Federal Requirements for a Nonprofit LLC

By Melanie Jo Triebel

An LLC, or limited liability company, is a form of legal entity that has more flexibility in its operations than a corporation, but which provides the protection of a corporation in shielding its owners from liability. An LLC which gains tax-exempt status under section 501(c)(3) of the Internal Revenue Code does not have to pay federal income taxes. Donors to these organizations may also deduct donations to the LLC from their own income taxes, which greatly aids in the LLC's fundraising efforts. Gaining and keeping nonprofit status for an LLC, however, requires strict compliance with state and federal law.

State Laws

Unfortunately, not all states allow LLCs to form and operate as nonprofit entities. In some states, the law as to whether LLCs can be formed and operated as nonprofit entities is simply unclear or unsettled. Before electing to form a nonprofit entity as an LLC and applying for tax-exempt status with the IRS, a founder should carefully determine whether this organizational option is available under state law.

Tax-Election Requirements

LLCs have some flexibility in how they choose to be taxed (much like a married couple can choose to file jointly or separately). To receive non-profit status from the IRS, an LLC must elect to be taxed as a corporation. If an LLC elects to be taxed other than as a corporation, it may still be exempt from taxes, if it is wholly owned by an organization that is itself a non-profit under Section 501(c)(3).

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Purpose of Organization

To gain tax-exempt status, an LLC -- like other organizations -- must be organized and operated for an appropriate, nonprofit purpose. Organizations with charitable, literary, educational, scientific or religious purposes may be exempt from federal taxes.

Conditions of LLCs

The IRS requires LLCs to comply with 12 conditions to gain tax-exempt status. Several of these relate to the legal creation of the LLC, referred to as its organization. The language of an LLC’s organizational documents must limit its activities to activities that further its exempt purpose and specify that that the LLC operates solely to further its members' exempt purposes. The language must limit the LLC's membership to 501(c)(3) organizations and government entities or instrumentalities, and the language must prohibit members from transferring their ownership interests outside those groups. The language must specify that the LLC cannot sell its assets and property outside those groups, except for fair market value. The documents must provide that members will enforce their rights in the LLC, and, in a separate document, the LLC must represent that it is created in compliance with state law.

Additional Requirements

The LLC must also meet the remaining IRS requirements for tax-exempt status, which ensure that the LLC does not become non-compliant after formation. The LLC's organizational documents must require that any future amendments to the documents be consistent with Section 501(c)(3), and they must prohibit the LLC from merging with or converting into a for-profit company. They must also guarantee that assets will only be used for exempt purposes upon dissolution of the LLC. In addition, they must provide a contingency plan should a member cease to be a 501(c)(3) entity or a government entity or instrumentality, and ensure that such a member not receive a distribution of assets.

Federal Compliance

Once an LLC gains tax-exempt status, it must continue to comply with federal law. The LLC must file a tax return each year setting forth its income and expenses. If it fails to do so for three years, it will lose its nonprofit status. The LLC must also file a return showing any substantial income it receives from any business the LLC operates that does not closely relate to its exempt purpose.

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Difference Between Incorporation & LLC for a Non-Profit
 

References

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How an LLC Claims Profit and Losses

A limited liability company, or LLC, is a business entity type that has a history in the United States that spans decades rather than centuries. The relative newness of the format means that the Internal Revenue Service has yet to recognize the LLC as a specific tax entity type. Instead, the IRS classifies an LLC as one of the existing entity types that are defined in the tax code, based on the number of owners, known as members, and the tax elections those owners make. Single-member LLCs can elect to be taxed as a sole proprietorship or a corporation. Multiple-member LLCs can elect to be taxed as a partnership or a corporation. The way a LLC claims profits and losses depends on this tax election.

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Once you form a limited liability company, or LLC, you can’t treat your business as a C corp unless you create a legal corporate entity for it. However, if you only want the LLC to file as a C corporation for tax purposes, the IRS allows for it, but the LLC must commit to comply with every corporate income tax rule for a minimum number of years.

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