Can an LLC be a nonprofit?
People who form their own businesses should consider how the type of business entity they choose will effect their taxation, as it will heavily influence how much profit will be left to distribute among the owners after expenses are deducted.
For example, a corporation tends to pay higher taxes than that of a limited liability company or sole proprietorship as it goes through double taxation while limited liability companies are considered as pass through entities.
There are instances when corporations are classified as nonprofit with nonprofits often being referred to as corporations.
For those that wonder if a limited liability company can be granted tax exemption and operate as a nonprofit the way corporations can, the answer is a yes though it is by no means a direct and uncomplicated process.
Can a limited liability company (LLC) be a nonprofit?
When a nonprofit organization is formed, it is usually formed as a corporation and for good reason.
Now this is not to say it is not possible to have a limited liability company as a nonprofit organization.
In fact, limited liability companies or “low profit limited liability companies” can exist as nonprofit LLCs.
There is a catch however in order for a nonprofit LLC to form.
The limited liability company will need to meet several requirements mandated by the Internal Revenue Service; specifically, its mandate known as the “Limited Liability Companies as Exempt Organization Update.”
In addition to meeting those requirements, a limited liability company needs to be owned completely by a sole tax exempt organization that is a nonprofit organization itself.
Limited liability companies are not typically formed as nonprofits due to how complex the process is.
A nonprofit limited liability company set up also happens to be a structure that not many people form due to how much time and effort it will take versus choosing to just form a nonprofit corporation instead.
To form a nonprofit limited liability company, every member of the nonprofit LLC must also be tax exempt nonprofit organizations themselves.
Each owner or member would have to be incorporated as a nonprofit organization before they can form as a nonprofit limited liability company.
Every member of the limited liability company would need to actively classify as nonprofit organizations otherwise, the nonprofit LLC cannot be formed.
If an actively operating business can claim its ownership by a sole tax exempt nonprofit organization, that limited liability company may be able to qualify as a nonprofit limited liability company.
It would be easier if a group of already established nonprofit organizations come together to form a tax exempt, nonprofit limited liability company though that scenario does not commonly happen.
It is more straightforward to incorporate nonprofit organizations as nonprofit corporations.
It is because of the relatively uncomplicated process of establishing a nonprofit corporation that only a few nonprofit limited liability companies exist.
The Internal Revenue Service does not grant statuses of tax exemption to nonprofits unless each member or party involved is proven to be a tax exempt organization.
What usually ends up happening is having a group of charitable, philanthropic or humanitarian organizations coming together to form a limited liability company which will then be granted tax exemption by the Internal Revenue Service provided that their purpose is strictly charitable.
Only qualified limited liability companies that comply with their states laws and regulation can form a nonprofit organization.
Each state will have different laws concerning nonprofit limited liability companies so it is always best to check in with that of your presiding state to also ensure that a nonprofit limited liability company is considered as a legitimate entity in your state.
It should be noted that several states do not recognize the term nonprofit limited liability company with many states considering that term as incorrect in place of referring to this type of set up as a “nonprofit liability company”.
There are states that are exempt to this such as Tennessee, Kentucky and Minnesota.
There are distinct legislations that were enacted to permit a limited liability company to be formed for any legal purposes it deems necessary including for nonprofit purposes in most states.
Internal Revenue Service (IRS) rules for forming a Nonprofit Limited Liability Company
It is up to the Internal Revenue Service to decide on whether or not a limited liability company formed can qualify as a tax exempt business entity.
In addition to having each member be a tax exempt entity, the 12 conditions under the Internal Revenue Service’s mandate entitled “Limited Liability Companies as Exempt Organization Update” must be complied with.
Those 12 conditions are:
- The documents filed, known as organizational documents, when establishing a tax exempt nonprofit organization must have a statement that explicitly states the boundaries of the limited liability company’s activities. The limited liability company must have its activities adhered to one or more tax exempt or nonprofit objectives.
- It must be clearly stated in the prime language of the limited liability company’s organizational documents that the LLC is only and purely being operated for the philanthropic or charitable purposes or objectives of its members.
- The organizational language has to mandate the compliance with Section 501 (c) (3) that states that each member of the limited liability company must be exclusively owned instrumentalities or political subdivisions of the state which are comparable to government units, governmental units that are actively affiliated with activities run by or related with the government or organizations that are solely nonprofit.
- The organizational language has to ban any indirect or direct transfers of any of the limited liability company’s membership interests to any recipients that do not comply with being a section 501 (c) (3) governmental unit or organization.
- The organizational language has to state that the interests in the limited liability company, the assets of the limited liability company and other matters pertaining to or of the limited liability company be only transferred to nonmembers that do not fall into the classification of a 501 (c) (3) organization. Section 501 (c) (3) organizations include governmental instrumentalities and units. Transfers to nonmembers that do not fall under the classification of section 501 (c) (3) must be done at fair market value.
- The organizational language has to guarantee the continuous use of the nonprofit limited liability company’s assets for purposes that are charitable upon dissolving the business. The nonprofit limited liability company’s assets that were acquired and used for the purpose of charity must only be used for charity even after the dissolution of the nonprofit limited liability company.
- The organizational language has to mandate compliance with any and all amendments of the nonprofit limited liability company to be consistent and relevant with section 501 (c) (3) in its articles of organization.
- The organizational language has to strictly prohibit the nonprofit limited liability company from becoming, converting and merging with a business entity that is made to profit
- The organizational language has to mandate the distribution of assets of the nonprofit limited liability company only to organizations classified in section 501 (c) (3), governmental instrumentalities or units. Conversely, the distribution of nonprofit limited liability company assets to members who are no longer part of an organization under those classified in section 501 (c) (3), governmental instrumentalities or units are prohibited.
- The organizational language has to have a provision dedicated to an acceptably reasonable contingency plan to cover for the events that will or might happen in case one or more members of the nonprofit limited liability company stops its function as an organization classified in section 501 (c) (3), governmental instrumentality or unit.
- The organizational language has to declare that the nonprofit limited liability company members will do their best efforts to enforce all their limited liability company rights to go after every equitable and legal remedy it can in the pursuit of protecting the interests of the limited liability company.
- The nonprofit limited liability company’s organization documents have to have provisions that are consistent and compliant with the limited liability company’s presiding state laws. The nonprofit limited liability company’s organizing documents also have to have provisions that can legally and in equity be enforced.
Compliance with all the 12 mentioned requirements when starting a tax exempt, nonprofit limited liability company may have the Internal Revenue Service permit the LLC formation.
State information regarding nonprofit limited liability companies
It is not a guarantee that the submission to the 12 requirements under the Internal Revenue Service’s mandate called “Limited Liability Companies as Exempt Organization Update” would automatically assure the formation of a nonprofit limited liability company.
Even if all requirements are adhered to, there are still other factors to consider that will decide on whether the formation of a nonprofit LLC is possible.
Before beginning the process of formation, state regulations and laws have to be checked and complied with, inclusive of determining if the limited liability company being formed is qualified to be a nonprofit organization.
There are certain types of business models that can be classified as tax exempt however, many business models are not operated as nonprofit.
The qualification of a limited liability company as a nonprofit entity will need to be dealt with before the process of formation can begin.
Once qualified, the rules and regulations of the state agency that supervises and oversees the business organizations in its area of responsibility will need to be obeyed.
Differing states will have differing laws and stances on nonprofit limited liability companies.
For example, in the state of California, the forms that are necessary and the instructions of how to form an LLC are available inclusive of what to do or the steps to take in forming a nonprofit limited liability company.
The information and materials needed can be found at the Office of the Secretary of State.
Meanwhile, in other states, organizations will need to file articles of incorporation and from there, form a nonprofit corporation without the option to form as a nonprofit limited liability company as is what is required in the state of Kentucky.
Limited liability companies can be formed to be recognized by the Internal Revenue Service as a nonprofit organization though the success of establishing this endeavor will depend on the state that is presiding over the business.
In order for an LLC to be recognized as a nonprofit organization, the limited liability company must comply with the Internal Revenue Service’s mandate known as the “Limited Liability Companies as Exempt Organization Update.”
When the limited liability company can comply with the mandate, the Internal Revenue Service will then consider the application of the limited liability company as a nonprofit LLC.
There are 12 conditions that have to be met before a limited liability company can begin to form as a nonprofit entity.
Of those 12 conditions, the main theme is the importance of the entity’s operations to be strictly of charitable purposes.
A nonprofit limited liability company can only be formed by organizations that are already recognized as tax exempt and it can only be formed for the sole purpose of charity.
If any member ceases to operate as a nonprofit entity, contingency plans will need to be made.
If any member is not already a nonprofit organization, formation as a nonprofit limited liability company will not be possible.
In the case of membership interests being transferred, that can only be done with recipients that fall under Section 501 (c) (3).
Meanwhile, the transferring of assets of the nonprofit limited liability company must be done at fair market value and can only be transferred to entities that do not fall under Section 501 (c) (3).
An emphasis is put on the fact that a nonprofit limited liability company can only be formed for the purposes of charity.
Its operations and activities can only be done for charitable purposes. It is strictly prohibited to have the nonprofit limited liability company become, merge with, or convert into a business made to profit.
Even in the event of the nonprofit limited liability company dissolving, the assets it has acquired to carry out its charitable operations have to continuously be used for charitable purposes only; with the distribution of its assets being permitted so long as it is done with organizations that fall under Section 501 (c) (3), governmental instrumentalities and units.
If a member would like to have assets distributed to him or her but do not anymore function as a governmental instrumentality, unit or Section 501 (c) (3) organization, the distribution will not be permitted.
Due to the amount of effort it takes to comply with each regulation inclusive of each member already needing to be a nonprofit organization in their own right in order to form a nonprofit limited liability company, it is uncommon to form nonprofit LLCs.
Instead, most people choose to incorporate as a nonprofit corporation which involves a more simple and straightforward process.
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IRS.gov "Limited Liability Companies as Exempt Organization Update" Page 1 . June 22, 2021