Dear Nonprofits – The IRS is Making Use of an LLC Easier

Nilan Johnson Lewis PA
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For nonprofits and the lawyers who love them, 2020 and 2021 have been full of frustrating interactions with the IRS. Getting the IRS to acknowledge and respond to basic communications has seemed more difficult than in the past. That is why we were pleasantly surprised to see new IRS guidance this month making the use of an LLC by a nonprofit clearer and easier.

How do Nonprofits use LLCs?

Nonprofits use LLC subsidiaries to “house” activities they want to control but do not want to carry out within the nonprofit corporate entity itself.

  • The most common reason for a nonprofit to use an LLC is to house an activity that needs a liability shield to protect the rest of the nonprofit’s assets from the activities of the LLC. The nonprofit is the sole member of the LLC. The LLC can be disregarded for tax purposes, meaning that the income and expenses of the LLC can “roll up” to the nonprofit’s IRS form 990. No additional federal tax filing is created or required, and Minnesota law provides that the LLC has the status of its parent for property tax exemption purposes.
  • Nonprofits also use LLCs to create clear separation (a unique and distinct brand identity) of a charitable activity or program from the rest of the nonprofit’s activities and programs. The nonprofit is the sole member. The LLC is disregarded for tax purposes.
  • Nonprofits also use LLCs to “hold” an activity that is an unrelated business. The nonprofit can be the sole member. When the unrelated business activities become too large in the context of the rest of the nonprofit’s activities, the LLC can elect to be taxed as a corporation. When the LLC elects to be taxed as a corporation, the tax exemption of the nonprofit is protected. The LLC can pay dividends “up” to the nonprofit member.

An LLC works well because it is simple to form and administer. The nonprofit member can take action as the member of the LLC without the need for the LLC to have its own board of directors. The tax treatment of an LLC can be chosen to “fit the need,” and an LLC is pretty easily converted to a corporation or merged into its sole member parent, if necessary.

What’s New About Nonprofits and LLCs?

On October 21, 2021, the Internal Revenue Service (IRS) issued a notice explaining the requirements an LLC must meet to obtain an IRS determination letter that the LLC qualifies as an organization described in IRC Section 501(c)(3). Previously, the IRS guidance on this topic listed 11 or 12 factors the IRS would consider in determining if an LLC could qualify as an exempt organization described in IRC Section 501(c)(3).

The 2021 notice provides that there are four requirements for an LLC to qualify as an exempt organization described in IRC Section 501(c)(3). They include:

  1. All members of the LLC must be charitable organizations or governmental units.
  2. The LLC’s governing documents must provide for the suspension of membership if any member of the LLC ceases to be a charitable organization.
  3. The LLC’s governing documents must include language restricting the LLC’s activities to charitable purposes and providing that any assets left upon the LLC’s dissolution will be distributed for charitable purposes.
  4. If the LLC is a private foundation, the governing documents must assure compliance with the various private foundation excise tax rules.

The 2021 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.

Take away:

As a result of new IRS guidance, nonprofits can use an LLC as a disregarded entity with more confidence that it will be treated as tax-exempt as described in Internal Revenue Code Section 501(c)(3). The IRS has provided easy-to-follow guidance for an LLC to obtain an IRS determination letter to show its exemption.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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