IRS Issues Guidance on LLCs as 501(c)(3) Entities

Nonprofits often use limited liability companies (LLCs) when they want to form subsidiaries to, for example, launch a new service or joint venture. However, federal regulations for tax-exempt organizations don’t specifically address LLCs. This makes new guidance from the IRS on the requirements an LLC must satisfy to be deemed tax-exempt welcome news.

Guidance gap

The Internal Revenue Code’s organizational test for Section 501(c)(3) organizations was established before the enactment of any state laws allowing LLCs. As a result, related regulations don’t discuss LLCs, and the IRS has never issued any formal guidance on requirements for recognizing LLCs as tax-exempt under Sec. 501(c)(3). Generally, though, the IRS has required that each LLC member be a Sec. 501(c)(3) tax-exempt organization, a governmental unit, or a wholly-owned instrumentality of a state or political subdivision thereof.

When the IRS began considering requirements for LLCs to qualify as Sec. 501(c)(3) organizations, it reviewed state LLC laws and how they differ from laws covering nonprofits. Some laws, for example, don’t allow LLCs to be organized and operated solely for charitable purposes. Moreover, most LLC laws include default provisions granting LLC members certain economic rights that may violate Sec. 501(c)(3) requirements. Confusion has sometimes ensued.

New rules of play

IRS Notice 2021-56 attempts to alleviate some of the uncertainty around LLCs in the nonprofit arena. The IRS says the notice’s requirements are intended to ensure that a Sec. 501(c)(3) LLC is organized and operated exclusively for exempt purposes — including that its assets are dedicated to an exempt purpose and don’t benefit private purposes.

According to the notice, the IRS will issue an LLC a tax-exempt determination letter if both its articles of organization and operating agreement include:

  • Provisions requiring that each LLC member be a Sec. 501(c)(3) tax-exempt organization, a governmental unit or a wholly-owned instrumentality of a governmental unit,
  • Explicit charitable purpose and charitable dissolution provisions that comply with existing regulations,
  • Provisions for complying with the applicable rules (for example, minimum distribution requirements and a prohibition against self-dealing) if the LLC is a private foundation, and
  • An acceptable contingency plan if a member ceases to be a Sec. 501(c)(3) organization or governmental unit (for example, suspending the member’s rights).

The LLC also must represent to the IRS that all provisions in its articles of organization and operating agreement comply with applicable state LLC law and are legally enforceable.

Some states prohibit the inclusion of provisions in the articles of organization other than those specifically required by state law. LLCs formed in these states can meet the IRS requirements by including the above provisions in the operating agreement. The operating agreement and articles of organization must not include any inconsistent provisions, though.

Note that the new requirements don’t affect LLCs already recognized as tax-exempt, whether as so-called disregarded entities (entities the IRS doesn’t consider to be separate from their owners for tax purposes) or as exempt entities in their own right.

More to come?

When the IRS published the new guidance in the fall of 2021, it requested public comments on the requirements. It also solicited comments on several issues related to tax-exempt status for LLCs — including whether individuals or organizations other than Sec. 501(c)(3)s, governmental units and wholly-owned subsidiaries of governmental units should be allowed to be members of Sec. 501(c)(3) LLCs. This suggests that additional guidance may be on the horizon. We’ll keep you updated on any important developments!