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Can a Limited Liability Company be a Tax-Exempt Organization?

Internal Revenue Service Form 1023The question has arisen among individuals interested in forming a nonprofit organization as well as in nonprofit circles as to whether a tax-exempt organization may have the legal structure of a limited liability company, generating much discussion if not confusion.  The answer, unfortunately, is neither simple nor straightforward.  Furthermore, it is not encouraging to many wishing to utilize this structure for their tax-exempt organization. 

Traditionally, to qualify as a Section 501(c)(3) organization exempt from federal income tax, the organization had to have been a corporation, community chest, fund, or foundation.  Since a trust is a fund or foundation, it, too, would have qualified; however, an individual or a partnership would not have qualified.

The limited liability company has evolved into the preferred choice of legal structure for many small businesses given its ease of formation; however, the limited liability company is not recognized as a unique and separate taxable entity per se by the Internal Revenue Service.  If the LLC has only a single individual member, it is customarily treated as a sole proprietorship and its income is reported on Schedule C of Form 1040.  In other words, the LLC is a “disregarded entity”, having no separate existence apart from its member. If two or more individuals own an LLC, it is customarily treated as a partnership and its income is reported on Form 1065.  All of its income, expenses, gains, losses, and other tax attributes “pass through” its separate legal structure as an LLC and are reported on the tax returns of its members.

Even though the limited liability company is not a legal corporation, it can, however, elect to be taxed as a C corporation by filing Form 8832.  After filing such, if it desires to be taxed as an S corporation, it then can file Form 2553.  Unless it elects to file as a corporation, the limited liability company has no separate existence apart from its members in the eyes of the Internal Revenue Service in spite of its legal existence as a separate entity.

Now let us address the question of whether a tax-exempt organization may have the legal structure of a limited liability company by considering various possible scenarios involving the different kinds of membership.

Assume the simplest scenario:  a limited liability company consisting of a single individual as its sole member.  Since the Internal Revenue Service would disregard the separate existence of the company apart from the individual member, any application for tax exemption under Section 501(c)(3) would be denied, since an individual cannot be a tax-exempt organization.

Next assume a more common scenario:  a limited liability company consisting of two or more individuals as its members.  Since this legal structure would be treated by the Internal Revenue Service as a partnership for tax purposes, its application for tax exemption, too, would be denied, since a partnership cannot be a tax-exempt organization.

Now assume the following:  that the individuals constituting the members of the limited liability company have elected to be taxed as a corporation before applying for tax-exempt status of its organization.  Would its application then be approved by the Internal Revenue Service, since corporations are an acceptable form for tax-exempt organizations?  The answer is still, no.  Why?  Because state laws generally provide LLC members with ownership rights in the assets of the LLC, the Internal Revenue Service is concerned that allowing non-exempt members would result in potential inurement of net earnings to individuals, use of assets not exclusively for charitable purposes, and dealings with private interests not at arm's length:  that is, the IRS wishes to ensure that the LLC is organized and operated exclusively for exempt purposes.

On the other hand, if the limited liability company consisted entirely of tax-exempt organizations or governmental units or instrumentalities as members, without any individuals as members, and elected to be taxed as a corporation and not as a partnership, then it would be eligible for approval as a tax-exempt organization under Section 501(c)(3), in spite of the fact that the presence of solely charitable members does not necessarily ensure that the organization will be operated exclusively for charitable purposes.  Presumably, the Internal Revenue Service has adopted the position that a tax-exempt organization whose members are tax-exempt organizations more likely would operate exclusively for charitable purposes than that composed of members other than tax-exempt organizations.

It is important to note that the limited liability company need not file an exemption application if it wished to be treated as a disregarded entity by its tax-exempt member.  The exempt parent of the disregarded LLC would simply treat the operations and finances of the LLC as its own for tax and information reporting purposes.  Consequently, all of its income would be tax exempt as well.

There has much discussion and confusion about whether a limited liability company is an eligible legal structure for a tax-exempt organization.  Given the review of the feasibility of the limited liability company as the legal structure of a tax-exempt organization under the several different scenarios as presented above, for all intents and purposes, one can only conclude that it would rarely be an acceptable form of organization by the Internal Revenue Service for most applicants applying for tax-exempt status.  Since the IRS will only recognize a limited liability company under section 501(c)(3) if all its members are section 501(c)(3) organizations, any individuals contemplating the formation of a tax-exempt organization would be well advised to incorporate before applying for tax-exempt status in order to avoid its application from being denied.

This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice.  For further information, please consult appropriate professional advice from your attorney and certified public accountant. 

Have a tax or an accounting question?  Please feel free to submit it to William Brighenti, Certified Public Accountant, Hartford CPA Accountants.  For information and assistance on any tax and accounting issue, please visit our website:  Accountants CPA Hartford.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.  The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein.  The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor.

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