Traditionally, an entity applying for tax exempt status under Code Section 501(c)(3) will be a corporation. With the rise in popularity of the LLC over the last 25 years, it’s a wonder that LLCs are not used more frequently to apply for federal tax exempt status. This can be explained in part because prior IRS guidance was released in 1959, well before the first state LLC Act was authorized. Additionally, Code Section 501(c)(3) does not specifically address LLCs, nor does any Treasury Department or IRS guidance regarding organizations under Code Section 501(c)(3).
To address the absence of guidance, the IRS recently published Notice 2021-56, which in part identified the following current standards that an LLC’s articles of organization and/or operating agreement must contain in order to be eligible for federal tax exempt status under Code Section 501(c)(3):
- Each member of the LLC must be a 501(c)(3) organization that is tax exempt under Code Section 501(a), or must be a governmental unit;
- An express charitable purpose;
- A contingency plan in the event one or more members of the LLC ceases to be an exempt 501(c)(3) organization or governmental unit; and
- In the event a member is a private foundation, the articles of organization or operating agreement must: (a) require that income for each taxable year be distributed in a manner to avoid penalty under Code Section 4942; and (b) prohibit self-dealing, retaining excess business holdings, making investments which may jeopardize the entity’s charitable purpose, and making any taxable expenditures.
The IRS is requesting comment on the existing standards as well as a variety of other specific questions relating to an LLC being granted tax exempt status. With the IRS seemingly taking steps to modernize the 501(c)(3) regulations to include LLCs, it will be interesting to see if any states seek to modernize their nonprofit acts to specifically allow for nonprofit LLCs, as many currently only contemplate nonprofit corporations. This may also present opportunities for existing tax-exempt entities that wish to create joint ventures with aligned organizations and may desire the protection of a separate tax-exempt determination letter for the venture.