As nonprofit organizations continue to play a role in providing vital services to communities in need, careful consideration regarding structuring these activities—including the formation of a new entity—is needed. Once a decision is made to form a new entity, a variety of factors, including business operations, personal liability, and ease of formation must be considered before deciding what type of entity to form.
Challenges of forming a new 501(c)(3) organization
For many years, the only option available to a nonprofit organization that wanted to expand its operations and form an entity (mostly for liability purposes) was to form a new nonprofit corporation and apply for tax-exempt status under Internal Revenue Code (Code) Section 501(c)(3). The process involves many steps—including forming a new nonprofit corporation, applying for tax-exempt status with the IRS, and filing for state exemptions. The current processing time for IRS Form 1023 applications is approximately eight months or longer in certain circumstances. Therefore, setting up a subsidiary organization with its own Code Section 501(c)(3) exempt status may be cost- and time-prohibitive.
Single-member LLCs: A potential alternative
Another option for nonprofit organizations is the use of a single-member limited liability company (LLC). A single-member LLC is, by default, treated as a disregarded entity that essentially does not exist for federal income tax purposes. Because the LLC is a disregarded entity whose sole member is exempt from federal income tax under Code Section 501(a), the LLC is not required to pay federal taxes or file a federal tax or information return. See Announcement 99-102, 1999-42 I.R.B. 545. Essentially, the LLC receives the benefit of its sole member’s tax-exempt status, and the LLC is treated as a component part of its member unless it elects to be regarded separately. The LLC’s tax status flows from its sole member; the LLC itself does not have independent tax-exempt status.
The IRS has also issued guidance regarding the treatment of sole-member LLCs in other contexts that may be relevant.
- IRS Notice INFO 2010-0052 states that a distribution made to a sole-member LLC by a private foundation will be treated as a qualifying distribution for purposes of Code Section 4942, provided that (a) the LLC is treated as a disregarded entity for federal tax purposes, (b) the LLC is formed to accomplish one or more exempt purposes described in Code Section 170(c)(2)(B), (c) the LLC’s sole member is a public charity, and (d) the LLC is not controlled by the distributing private foundation.
- Contribution to a sole-member LLC is treated in the same manner as a contribution directly to an exempt member, pursuant to IRS Notice 2012-52. Therefore, if all the other requirements of Code Section 170 are met, a contribution to the LLC will qualify as a tax-deductible charitable contribution to the extent allowed under Code Section 170.
Best practices when forming a single-member LLC
The benefits of forming a single-member LLC are not automatic. Forming a separate legal entity requires a nonprofit organization to establish procedures to ensure that the LLC is operated separately and distinct from the sole-member nonprofit organization. Maintaining this separation can minimize the risk of an audit. Some best practices include:
- Document the nonprofit organization’s status as sole member of the LLC in the LLC operating agreement. The nonprofit may manage the LLC directly (e.g., acting through its board of directors) or establish a separate board of managers.
- Document the purposes for which the LLC is being formed. This is typically done in the LLC operating agreement and may include specific limitations restricting the LLC’s activities to those consistent with Code Section 501(c)(3) requirements.
- Document decisions made regarding the LLC in separate resolutions either by the nonprofit organization’s board or the separate board of managers.
- Ensure that the LLC is adequately capitalized so that it can conduct its activities as a separate entity.
- Document decisions by the nonprofit organization regarding its initial, as well as any subsequent, capital contribution to the LLC. Transferring funds between bank accounts without formal documentation and approval calls into question whether the LLC should be treated as a separate entity.
- Maintain separate bank accounts and financial statements to demonstrate the single-member LLC is truly a separate entity rather than one operating as an alter ego of the nonprofit organization.
It is also important to consider state law. For example, Code Section 501(c)(3) organizations generally qualify for state sales tax, state income tax, and real property tax exemptions, while LLCs may not even if disregarded for tax purposes.