Can an LLC Qualify as a Tax-Exempt Nonprofit?

This is a vexing (but fascinating) question that cuts to the heart of the difference between nonprofit organizations and federal tax-exempt status, and it really conceals two questions:

  1. Can an LLC qualify as a nonprofit?

  2. Can an LLC obtain federal tax-exempt status?

The terms “nonprofit” and “tax-exempt,” often used interchangeably, don’t mean the same thing in the business world. Nonprofit status is a state-defined concept that differs a little from state to state, and it is possible to form a nonprofit at the state level without qualifying (or even bothering to pursue) federal tax-exempt status. Tax-exempt status, however, is a federal concept defined under Section 501(a) of the Internal Revenue Code, which includes 501(c)(3) status for public charities and private foundations.

So we end up with two very different possibilities:

  1. You can form a nonprofit limited liability company (LLC) by filing articles of organization in one of the few states that allow the formation of nonprofit LLCs, a process that does not guarantee tax-exempt status with the IRS. In most states, however, it isn’t possible to form a nonprofit LLC at all.

  2. An LLC can obtain federal tax-exempt status from the IRS, regardless of the state in which it was formed, if it elects to get taxed as a corporation and permanently dedicates its income and assets to IRS-approved tax-exempt purposes, and if its members are all 501(c)(3) tax-exempt organizations (no human members allowed!).

Curiously, a state may recognize an LLC as a nonprofit without the IRS granting that LLC tax-exempt status, and an LLC not officially recognized as a nonprofit at the state level might still obtain federal tax-exempt status from the IRS.

Sound complicated? It should. The concepts “nonprofit LLC” and “tax-exempt LLC,” though gaining some legal traction in recent years, are still in their infancy and still evolving. Unless you are utterly devoted to forming a nonprofit LLC eligible for federal tax-exempt status, and unless you have the time to research the relevant state and federal regulations to make that happen, you might operate your LLC without nonprofit and tax-exempt status or form a nonprofit corporation instead.

The Nonprofit LLC

Currently only a few states (including North Dakota, Minnesota, and Kentucky) have laws governing the formation of nonprofit LLCs, and the requirements differ a little from state to state. In Kentucky, for instance, you can form a nonprofit LLC with natural individuals—real people like you and me—as members, but North Dakota and Minnesota only allow organizations as members.

In each case you will file nonprofit LLC articles of organization with the office of the secretary of state, pay a state filing fee, and go through the usual rigmarole involved in getting a nonprofit registered and licensed with the appropriate state and local agencies.

But obtaining nonprofit status at the state level doesn’t guarantee federal tax-exempt status for your nonprofit LLC. Not surprisingly, the IRS has its own special rules for LLCs seeking federal tax-exempt status.

The 501(c)(3) Tax-Exempt LLC

Fortunately, obtaining federal tax-exempt status has nothing to with a state recognizing your LLC as a nonprofit organization, so it’s possible in most states to form an LLC that goes on to obtain recognition from the IRS as a 501(c)(3) tax-exempt charity.

Possible, that is, but not common.

When an LLC does obtain 501(c)(3) status, it’s usually because an existing 501(c)(3) organization wants to form a tax-exempt subsidiary of some kind, so the organization starts a nonprofit LLC with itself as the only member. Or maybe two or more 501(c)(3) organizations want to combine their efforts to accomplish a shared charitable goal, so they form a nonprofit LLC together and become its members.

These situations work because one of the IRS’s rules for tax-exempt LLCs is that every member has to be a 501(c)(3) tax-exempt organization. Human individuals, for-profit businesses, and nonprofits without 501(c)(3) status don’t qualify. This is because 501(c)(3) organizations have to commit their income and assets exclusively to a tax-exempt, broadly charitable purpose. Under no circumstances should the nonprofit serve to enrich individuals during the nonprofit’s lifetime or at the point of its dissolution.

The LLC’s flexible organizational structure and its ability to alter its purpose and direction more easily than a corporation—the very things, in other words, that make LLCs popular in the for-profit business world—make it riskier for the IRS to grant an LLC tax-exempt status. So the IRS compromises. It allows for LLCs to obtain tax-exempt status, but only if they get formed by organizations already completely dedicated to serving a tax-exempt purpose.

How to Get 501(c)(3) Tax-Exempt Status For An LLC

There are 3 routes to obtaining 501(c)(3) status for an LLC:

  1.  The LLC applies to the IRS for recognition as a tax-exempt entity by filing Form 1023 (the Application for Recognition of Exemption). It must also elect to get taxed as a corporation (not as a sole proprietorship or partnership), and its members must be 501(c)(3) tax-exempt organizations.
  2. If the LLC only has one member—itself a tax-exempt 501(c)(3) organization—the parent organization can treat the LLC’s income as its own for tax purposes, and the IRS treats your LLC a little like a sole proprietorship).
  3.  If the LLC has two or more members—each tax-exempt 501(c)(3) organizations—the LLC’s income and expenses get distributed to its members for tax purposes, and the IRS treats the LLC like a partnership.

In the first case, the LLC gets treated as a distinct tax-exempt organization by the IRS, which is why it needs to file Form 1023 separately from its parent organization. In the second and third cases, however, the IRS treats the LLC as part of its parent organization(s) for tax purposes, so it isn’t necessary for the LLC to apply separately from its parent for tax-exempt status.