Q&A #122 – Why would a nonprofit, tax-exempt organization form a single-member LLC?

Question: I am the Executive Director of a 501(c)(3) nonprofit organization that has been considering forming a subsidiary organization to carry out certain fee-for-service programs, mainly for liability protection reasons. It was suggested that we consider forming a single-member LLC instead of a subsidiary tax-exempt organization. What are the advantages of this approach?

Answer: When properly formed, a single-member LLC (SMLLC) that is wholly owned by a tax-exempt organization protects the parent organization from liability for the SMLLC’s activities while providing the SMLLC with the benefits of the parent organization’s tax-exempt status for federal tax purposes. The SMLLC structure is also generally easier to establish and more flexible than a subsidiary corporation.

Liability protection is usually the main reason for moving activities into any type of subsidiary, and a SMLLC generally provides the same liability protection as would a subsidiary corporation, provided that certain formalities are properly observed such as having an operating agreement in place and maintaining separate bank accounts.

The SMLLC structure also avoids some of the complications that arise with the formation of a subsidiary corporation. A SMLLC is generally treated as a disregarded entity for most federal tax purposes pursuant to Treas. Reg. § 301.7701-2 (unless the SMLLC submits Form 8832 electing treatment as a corporation). Among other implications, this means that a SMLLC that is wholly owned by a tax-exempt parent organization is automatically treated as tax-exempt for federal income tax purposes and does not need to file its own Form 1023 or Form 1024 with the IRS.

However, this automatic tax-exempt status may not apply for state tax purposes so consult your organization’s tax advisors regarding the applicable state tax consequences of forming a SMLLC.

Similarly, SMLLC that is wholly owned by a tax-exempt parent organization does not file its own Form 990 since all revenue, expenses, and assets are attributed to the parent organization and get reported on the parent’s Form 990. Attribution of the parent organization’s tax-exempt status means that a SMLLC also does not need to separately satisfy public charity requirements, such as meeting public support tests based on its own revenue or qualifying as a “supporting organization.” So long as the parent organization remains a public charity, this treatment will apply to the SMLLC as well.

Further, the IRS clarified in Notice 2012-52 that donations to a SMLLC that is wholly owned by a 501(c)(3) organization are eligible for the charitable deduction as if the donations were made directly to the parent 501(c)(3) organization.

Note that the most recent IRS guidance on LLCs in the 501(c)(3) context (Notice 2021-56) was primarily focused on analyzing 501(c)(3) qualification of LLCs with more than one owner (a structure that we do not typically recommend) and should not affect the analysis of SMLLCs.

Planning Tip – The “operating agreement” of a single-member LLC (SMLLC) is not only crucial for protecting the parent organization from liability related to the SMLLC’s activities, but also an important governance document. Think carefully about who within the parent organization is empowered to make decisions for the SMLLC (for example, the Board of Directors, officers, or another authorized committee), and make sure the decision-making processes for this body are clearly reflected in the operating agreement just as they would be in the organization’s Bylaws or a committee charter.

The ease and flexibility of SMLLCs are advantages that make this structure worthy of consideration in a wide variety of situations, and SMLLCs can be especially useful where a nonprofit organization is launching a new activity or pilot program that may be temporary.

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