Difference Between Incorporation and LLC for a Nonprofit

By Tom Speranza, J.D.

Difference Between Incorporation and LLC for a Nonprofit

By Tom Speranza, J.D.

Nonprofit entities, sometimes called exempt entities because of their exemptions from certain state and federal tax obligations, form to serve a public interest rather than to operate as a business or generate profits for individuals. To the extent that a nonprofit generates income, it must use the money to fund its operations and further its mission. In other words, it cannot distribute the income to private shareholders or individuals.

Man and woman in blue volunteer shirts interacting with kids and putting toys in box that says "donations"

Traditionally, nonprofits form as corporations, but states have begun to recognize limited liability companies (LLCs) as eligible for nonprofit status.

What Qualifies an Entity as a Nonprofit?

The U.S. Internal Revenue Service (IRS) recognizes 27 different kinds of nonprofits, including credit unions, daycare centers, fraternal organizations, and teachers' retirement funds.

The most popular nonprofit type, commonly viewed as a traditional charity, qualifies under Section 501(c)(3) of the U.S. tax code. This 501(c)(3) status exempts the organization from certain federal income taxes and allows donors to deduct donations made to the organization for federal tax purposes. A 501(c)(3) nonprofit's purposes must be charitable, religious, educational, scientific, or literary. According to the IRS, the term "charitable" involves any one of the following objectives:

  • Relief of the poor, distressed, or underprivileged
  • Advancement of religion
  • Advancement of education or science
  • Erection or maintenance of public buildings, monuments, or works
  • Lessening the burdens of government
  • Lessening neighborhood tensions
  • Eliminating prejudice and discrimination
  • Defending human and civil rights secured by law
  • Combating community deterioration and juvenile delinquency

State Recognition of Nonprofit LLCs

It's important to remember that not all states permit a nonprofit to exist in LLC form, but the clear trend is an increasing number of states either formally codifying the nonprofit LLC as a new entity or expanding the definition of the state's existing LLC to include those formed for nonbusiness purposes.

Formation

Nonprofit corporations and nonprofit LLCs are different in several important ways. A nonprofit corporation forms by filing Articles of Incorporation, while an LLC requires Articles of Organization, sometimes called Articles of Formation. These documents are similar, as they both require only basic information about the entity, including its name, purpose, and registered agent. Because a nonprofit corporation does not issue stock, its articles of incorporation do not include the authorized stock section required by a for-profit corporation.

If the nonprofit plans to seek 501(c)(3) status, the articles must also include certain IRS-mandated language. For example, the IRS requires a provision directing the distribution of any remaining assets after the entity's dissolution or termination to another nonprofit organization.

An experienced corporate or tax lawyer can ensure that your nonprofit's articles contain all provisions needed to obtain tax-exempt status.

Initial Documentation

Nonprofit corporations require bylaws that outline the rules by which directors, officers, and any members hold meetings, vote, and manage the organization. Nonprofit LLCs require an operating agreement to state how the members and managers, if any, will run the organization. As a general rule, state LLC laws are more permissive and flexible than state corporation laws, which means that a nonprofit LLC's operating agreement can be more easily drafted to fit an organization's particular situation. Corporate bylaws tend to follow a standard format and are not as customizable.

Your corporate lawyer can help you determine the best way to structure your nonprofit.

Governance

Most states impose more governance requirements on nonprofit corporations than nonprofit LLCs. For example, nonprofit corporations are often required to have at least three directors who must appoint officers holding president, treasurer, and secretary titles. In most states, however, one person can hold multiple officer titles.

An LLC, in contrast, can collapse the distinction between directors and officers and simply appoint managers to run the nonprofit.

Nonprofit corporations do not have shareholders, but they have the option of designating persons or entities as members with the power to elect directors and approve major transactions such as mergers or dissolution.

For LLCs, members are not optional—each LLC must have at least one member. But state laws permit members to also manage an LLC, making it a member-managed LLC. This means that a nonprofit LLC can form with a single person serving as both member and manager.

State Tax Exemptions

Nonprofits in most states can apply for exemptions from sales, property, and state income tax, but the exemptions are only available to LLCs if the state legally recognizes nonprofit LLCs.

Federal Tax Exemption

Using the Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code (Form 1023), a nonprofit can apply to the IRS for 501(c)(3) status to exempt itself from federal income tax and to allow its donors to deduct donations made to the organization. Any nonprofit corporation that meets the requirements outlined in Form 1023 can obtain 501(c)(3) status, but, under current IRS rulings, a nonprofit LLC cannot obtain 501(c)(3) status unless it meets both of the following criteria:

  • The LLC elects to be taxed as a corporation.
  • All of its members are also 501(c)(3) organizations, governmental units, or instrumentalities thereof.

This current limitation on LLCs is not settled law and may change as more states recognize nonprofit LLCs. However, it remains a major drawback on the use of LLCs for nonprofit organizations.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.