IRS Issues More Definitive Standards for Section 501(c)(3) Tax-Exempt Limited Liability Companies

4 min

The Internal Revenue Service (IRS) published Notice 2021-56 on October 21, 2021, formalizing the standards that a limited liability company (LLC) must meet to obtain IRS recognition of Section 501(c)(3) tax-exemption. The Notice is a welcome update on LLC qualification for Section 501(c)(3) recognition because the last IRS guidance on this topic was nonbinding and issued 20 years ago, shortly after LLCs emerged as a new form of business structure in the 1990s. Since that time, LLCs have become widely used by nonprofit organizations in structuring subsidiaries, such as to house specific activities and corral potential liability, to provide for less formal governance, to pilot new projects or joint ventures, and to allow for some distance from the parent organization's brand.

The Notice does nothing to slow down that trend, as it simplifies existing technical guidance and makes clear the IRS's acceptance of LLCs if the required conditions are met. Importantly, the Notice does not affect LLCs that are currently recognized as tax-exempt under Section 501(c)(3), either as a disregarded part of an exempt organization or as an exempt entity in their own right.

Limited Liability Companies as Exempt Organizations

The four requirements described in the Notice are intended to ensure that an LLC seeking exemption under Section 501(c)(3) is organized and operated exclusively for Section 501(c)(3) tax-exempt purposes, consistent with the organizational and operational tests for all types of Section 501(c)(3) organizations. The Notice requires an LLC seeking exemption to include the following provisions in both the articles of organization filed in its jurisdiction of formation and its operating agreement:

  1. A requirement that all members of the LLC must be charitable organizations, governmental units, or wholly owned government instrumentalities described in Section 501(c)(3) or Section 170(c)(1) of the Internal Revenue Code;
  2. Clauses setting forth the charitable purposes of the LLCs and that any assets left upon the LLC's dissolution will be distributed for charitable purposes;
  3. If the LLC is a private foundation, provisions that assure compliance with the various "chapter 42" excise tax rules, as required for private foundations that are nonprofit corporations; and
  4. An acceptable contingency plan (such as suspension of its membership rights until a member regains recognition of its Section 501(c)(3) status) in the event that any member of the LLC ceases to be a charitable organization, governmental unit, or wholly owned government instrumentality.

Previously, the IRS indicated that LLCs had to satisfy twelve different conditions to qualify for Section 501(c)(3) tax-exempt status. These conditions were described in informal continuing education guidance issued to tax practitioners in 2000 and updated in 2001. The new standards reflected in the Notice appear to simplify the approach for dealing with tax-exempt LLCs by reducing the number of conditions for exemption from twelve to four requirements. Additionally, the new Notice generally carries more weight than the less formal continuing education text guidance from 2000 and 2001.

Recognizing the wide array of state LLC laws, the Notice also clarifies that all provisions in the LLC's articles of organization and operating agreement must be consistent with the applicable state LLC law. However, the IRS notes that the standard may change if state LLC law bumps up against the new requirements. If the applicable state LLC law prohibits the addition of certain provisions to the articles of organization, the IRS states that LLCs can otherwise satisfy the applicable requirements by including those relevant provisions in the operating agreement, so long as the operating agreement is not inconsistent with the articles of organization.

Lastly, in the Notice, the IRS continues to refrain from establishing a position on whether, and under what circumstances, LLCs may qualify for exemption under other Section 501(c) categories. It also does not address other kinds of entities that have been used to structure activities connected with charitable and other exempt organizations, either through pass-through entities, such as partnerships, or for-profit social enterprises, such as benefit "B" corporations. Guidance on this matter would be useful for title-holding companies, trade associations, advocacy groups, and other types of exempt organizations that currently utilize or could benefit from utilizing entity forms other than a nonprofit corporation structure in their joint venture activities or their subsidiary or affiliated entity management.

Request for Public Comment

The IRS has invited public comment from interested parties on the proposed standards and the interpretation of state LLC laws as they may relate to Section 501(c)(3) requirements. Comments may be submitted through February 6, 2022. Nonprofits operating as, or affiliated with, nonprofits operating as LLCs should review the new requirements for exemption to ensure compliance with tax law and consider submitting comments.