A Consideration of an LLC for a 501(C)(3) Nonprofit Organization
David S. Walker
Drake University Law School
October 8, 2012
William Mitchell Law Review, Vol. 38, pp. 627-77, 2012
Drake University Law School Research Paper No. 12-24
With limited liability companies (LLCs) being formed at two to three times the frequency with which people form corporations, the LLC is indisputably the "entity of choice" for one forming a business today. Quite apart from the advantages in tax treatment that an LLC offers, the flexibility, adaptability, and informality the LLC offers as "a creature of contract" is of real value to those forming a business organization, especially one that is "small" or has relatively few people involved in its organization and management. In contrast, in the nonprofit sector it is the nonprofit corporation — with its less flexible structure and myriad formalities — that is the predominant form of organization.
The nonprofit sector is large and growing and includes two million or more various kinds of nonprofit organizations exempt from federal taxation under § 501(c) of the Internal Revenue Code. The largest percentage of registered and reporting nonprofits — 60%, practically speaking — are organized under § 501(c) (3) of the Code. These are "public charities" subject to a "nondistribution constraint" and to which both organizational and operational tests are applied to ensure that they serve "a public rather than a private interest." According to data reported by The Urban Institute, nearly half of these reported annual expenses of less than $100,000, and just short of another 30% reported expenses above $100,000 but less than $500,000. These are "small charities" for which organization as an LLC rather than as a corporation could be suitable and advantageous.
The IRS does not dictate the form in which to organize a nonprofit; and in consequence, the question arises whether a LLC would be possible and appropriate. Although the LLC is in fact being used in the nonprofit organizational world, the IRS has limited use of the LLC to situations where a 501(c) (3) nonprofit is the organizer. It is time to rethink that position since much has changed since the IRS announced that position. Nevertheless, several questions would have to be addressed and resolved consistently with nonprofit law principles — questions for which LLC Acts typically provide default positions that run counter to nonprofit principles. These include:
- whether operation of a 501(c) (3) nonprofit is a proper purpose for an LLC, since an LLC typically operates a business for profit and provides individual members with flow-through tax treatment?
- whether an LLC's management structure is appropriate for a nonprofit?
- whether fiduciary duties of management, and the freedom to narrow and amend them by agreement, is consistent with a 501(c) (3) organization?
- whether state laws authorizing LLCs are consistent with the Internal Revenue Code's ban on inurement and private benefit for a 501(c) (3)?
- whether state LLCs laws under which a 501(c) (3) nonprofit might be organized offer the necessary protection of charitable assets?
This article explores each of these questions and concludes that none should prevent an LLC from being considered for a 501(c) (3) nonprofit organization, especially a small charity. IRS regulations, however, considerably cloud that possibility and make it unlikely. Yet changes in state legislation since the IRS initially adopted its position allow an LLC to address concerns the IRS has about a public charity, and reconsideration of its position is warranted in order to make available to the nonprofit world — especially small charities — the structural and operational advantages of an LLC.
Number of Pages in PDF File: 52
Date posted: October 9, 2012 ; Last revised: January 28, 2014