Should nonprofits use LLCs in connection with their operations? Possibly yes, since some common as well as relatively unusual circumstances may warrant developing and operating limited liability companies as a strategic tool for risk management, privacy, tax benefit, and other purposes. This article addresses many helpful options for LLCs within the nonprofit context, as well as LLC distinctives, formational aspects, tax treatment, and management too.
LLCs’ Basic Functionality
Why are LLCs so useful? To answer this question, it is important to first understand their basic legal characteristics.
First, LLCs are formed under state law. States uniformly have such LLC laws, along with corporation and partnership laws. These state laws typically have much in common, such as recognizing that LLC are hybrid entities. More specifically, LLCs combine the “legal person” status of corporate status, and therefore capable of shielding owners from potential liability, with the flexibility of partnership arrangements and therefore allowing for streamlined control without the necessity of a governing board. Many state laws expressly allow LLCs to be nonprofit in nature, but others are silent or require that LLC be for profit only.
Second, LLCs may be “disregarded” or “regarded” for federal and state income tax purposes. The default rule for an LLC with a single Section 501(c)(3) nonprofit owner – ““member” in LLC parlance - is “disregarded” tax-exempt status. In other words, the LLC’s revenues and expenses are reported (i.e., passed) through the tax-exempt member’s tax return. The LLC’s financial activity should be reported on the member’s annual Form 990. Such LLCs thus effectively take on the tax-exempt status of their owning member. For this reason, tax-deductible contributions may be made directly to a disregarded LLC that is wholly owned by a Section 501(c)(3) public charity.1
“Regarded” LLCs are those for which one or more members affirmatively elect such “regarded” status through filing IRS Form 8832, and therefore the LLC is treate for tax purposes the same as a C corporation. Such independent tax reporting may be appropriate when an LLC is operated for business purposes or where the LLC’s nonprofit member does not want to report the LLC’s financial activity on its own IRS Form 990. Such LLCs typically file IRS Form 1120 tax returns, which is likewise the applicable tax return for C corporations.
LLCs as a Corporate Utility Tool
LLCs are used extensively throughout the business world as a desirable way to silo risk – that is, to separate one entity’s potential liability for debts and other obligations from other entities. Similar risk management considerations hold true for nonprofit corporations too, particularly since LLCs can be cheaper to form and easier to manage. Here are some examples from our law firm’s experience:
- Nonprofits that hold real estate within an LLC;
- Nonprofits that start business activities, separate from their tax-exempt missions;
- Nonprofit that start additional nonprofit programs but want to avoid the legal necessity of a governing board for such activities;
- Nonprofits, particularly religious organizations, that send funds overseas without revealing their nature for security-related reasons;
- Nonprofits that otherwise want to keep certain activities private, and not subject to public disclosure, such as through “regarded” LLCs that do not report their activities via their members’ Form 990 returns (which are required by law to be publicly available);2
- Nonprofits that may need to receive grants for which an LLC could be eligible, but not the nonprofit itself; and
- Individuals who seek to engage in mission-oriented activities but without the accompanying limitations of tax-exempt status (as addressed below).
Each of these LLCs can be quite beneficial, but they are not equally advisable. Much depends on specific goals and related legal constraints.
For example, with the first example regarding real estate, such LLC use may not actually accomplish the desired risk management goal because the nonprofit will own the LLC. In the event that a nonprofit’s assets become at risk for its liabilities (e.g., a personal injury judgment in excess of insurance coverage), the nonprofit’s LLC membership interest will be one of the nonprofit’s assets – and therefore potentially available to satisfy the nonprofit’s liabilities. A different risk management tool is therefore preferable, such as another nonprofit corporation (controlled but not owned, as a legal matter), which in turn could be a Section 501(c)(3) public charity or a Section 501(c)(2) title-holding company.
Many nonprofits seek to start separate projects that may be businesses or other nonprofit endeavors. Some examples could include daycare and summer camp programs (excellent for separate legal status in light of the relatively high risk involved with such operations) or entrepreneurial projects like cleaning businesses, other personal services, and educational programs. Such LLCs are effectively subsidiaries of the nonprofit owner. In terms of managing the LLC, it may be run by a manager designated by the nonprofit owner. Alternatively, the LLC may be developed with a governing board – effectively a committee that typically is appointed by the nonprofit owner’s board.
The governing board aspect may be significant. For example, if a nonprofit experiences challenges with finding enough leaders for its own board, the LLC model can prove quite attractive. That is especially true when such consideration is combined with goals for risk management, desired opaqueness regarding the nonprofit’s operations, or special circumstances like grantmaking eligibility restrictions.
The last category listed regarding individuals’ mission-oriented activities above can be important too. Not every mission warrants tax-exempt constraints, especially considering that nonprofits are controlled but not owned, that they must have a governing board, and that their assets are restricted to nonprofit purposes (including dissolution requirements for distribution of charitable assets). For these reasons, some organizational founders may determine that a stand-alone business LLC is the best vehicle for pursuing their objective, and nicely so with the LLCs corporate attribute of protection against potential liability.3
Every Tool Has Its Limits
Notably, an LLC may apply itself for Section 501(c)(3) tax-exempt status, as a “regarded” entity (per above). But such approach can involve pitfalls, for at least two reasons.
First, the IRS may look askance at this relatively unusual approach, and so too may donors, government funding agencies, grant-makers, and others. Such skepticism is primarily because LLCs are often viewed as being only business in nature, not nonprofit. That may be a legally incorrect perception, but it tends to exist nonetheless.
Second, a Section 501(c)(3) LLC will not enjoy the extensive benefits available under state nonprofit laws, which include numerous default governance rules, indemnification provisions for directors and officers, and other helpful language for operating tax-exempt organizations within applicable IRS parameters and other best practices. Consequently, the best entity choice answer for mission-minded leaders may be to form and develop a nonprofit corporation as the Section 501(c)(3) tax-exempt entity – and then maybe consider whether (and why) to form an ancillary LLC within a multi-entity structure.
LLCs’ Further Usefulness for Tax Compliance and Multi-Entity Structuring
There’s more! Digging deeper into the above list, Section 501(c)(3) organizations can use LLCs to help protect their tax-exempt status while engaging in commercial activities. IRS regulations state that such organizations must be operated exclusively for exempt purposes, and the IRS defines “exclusively” here as “primarily." If more than an insubstantial part of the organization’s activities is devoted to nonexempt purposes, then it may fail this operational test and lose its tax-exempt status. But if the organization seeks to engage in a commercial enterprise – say, opening a bookstore – it may create a taxable subsidiary LLC to own and manage the business, thus limiting the tax-exempt owner’s commercial activity.
LLCs may also be an extremely helpful vehicle for joint ventures between nonprofits and for-profit entities or other investors. An LLC’s owners may be nonprofit corporations, business, corporations, partnerships, individuals, other LLCs, or any combination thereof. This flexible entity structure allows nonprofits to partner with investors in business ventures that can help support their exempt missions. For example, a nonprofit may engage with a handful of investors to start up a coffee shop, using its share of the coffee shop’s profits to support its exempt programming.4
LLC Formation and Development
After the decision is reached to use an LLC, a key initial step is to identify the state of formation. An LLC may be formed in any state regardless of where it plans to do business. But certain additional strategic considerations may apply, most notably as follows. First, if the LLC is to be nonprofit in nature, then applicable state law should be checked to confirm that such approach is legally available. Second, if the leaders desire opaqueness, such as to not disclose the LLC’s owner, then certain states may be more attractive in terms of what they do (and do not) require for disclosure through the publicly filed articles of organization and annual report. Third, keep in mind that an LLC formed in one state but operated in another state will require registering the LLC as a “foreign business” in the latter state. This second state registration adds some costs to formation and ongoing operation. Last, some states have otherwise more favorable LLC statutes than do others, so it is prudent to weigh the benefits of local formation against the desirability of the local state’s LLC statute and other relevant law.
In connection with this key foundational question, the LLC’s name should be determined. Certain name requirements are specific to LLCs and vary depending on the state of formation. Most state laws require that an LLC’s name must include the suffix “LLC” or other similar identifier. In addition to considering such requirements, it is important to check the secretary of state’s records in the state of formation, to ensure that the desired LLC name is not already taken by an existing entity. For LLCs owned by a nonprofit, it also may or may not be desirable to use a name closely similar to the nonprofit’s name. Once the LLC’s name is selected, the LLC’s articles of organization may be developed and filed with the state – typically, the secretary of state. Upon filing, the LLC is officially created.
Significantly for LLCs that fit within their owners’ nonprofit tax-exempt status, the articles of organization must contain a purpose statement that is similarly consistent with its owner’s nonprofit tax-exempt purpose. As a basic example, an LLC’s corporate purpose could be as follows: “to promote the tax-exempt purposes of the LLC’s owner.” A nonprofit LLC’s purpose statement should not be the generic “for any lawful purpose,” since such verbiage includes both for-profit and nonprofit activities. The LLC’s articles of organization also must contain other IRS-mandated language consistent with such intended tax-exempt status, with very careful attention given to such legal compliance requirements. Depending on applicable state law, the articles may also include the name of the owner – listed as “member” – as well as the initial manager and registered agent. Note too that LLCs may be “member-managed” (e.g., by a nonprofit owner, through its board) or manager-managed (i.e., through the manager designed by the owner).
Once the articles are filed, the LLC should obtain its own employer identification number, or EIN, from the IRS. This nine-digit number will identify the LLC in IRS records and may be used for the LLC’s bank account. If the LLC is treated as “regarded” (and therefore as a C corporation for income tax purposes) through filing the IRS Form 8832, then this EIN will be used for its own tax return. Note too that the IRS Form 8832 may be filed as well to confirm “disregarded” pass-through tax status, such as to memorialize that such approach was intentionally chosen.
Building on this organizational foundation, the key operational document for LLCs is the aptly named “operating agreement.” This document need not be filed with any government agency as part of the LLC’s formation or other reporting. Rather, it is used for internal purposes to identify how the LLC will be managed (e.g., by a single manager, multiple managers, or a governing board) and what processes it will follow in its operations. Specific operating agreement terms include the following: definitions; LLC purposes (corresponding to the articles); limitations (which may be consistent with Section 501(c)(3) parameters, if nonprofit in nature); the owner(s) and accompanying voting rights; financial matters including contributions; tax status; management control, powers, and discretion; and major changes such as dissolution. Extensive attention may warranted for this critically important governing document (akin to bylaws for nonprofit corporations).
LLC Management
As noted above, an LLC may be managed by its member or by a manager. In a member-managed LLC, the member handles the day-to-day affairs of the LLC’s operation. This operational structure has the advantage of giving the member (or members) direct control over all decisions and provides a simple governance structure ideal for smaller enterprises. Typically with nonprofit ownership of LLCs, management is exercised through the nonprofit member’s own governing board (or perhaps a committee thereof).
An LLC with a nonprofit single member can benefit from a member-management structure if the nonprofit’s leadership intends to be regularly involved in the affairs of the LLC. But the manager-management may be preferred, such as for streamlined operations, effective delegation, or other management-related goals and needs.
In a manager-managed LLC, the member appoints a manager to handle the operational affairs of the LLC, while the member retains authority over major decisions as may be identified in the operating agreement. For example, If the LLC’s manager resigns or is removed by the member, then the member chooses a new manager (or managers) in accordance with the provisions of the LLC’s operating agreement. Manager-managed LLC’s have the advantage of centralized decision-making for quick responses to changing circumstances or business needs, and therefore such approach may be quite attractive. They also allow nonprofit leaders to focus on the nonprofit owner’s own activities without undue distraction.
Significantly, LLC management by a designated manager helps promote optimal risk management in light of inherently separate decision-making processes, particularly for day-to-day operations. To illustrate, consider a person who alleges injury at a summer camp operated by an LLC. The person may sue both the LLC and its member, particularly to seek the member’s own assets for satisfaction of a potential liability award. The claimant may assert as well that the member’s governing directors of the board should be personally liable, based on their gross negligence or other wrongful conduct involving the LLC’s summer camp operations. The more distanced the member and its governing leaders, the more likely it is that they will not be held liable. Instead, all such risk should be siloed within the LLC – as run by its manager or management team. Such risk-related considerations provide compelling, although not necessarily determinative, reasons for manager-managed LLCs.
Wrapping up
The LLC is an enormously attractive entity option available to nonprofits, business, and individuals. The available liability protections combined with its governing flexibility makes LLCs an important strategic tool to consider, with resulting choices ultimately based on all circumstances and goals at hand. For nonprofit leaders seeking creative, cost-effective, and risk mitigation options, the LLC option may warrant a careful evaluation.
[1] Note too that for churches and other Section 501(c)(3) nonprofits that are exempt from IRS Form 990 filing requirements, their LLCs’ financial activity need not be reported to the IRS so long as such activity is related to the member’s tax-exempt mission. For more information about unrelated business income tax liability and accompanying IRS Form 990-Treporting obligations, please see our law firm’s blog article addressing these important tax compliance matters.
[2] Note, however, that a tax-exempt owner will need to report the existence of a wholly owned LLC on Schedule R of its IRS Form 990, if such owner is obligated to file Form 990s, regardless of the LLC’s tax treatment.
[3] For more information about such liability considerations, please see our firm’s blog article.
[4] For more information about nonprofits involved with joint ventures, please see our firm’s blog article. Our firm also addresses multi-entity structuring involving nonprofits in another blog article.
