Why and How Nonprofits Use Limited Liability Companies (LLCs)

The Limited Liability Company (LLC) is a flexible and widely used entity structure in virtually every industry, from one-person businesses to some of the largest companies in the world. LLCs can also be useful as a subsidiary or joint venture vehicle for certain nonprofit programs or activities, but the use of single-member and multi-member LLCs in a nonprofit context is often misunderstood.

Background

An LLC is a type of business entity structure available under state law, and is a possible alternative to other entity types such as business (or stock) corporations, nonprofit (or nonstock) corporations, partnerships, and trusts. LLCs are popular because they offer the possibility of liability protection to the LLC owners (called “members”) with relatively more flexibility and ease of administration than other types of entities.

LLCs are particularly flexible with respect to their tax treatment, with options that vary depending on whether the LLC is a single-member LLC (an LLC with only one owner, sometimes abbreviated as “SMLLC”) or a multi-member LLC (an LLC with more than one owner).

By default, a single-member LLC is taxed as a “disregarded entity,” which means that the LLC’s revenue, expenses, and assets flow through to the LLC’s sole member and are reported as revenue, expenses, and assets of the sole member for federal tax purposes (including on the Form 990). However, by filing IRS Form 8832, a single-member LLC can elect to be treated as a “C Corporation” that is taxed separately from its owner, which may be useful for some organizations with unrelated business activities (as mentioned briefly below).

Similarly, a multi-member LLC is taxed as a partnership by default, which means the LLC files a Form 1065 tax filing for informational purposes only, while income, gains, losses, deductions, and credits are all passed through and allocated to the LLC’s members. As with single-member LLCs, multi-member LLCs may file IRS Form 8832 to elect to be taxed as “C Corporations.”

Subject to certain qualification requirements, single-member and multi-member LLCs may also file IRS Form 2553 to elect treatment as an “S Corporation” (special type of flow-through corporation). This generally has little relevance for nonprofit organizations and, therefore, is not covered in this article.

Why Nonprofits Typically Use LLCs

The reasons nonprofits generally consider using LLCs as a subsidiary or joint venture entity are usually based on one or more of the following criteria: (1) liability protection; (2) independence (or separation) of day-to-day governance; and (3) independence (or separation) from the organization’s brand.

• Liability Protection. Liability protection is a key feature of the “Limited Liability Company” structure. An LLC that is formed to hold certain assets and/or run certain activities of a nonprofit organization can help shield the organization from debts, lawsuits, and other liabilities arising from these assets and/or activities. This liability protection generally applies even for single-member LLCs that are considered “disregarded entities” for tax purposes, subject to a caveat: an organization that has a single-member LLC must be extra careful to respect operational formalities and the separateness of the LLC, such as having and complying with an “Operating Agreement” for the LLC, maintaining a separate LLC bank account, and ensuring that the LLC has sufficient funds to cover its operations. Courts are sometimes inclined to disregard the liability protection (“pierce the veil”) of an LLC where these formalities have not been observed, especially in the case of single-member LLCs.

• Independence of Day-to-Day Governance. An LLC can be a way for an organization to empower officers, employees, or one or more committees to run certain programs and activities with more independence than would be possible or appropriate if the programs or activities were run directly by the organization. This independence can be important where the organization does not want to be perceived as controlling certain activities (such as an event, scholarship program, research, or publication) and/or wants to encourage innovation and experimentation in an unbiased environment. While an LLC should always be subject to oversight by its member(s), having a dedicated bank account for an LLC and a governance structure under which which the LLC management team is authorized to execute contracts and incur expenses within a member-approved budget can are important examples of ways to establish and project independence of the LLC’s day-to-day governance.

• Brand Independence: As with independence of day-to-day governance, separating certain programs and activities in an LLC can be an effective way to establish the independence of the name(s) and brand(s) of these special programs and activities. This is especially helpful for programs and activities that will benefit from having separate brand recognition, such as in situations where having too close of an alignment with the parent entity could be detract from the organization’s goals (for example, a research program that will have more credibility if it is separated from the parent entity).

Note that many of these same goals can also be achieved by forming a subsidiary corporation rather than an LLC. While LLCs are sometimes preferred due to their relative flexibility and ease of administration, the choice of entity should be made carefully with input from the organization’s attorneys, accountants, and other qualified advisors.

One Use of LLCs to Avoid

Before discussing the ways LLCs can be useful for nonprofit organizations, let’s briefly address one use of an LLC that is usually not recommended: forming an LLC as a standalone entity with the intention of applying for 501(c)(3) or another federal tax-exempt status for the LLC.

While forming a single-member (disregarded entity) LLC solely owned by a 501(c)(3) nonprofit organization can be an effective strategy (as discussed below), in most other cases the preferred vehicle for a standalone tax-exempt organization is a traditional nonprofit (or nonstock) corporation.

In theory, it is possible in certain situations for a standalone LLC to be structured in a way that qualifies for 501(c)(3) status as noted in the Form 1023, Form 1024, and Form 1024-A, all of which list LLCs as a possible choice of organizational structure. However, using LLCs instead of traditional nonprofit (or nonstock) corporations to achieve standalone tax-exempt status is problematic for two reasons: 

First, state nonprofit corporation statutes are better suited to the requirements and public expectations of federal tax-exempt status, including the requirement to have a Board of Directors (or similar governing body with oversight responsibilities and fiduciary duties), conflict of interest rules and laws restricting private inurement and diversion of assets for private purposes, as well as volunteer immunity and other protections. In contrast, state LLC statutes are tailored to for-profit businesses, and have none of the provisions that help to ensure compliance with tax-exemption requirements. Consequently, an LLC’s governing documents would need to be substantially customized and adapted to meet nonprofit tax-exemption requirements, an extremely cumbersome task that is prone to errors and omissions and likely could not replicate many of the protections that exist under the applicable state nonprofit corporation statutes. 

Second, current IRS guidance set forth in IRS Notice 2021-56 makes clear that the circumstances in which an LLC can qualify on its own for 501(c)(3) status are very narrow. While this guidance does not apply to a single-member LLC solely owned by a 501(c)(3) nonprofit organization that is treated as a “disregarded entity,” IRS Notice 2021-56 requires that in other cases an LLC can qualify for 501(c)(3) status only if its governing documents include: (1) provisions requiring all of the LLC’s members to be 501(c)(3) charitable organizations or governmental units or instrumentalities; (2) charitable purpose and dissolution language required of all 501(c)(3) organizations; (3) compliance language in the event the LLC is classified as a private foundation; and (4) an acceptable contingency plan in the event the LLC’s members cease to be 501(c)(3) charitable organizations or governmental units or instrumentalities.

Under this guidance, for example, an LLC will not qualify for 501(c)(3) status if it is formed by a group of individual “members” who intend to function as the organization’s “Board of Directors,” even if the LLC’s governing documents attempt to replicate the 501(c)(3) requirements under federal tax law.

How Nonprofits Typically Use LLCs

Some of the most common ways LLCs are generally used by nonprofit organizations include: (1) as a vehicle for fiscal sponsorship; (2) as a single-member LLC subsidiary to hold certain assets and run specific programs and/or activities; and (3) as a multi-member LLC for joint ventures and partnerships with other nonprofit and/or for-profit entities.

Fiscal Sponsorship

An LLC can be an effective vehicle for fiscally sponsored programs under a variety of fiscal sponsorship structures including Model A, Model B, and Model C. In Model A or Model B fiscal sponsorship (in which the fiscally sponsored project is considered a program of the fiscal sponsor organization), a single-member LLC can be a way to provide liability protection to the fiscal sponsor while providing more independence to the project managers.

In Model C fiscal sponsorship (in which the fiscally sponsored project is a separate entity from the fiscal sponsor, with the fiscal sponsor serving primarily in a grant-receiving / grant-making role), an LLC can sometimes be an efficient way to receive grants from the fiscal sponsor and avoid the unwise decision to route these grants through a personal bank account of one of the people leading the fiscally sponsored project.

However, before using an LLC for a Model C fiscal sponsorship, be aware that: (1) project manager(s) who serve as members of an LLC will have personal income tax consequences from grants received from the fiscal sponsor due to the flow-through tax treatment of an LLC; and (2) an LLC is usually not an ideal choice of entity for projects that plan on submitting a Form 1023 later, since an LLC whose members are individual project managers will not qualify for 501(c)(3) status pursuant to IRS Notice 2021-56.

For Model C fiscally sponsored projects that plan on applying for their own 501(c)(3) status within a year or two after starting a fiscal sponsorship relationship, a nonprofit corporation is often a better choice of entity. In the event an LLC is used for a Model C fiscal sponsorship, the process of applying for 501(c)(3) status will typically require the formation of a separate nonprofit corporation and the transfer of assets from the LLC to the nonprofit corporation (a complex transaction that should not be undertaken without consulting an attorney).

Single-Member LLCs

A single-member LLC subsidiary with “disregarded entity” status can be a preferred vehicle for a 501(c)(3) or other tax-exempt organization that wishes to isolate certain assets, programs, or activities in a separate entity for the liability, governance, and/or brand independence reasons, as discussed above.

As a “disregarded entity,” a single-member LLC is, by default, automatically deemed to have the same tax-exempt status of its sole owner for most tax purposes. Thus, a single-member LLC (subsidiary) whose sole member (parent) is a tax-exempt organization does not need to submit a Form 1023, Form 1024, and Form 1024-A to achieve the benefits of tax-exempt status. In this case, the LLC’s revenue, expenses, and assets are treated as revenue, expenses, and assets of the member, and are reported on the member’s Form 990. Similarly, donations made to a single-member (disregarded entity) LLC are eligible for the charitable deduction as if made directly to the 501(c)(3) member. See IRS Notice 2012-52.

In certain cases, a tax-exempt organization may wish to form a single-member LLC that files IRS Form 8832 to elect to be treated as a “C Corporation” rather than a disregarded entity. Here, the LLC subsidiary would be a taxable entity that is taxed separately from its sole owner, and the LLC’s revenue, expenses, and assets would not be consolidated with the member’s revenue, expenses, and assets for Form 990 reporting purposes. This treatment can be useful in situations where the organization has one or more “unrelated businesses” that trigger substantial unrelated business income tax (“UBIT”) and could jeopardize the organization’s tax-exempt status if not spun off to a separate entity due to the size and materiality of the activity.

Additionally, in more advanced situations an LLC with C Corporation treatment could be useful as a so-called “UBIT Blocker” to hold interests in certain investments and partnership activities that would be attributed to the organization if held directly by the organization.

Joint Ventures with Other Entities

Multi-member LLCs are also often used as a vehicle for joint ventures and partnerships with other nonprofit and/or for-profit entities. For example, if two 501(c)(3) nonprofit organizations wish to jointly run a program, forming an LLC with a carefully drafted Operating Agreement can be an effective way to formalize the relationship and protect each organization from liabilities that could result from the conduct of the other party. With two or more 501(c)(3) organizations as the LLC’s members, the LLC would, by default, be treated as a partnership for tax purposes. Alternatively, the LLC could qualify for 501(c)(3) status itself to the extent it satisfies the requirement of IRS Notice 2021-56.

It is also possible for a tax-exempt organization to form an LLC with one or more for-profit entities as the other members, however these structures raise complex private inurement and private benefit issues and should be approached with caution and with the advice of qualified legal counsel. See Rev. Rul. 98-15 and Rev. Rul. 2004-51.

Planning Tip: A nonprofit organization that wishes to form an LLC to hold certain assets and/or run certain activities should give careful thought to the drafting of the LLC’s essential governing documents: the Articles of Organization and Operating Agreement. Most off-the-shelf template LLC documents have not been drafted specifically for nonprofit organizations and usually lack provisions that are important for nonprofit legal and governance considerations and requirements. In these situations, getting advice from attorneys with both for-profit and nonprofit experience will be crucial.

Conclusion 

There are numerous other issues and considerations involving LLCs that are outside the scope of this article, such as how to handle donor acknowledgments, navigating charitable solicitation registration laws, issues that arise when drafting the LLC Operating Agreement, and many other issues and considerations.

Nonetheless, understanding the basics of LLCs, their possible advantages for nonprofit organizations, and the variety of ways they can (and cannot) be used in a nonprofit context is an important first step to using LLCs correctly and to their fullest potential. As with most complex entity structure decisions, it is important to weigh the pros and cons of the different options with input from attorneys, accountants, and other qualified advisors regarding the legal, financial, governance, and reporting consequences of these choices.

 You might also be interested in:

Why and How Should a Nonprofit Form a Subsidiary?

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