A limited liability company (LLC) is a legal form of enterprise, owned by one or more members, that may be organized and operated for a wide variety of purposes, including charitable purposes. One of the major advantages of an LLC is the limited liability protection it offers to its members. Members are generally not liable for the debts and obligations of the LLC except to the extent of their investments in the LLC.
While technically, there is no such thing as a nonprofit LLC in the vast majority of states (Minnesota, Tennessee, and Kentucky being notable exceptions), there are tax-exempt LLCs, and these entities are commonly referred to as “nonprofit limited liability companies” or “nonprofit LLCs”. For the purposes of this article, I’ll refer only to tax-exempt LLCs that are organized and operated for charitable purposes.
An LLC may be recognized by the IRS as tax-exempt for federal income tax purposes in any of these scenarios:
- The LLC may apply for recognition of exemption under Internal Revenue Code 501(c)(3) by filing Form 1023. See IRS Website.
- The LLC may be a disregarded entity for federal income tax purposes and take on the tax characteristics of its sole member, a 501(c)(3) organization.
- The LLC may be considered a pass-through entity for federal income tax purposes and accordingly its income (and expenses) will be attributed to its members, all of which are 501(c)(3) organizations.
Generally, a domestic LLC exempt under Section 501(c)(3) of the Internal Revenue Code will be eligible to receive (a) deductible charitable contributions and (b) private foundation grants without the need for expenditure responsibility. See IRS Notice 2012-52.
See Instructions for Limited Liability Company Reference Guide Sheet (IRS).
While an LLC may be recognized by the IRS as tax-exempt for federal income tax purposes, this does not necessarily mean that it will be recognized as exempt from state income taxes or state property taxes. In California, an LLC (other than one electing to be taxed as a corporation) will be recognized as tax-exempt for state income and franchise tax purposes only if it is qualifies as a title-holding company under Revenue and Taxation Code Section 23701(h) or 23701(x). it will be recognized as exempt from state property taxes if it separately qualifies under the welfare exemption.
See Limited Liability Companies and Tax-Exempt Status (Franchise Tax Board); Limited Liability Companies As Tax-Exempt Organizations; Limited Liability Companies and Qualification for the Welfare Exemption.
Use of an LLC by a Nonprofit
A nonprofit may want to establish and own an LLC for multiple reasons, including:
- To protect itself from the risks and liabilities associated with the assets or activities of the LLC. This isolation-of-risk strategy may be particularly appropriate where the LLC’s assets (e.g., real property with environmental risks) and/or activities (e.g., adventure camps) have a higher risk profile than the nonprofit’s assets and activities.
- To operate a business that is not substantially related to advancing its exempt purpose without exposing itself to revocation of its 501(c)(3) exempt status. This strategy is commonly employed where a nonprofit desires to carry on an unrelated business that is substantial in scope and size. In this case, the LLC will not be tax-exempt.
- To operate a joint venture with one or more other entities. The LLC housing the joint venture may be tax-exempt if all of its members are tax-exempt or taxable if its members consist of both nonprofit and for-profit organizations.
See Single Member LLCs: The flexibility of limited liability companies is one asset for nonprofits (Alliance for Children & Families Magazine).
Fiscal Sponsorship Using an LLC (Model L)
A nonprofit fiscal sponsor may want to establish and own an LLC to protect itself from the risks and liabilities associated with the assets or activities of the sponsored project. If appropriately structured, an LLC solely owned by a fiscal sponsor may be considered tax-exempt as a disregarded entity and seek out its own deductible charitable contributions and private foundation grants, as described above.
The Model L fiscal sponsorship strategy may be worthy of consideration under a couple of circumstances:
- Where comprehensive fiscal sponsorship (Model A) is being considered but the risks and liabilities associated with a new project are of significant concern to the fiscal sponsor.
- Where an existing nonprofit wants to dissolve and transfer its programs to a fiscal sponsor but the fiscal sponsor is concerned about potential successor liability.
Among the issues for fiscal sponsors to be aware of before setting up a Model L fiscal sponsorship:
- The activities of the LLC may be attributed to the fiscal sponsor for tax purposes. If the LLC engages in substantial lobbying (relative to the fiscal sponsor’s limits) or prohibited political intervention activities, the fiscal sponsor’s 501(c)(3) status may be jeopardized. And the LLC’s unrelated business activities may result in unrelated business taxable income to the fiscal sponsor.
- The LLC is itself a charitable asset owned by the fiscal sponsor impressed with a charitable trust. Accordingly, the board members of the fiscal sponsor have a duty to protect such asset from misuse. The fiscal sponsor’s selection of a manager to manage the LLC should accordingly be made with reasonable care (query whether it would be prudent to eliminate a manager’s fiduciary duties to the fiscal sponsor, if possible). The fiscal sponsor itself will likely not want to be the manager in order to mitigate against the possibility of ascending liability.
- The selection of the state in which the LLC is to be organized.
- The LLC may need to be adequately capitalized to mitigate against the risks of veil piercing and ascending liability.
- There may be different ways for the fiscal sponsor to be paid for such arrangement, including through fees or distributions to the sole member. However, the payments should be clearly defined in a written agreement to mitigate against the risks of veil piercing and ascending liability.
- The LLC will not be disregarded for employment tax purposes and will have all of the responsibilities of an employer to the extent it has any employees.
See The Use of LLCs in Fiscal Sponsorship – A New Model (Taxation of Exempts); Successor Liability in a Model A Fiscal Sponsorship (Nonprofit Law Matters, Adler & Colvin); Using LLCs in Fiscal Sponsorship: 3 Detailed Responses to Questions (GrantSpace)
Use of an LLC Instead of a Nonprofit
An LLC can have a social good purpose and, just like any individual, can engage in charitable and philanthropic activities. For federal income tax purposes, it may be a pass-through without any entity level taxes. However, under such circumstances, any net income of the LLC will be attributed, and may be taxable, to the individual owner(s). For a charitably inclined owner, this may not be an issue, particularly if the LLC is not going to produce significant net income or will engage in earned income activities that would otherwise be prohibited if run by a 501(c)(3) nonprofit. In addition, as a nonexempt entity, the LLC would not be constrained by the tax laws applicable to 501(c)(3) organizations. Accordingly, in addition to making charitable grants to charities, which the LLC may do just like a foundation, the LLC may also make investments in for-profit social enterprises, engage in political campaign activities and unlimited lobbying, and enter into creative collaborations with various for-profits, all of which may be impermissible to a 501(c)(3) nonprofit.
See Chan Zuckerberg Initiative – Taxable Social Enterprise – Part 2 for a discussion of some benefits of using an LLC instead of a nonprofit.
Low-profit Limited Liability Companies (L3Cs)
An L3C is a special form of LLC that significantly furthers the accomplishment of one or more charitable and/or educational purposes. Generally, an L3C can be used in place of a traditional LLC in any of the scenarios above. See our earlier posts on the L3C.
2021 Revenue Ruling (UPDATED 12/23/21)
Guidance issued for LLCs seeking tax-exempt recognition (Journal of Accountancy, 10/22/21)
Deeper Dive (UPDATED 4/17/17)
Section 501(c)(3) Organizations, Single Member Limited Liability Companies, and Fiduciary Duties (Ellen Aprill, Loyola Law School)
Sample Questions [Applications for Exemption] – Limited Liability Company (IRS)