doctrine. Furthermore, this Comment argues that from a policy perspective, the private benefit received by for-profit investors in the L3C should be permitted by the IRS as a necessary means for achieving more efficient and effective charity.
To provide the proper context for the discussion, Part II.A of this Comment presents the current issues facing private foundations and their grantmaking strategies. Part II.B outlines the PRI and expenditure responsibility rules and demonstrates the potential of PRIs by reviewing two private letter rulings issued by the IRS. Part II.C examines the current state of L3C legislation and explains the operation of the tranched investment strategy. Part II.D identifies the crucial difference between the private benefit doctrine and private inurement, explains the control standard of the private benefit doctrine, explores the doctrine’s scope, and summarizes the scholarship in response to the doctrine’s current state of uncertainty. Part II.E reviews the criticisms set forth by scholars regarding the inherent risks foundations face by participating in the L3C’s tranched investment structure.
Part III.A begins the Discussion by clarifying that the private benefit doctrine presents a more likely problem than private inurement for foundations seeking to make PRIs in L3Cs. Part III.B evaluates the extent to which the expenditure responsibility rules overlap with the private benefit control standard and reveals their functional equivalency. Finally, Part III.C argues that from a policy perspective, the private benefit received by the L3C’s for-profit investors should not threaten the exempt status of private foundations that provide the PRIs which facilitate capital formation. Without this risk, foundations will be encouraged to furnish the essential start-up capital to social entrepreneurs who seek to find more efficient solutions to society’s most pressing problems.