Insights

THE FUTURE OF LIMITED LIABILITY COMPANIES AS SECTION 501(c)(3) ENTITIES

To date, the Internal Revenue Service (IRS) has generally not processed applications by limited liability companies (LLC) for recognition as a tax-exempt entity under Section 501(c)(3) of the Internal Revenue Code.  The last IRS guidance on this topic was nonbinding and was issued 20 years ago, shortly after LLCs emerged as a new form of business structure in the 1990s. Since that time, LLCs have become widely used by nonprofit organizations in structuring subsidiaries, such as to house specific activities and minimize potential liability, to provide for less formal governance, to pilot new projects or joint ventures, and to allow for some distance from the parent organization. However, both the Internal Revenue Service and state authorities recognize the use of single member limited liability companies (“SMLLC”) whose sole member is an exempt organization. In such circumstances while the SMLLC would apply for its own employer identification number, no separate application on Form 1023 for tax exempt status was required.

The benefits of LLC status flow to the SMLLC.  New York City has recognized that property owned by an SMLLC whose sole member is an exempt entity would likewise be exempt from real estate taxation and, if applicable, transfer taxes.

In October  2021,  the IRS  published Notice 2021-56 formalizing the standards that a limited liability company (LLC) must meet to obtain standalone IRS recognition of its Section 501(c)(3) tax-exemption.

The Notice simplifies existing technical guidance and makes clear the IRS’s acceptance of LLCs as tax exempt if the required conditions are met.  (The Notice does not affect LLCs that are currently recognized as tax-exempt under Section 501(c)(3), either as a disregarded entity or as part of an exempt organization.)

The four requirements described in the Notice are intended to ensure that an LLC seeking exemption under Section 501(c)(3) is organized and operated exclusively for Section 501(c)(3) tax-exempt purposes, consistent with the organizational and operational tests for all types of Section 501(c)(3) organizations. The Notice requires an LLC seeking exemption to include the following provisions in both the articles of organization filed in its jurisdiction of formation and its operating agreement:

  1. A requirement that all members of the LLC must be charitable organizations, governmental units, or wholly owned government instrumentalities described in Section 501(c)(3) or Section 170(c)(1) of the Internal Revenue Code;
  2. Clauses setting forth the charitable purposes of the LLC, limitations on private inurement and requiring that any assets left upon the LLC’s dissolution be distributed for charitable purposes;
  3. If the LLC is a private foundation, provisions that assure compliance with the various special tax rules required for private foundations; and
  4. An acceptable contingency plan (such as suspension of its membership rights until a member regains recognition of its Section 501(c)(3) status) in the event that any member of the LLC ceases to be a charitable organization, governmental unit, or wholly owned government instrumentality.

Recognizing the wide variances in state LLC laws, the Notice also clarifies that all provisions in the LLC’s articles of organization and operating agreement must be consistent with the applicable state LLC law. However, the IRS notes that the standards may change if state LLC law bumps up against the new requirements. If the applicable state LLC law prohibits the addition of certain provisions to the articles of organization, the LLCs can otherwise satisfy the applicable requirements by including those relevant provisions in the operating agreement, so long as the operating agreement is not inconsistent with the articles of organization.

In the Notice, the IRS continues to refrain from taking a position on whether, and under what circumstances, LLCs may qualify for exemption under other Section 501(c) categories.

The IRS has invited public comment on the proposed standards and the interpretation of state LLC laws as they may relate to the new Section 501(c)(3) requirements.

February 2022

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