What is an L3C (Low-Profit Limited Liability Company)?

A low-profit limited liability company, known as an L3C, is essentially a combination of a limited liability company (LLC) and a non-profit. The goal of an L3C is to make money alongside a social purpose or public benefit, such as fighting climate change.  

L3Cs ride the wave of social entrepreneurship that has emerged in recent years, aiming to kill two birds with one stone – make money while making the world a better place. This guide walks you through what an L3C is and what it’s not to help you decide whether it’s right for you. 

L3C Requirements

To be an L3C, your business must meet the following 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 is not a significant purpose. 
• The accomplishment of political or legislative goals is not among its purposes.

For the L3C, social purpose needs to be the primary goal, while profit is secondary. Profit is mainly seen as a means to achieving the stated end or social benefit. Also, your social purpose cannot be political, such as lobbying for a particular right or law. 

As of late 2022, only some states and territories allow the formation of L3Cs: Illinois, Kansas, Louisiana, Maine, Michigan, Missouri, North Dakota, Rhode Island, Utah, Vermont, Wyoming, Puerto Rico, and the federal jurisdictions of the Crow Indian Nation of Montana and the Oglala Sioux Tribe.

L3Cs can legally operate in any state but can only be formed and registered in the aforementioned jurisdictions. 

Rules vary regarding how L3Cs can operate in states that don’t recognize the L3C structure. For example, some states will grant a certificate of authority for a foreign L3C, while others require that you register as a foreign LLC. So again, you’ll need to check with the states where you plan to operate to see what’s required. 

L3C Funding

Under Internal Revenue Service (IRS) regulations, charitable, tax-exempt foundations must pay 5% of their funds annually to a charitable project or activity called a program-related investment or PRI. IRS rules regarding PRIs are quite detailed and strict, and the regulations around L3Cs echo these rules to simplify PRI investments in L3Cs. 

As a result, PRIs are the primary funding vehicle for L3Cs. However, they can also get funding from banks and investors, as long as these investors understand that the social purpose is of greater importance than the return on investment. 

L3C Management

L3C management is much like that of an LLC. 

In a member-managed L3C, members handle all management duties. In a manager-managed L3C, non-member employees oversee operations and management duties. 

Note that with a manager-managed L3C, a member can be a manager, but only in cooperation with another manager who is not a member. 

Member-managed L3Cs generally work best for L3Cs with few members, all of whom can take an active role in day-to-day operations. On the other hand, manager-managed L3Cs are best for L3Cs with multiple members, some of whom want to be “silent” or passive members and not involved in day-to-day operations.

Most L3Cs are member-managed, as they are small businesses that cannot afford a management team.

Some states require that when you register your L3C with the state, you declare whether your L3C will be a member- or manager-managed, so be aware that you may need to make this decision before you file. 

L3C Taxation

L3Cs are taxed just like LLCs.

L3Cs are pass-through entities, which means income passes through to the member or members. If the L3C has only one member, it’s taxed as a sole proprietorship. If the L3C has more than one member, it’s taxed as a partnership. 

However, L3Cs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. You can choose to be taxed as a C-Corp or an S-Corp.

C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But keep in mind that C-Corp shareholders – who, in the case of an L3C, are members – must also pay taxes on their distributions, called double taxation. 

However, members are subject to self-employment tax in an L3C that is taxed by default as a sole proprietorship or partnership. Once such L3C becomes taxed as a corporation, self-employment taxes no longer apply. 

Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status. 

With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses. 

L3C vs. Benefit Corporation (B-Corp)

A benefit corporation is a type of corporation similar to an L3C in that benefit corporations are intended to make money and have a social purpose. 

The main difference 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.

Note that more states allow the formation of B-Corps than L3Cs. 

Forming an L3C

Your L3C should also have an operating agreement. 

Most states do not require an operating agreement, but it’s a crucial document. It defines members’ ownership percentages of members and profit and loss allocations. Those are essential elements of the operating agreement, but it should also include the following:

• Each member’s rights and responsibilities
• Management structure and roles 
• Voting rights of each member
• Rules for meetings and voting
• What happens when a member sells their interest, becomes disabled, or dies

For an L3C, the operating agreement should also define and clarify the social purpose. 

In Closing

An L3C might be the right business structure if you have social entrepreneurship aspirations. It will allow you to make a living while working toward a broader public benefit. 

However, if you’re unsure whether an L3C is right for you, check with your tax advisor and attorney. You’ll want to make sure your business gets off on the right foot so you can get on with making the world a better place!