Limited Liability Company—Either For-Profit or Nonprofit, but Not Tax-Exempt
The men’s group in our hypothetical almost certainly could be formed as an LLC organized to operate the annual retreat. Virtually all states allow an LLC to be organized for any lawful purpose—unlike for-profit corporation statutes which typically require a “business” purpose. Moreover, as noted above, four states authorize nonprofit LLCs. Formation as an LLC offers significant advantages over an unincorporated nonprofit association, not the least of which would be liability protection for the members of our hypothetical men’s group. The members of the men’s group could become members of an LLC, could fund the retreat via payments—arguably capital contributions—to the LLC, and could appoint managers of the LLC to arrange and manage the retreat.
From a federal income tax perspective, the LLC essentially would operate as an expense-sharing arrangement, and thus most likely would not be treated as a partnership or other tax entity for federal income tax purposes (see Reg. § 301.7701-1(a)(2) (two or more persons joining together to construct a drainage ditch does not constitute a partnership for federal income tax purposes)). Even if the LLC were considered a partnership for federal income tax purposes, its expenses almost certainly would match its income from the payments (capital contributions?) by the members. Note, however, that the contributions of the men towards the expenses of the annual retreat would not be tax deductible. Instead, such contributions would be considered nondeductible personal expenses (see I.R.C. § 262). To be tax deductible, the LLC would have to qualify under I.R.C. section 501(c)(3), and any contributions by the members would have to qualify as charitable gifts under section 170, not payments in exchange for the return benefit of goods and services received at the retreat (Reg. § 1.170A-1(h)).
Interestingly, the IRS’s current position is that an LLC patterned after our hypothetical men’s group cannot function as a (c)(3) organization unless all of its members are (c)(3) organizations, governmental units, or instrumentalities thereof. Apparently, this is the IRS’s position even if the organization otherwise would qualify as charitable, educational, religious, or exempt in some other fashion under section 501(c)(3). Note, however, that this is only the IRS’s position. It is not settled law. Clearly, a nonprofit corporation with an exempt purpose may have nonexempt, nongovernmental members and nevertheless qualify as a (c)(3) organization, provided the “nondistribution constraint” is met, and other required provisions are set forth in the organization’s governing documents. If the IRS’s position is litigated, it is conceivable that a properly organized and operated LLC could qualify as a (c)(3) organization even if it has nonexempt, nongovernmental members. Arguably, this clearly should be so if the LLC is formed in one of the four states that statutorily authorize nonprofit LLCs. Those four states noted above impose the “nondistribution constraint” (as well as other requirements) on nonprofit LLCs similar to the restrictions imposed upon nonprofit corporations. It is unlikely, though, that a taxpayer would be willing to challenge the IRS’s position when a duly formed nonprofit corporation easily can obtain IRS approval for (c)(3) status.
SMLLC Subsidiary of Tax-Exempt Organization (or Fiscal Sponsorship)
Alternatively, our hypothetical men’s group could be formed as a SMLLC owned by an existing charitable organization that is exempt under section 501(c)(3). For instance, if the men’s group was affiliated with a church, then the church could form and be the sole member of an LLC that conducts the annual retreat. The SMLLC owned by the church would be considered an exempt division of the church itself.
A variation of the charitably owned SMLLC is a “fiscal sponsorship” using an LLC (see S. Chiodini & G. Colvin, The Use of LLCs in Fiscal Sponsorship—A New Model, 22 Tax’n of Exempts 7 (2011)). A fiscal sponsorship arrangement essentially lends the sponsor’s (c)(3) status (including administrative functions) to a project aligned with the sponsor’s exempt purpose. The fiscal sponsor thereby may receive charitable grants and tax-deductible contributions that it otherwise would be unable to receive. For example, a church or other (c)(3) affiliated with our hypothetical men’s group could enter into a fiscal sponsorship agreement with the LLC (likely owned by the (c)(3) but conceivably owned by the members) to conduct the annual retreat. So long as the (c)(3) exercises complete control over the LLC’s finances concerning the retreat, grants and contributions to the LLC (provided they are not payments for goods or services) should be tax deductible as if contributed to the (c)(3) itself.
Although the church also could form a nonprofit corporation instead of an SMLLC to organize and conduct the retreat, the SMLLC has at least one significant advantage. Specifically, before the existence of disregarded SMLLCs, (c)(3) organizations or their donors used “supporting organizations” or “title-holding corporations” to function as exempt subsidiaries. Because they are not disregarded like an SMLLC, however, supporting organizations are highly regulated and must separately apply to the IRS for recognition of their exempt status. Title-holding corporations are, as the name suggests, exempt organizations formed to hold title to real property. Although not required to separately apply for exempt status, title-holding corporations are subject to strict limitations on their activities (I.R.C. § 501(c)(25) (limited to being organized to hold title to real property and collect the income therefrom for remittance to the title holding company’s exempt parent)). Operating a men’s retreat likely would not be permitted.
Despite the advantages associated with the use of disregarded SMLLCs by (c)(3) organizations, some caveats are in order. For instance, SMLLCs are not disregarded for employment tax purposes (Reg. § 301.7701-2(c)(2)(iv)-(v) rev’g Notice 99-6, 1999-1 C.B. 321). Therefore, if a nonprofit or charitable organization’s disregarded SMLLC has employees, it ordinarily will be subject to employment tax filings and payments distinct from the parent organization (see Reg. §§ 31.3121(b)(3)-1T; 31.3127-1T; 31.3306(c)(5)-1T; 301.7701-2T (generally treating SMLLC as separate entity for employment tax purposes but also permitting SMLLC to be disregarded for certain religious exceptions)). Furthermore, even though most states follow the default federal income tax classification of SMLLCs as disregarded entities, not all states do so. Moreover, nonincome-based state taxes—such as franchise, sales, use, and property taxes—can apply to nonprofit and charitable SMLLCs absent a specific exclusion. Finally, as far as the authors are aware, current law is unclear whether federal or state charitable immunity or other laws protecting volunteers of nonprofit organizations (as opposed to the organization itself) from tort claims apply to volunteers of disregarded SMLLCs of nonprofit organizations. Tort liability protection for volunteers could be a critical determining issue for our hypothetical men’s retreat.
“Social Enterprise” and LLCs
In addition to their growing use within the nonprofit sector, LLCs are used for quasi-charitable (social enterprise) purposes. Social enterprise has no legal definition, but generally it is understood as using traditional for-profit business approaches to address social or environmental concerns. For instance, if our hypothetical men’s group sought to operate the retreat on a for-profit basis, opened it to the public, and charged fees to attendees, then the organization might be considered an educational social enterprise. Note that there are no tax benefits associated with operating a business as a social enterprise.
Low-profit limited liability companies (L3Cs) can be used to conduct a social enterprise with a charitable or educational purpose. An L3C essentially is a variant of a regular LLC (and the enabling statute typically is set forth in the jurisdiction’s normal LLC statute). To be an L3C, an LLC: (i) must further the accomplishment of a charitable purpose; (ii) would not have been formed but for its relationship to the charitable purpose; (iii) must have “no significant purpose” of producing income or appreciation in property; (iv) must not have a political or legislative purpose; and (v) must use the name “low-profit limited liability company” or the abbreviation “L3C” in its name. Eight states have L3C statutes:
- Vermont (Vt. Stat. Ann. tit.11, §§ 4161, 4162)
- Illinois (805 ILCS 180/1-5, 805 ILCS 180/1-10, 805 ILCS 180/1-26, 805 ILCS 180/5-5)
- Louisiana (La. Rev. Stat. Ann. §§ 12:1301(A)(11.1), (12), 12:1302(C), 12:1305 (B)(3), 12:1306(A)(1), 12:1309(A))
- Maine (Me. Rev. Stat. Ann. tit. 31, §§ 1502(16), 1508, 1611)
- Michigan (Mich. Comp. Laws § 450.4102(m))
- Rhode Island (R.I. Gen. Laws §§ 7-16-2(27), 7-16-9, 7-16-49, 7-16-76)
- Utah (Utah Code §§48-2c-412, 48-2c-1411)
- Wyoming (Wy. Stat. §17-29-102(a)(ix), et seq.)
At one point, North Carolina had an L3C statute, but repealed its law effective January 1, 2014 (see N.C. Gen. Stat. §§ 57D-2-01, 57D-2-21, 55D-20(a) (2013) as repealed by S.B. 439).
L3Cs are designed to dovetail with and satisfy (at least in their organizational documents) the program-related investment (PRI) requirements set forth in the I.R.C. (at section 4944) and corresponding regulations (at section 53.4944-3). PRIs are investments made with a primary purpose of accomplishing a charitable purpose. PRIs occasionally are used by private foundations to make risky but worthwhile investments (e.g., low-interest loans) in private enterprises to accomplish charitable purposes rather than simply making a grant to the same enterprise. In other respects, the L3C statutes leave the details of the economics, management duties, transaction approvals, voting, indemnification, and other matters of the L3C to the articles of organization and the operating agreement.
Critics justifiably point out that, because the L3C is not preapproved by the IRS to accept PRIs, unless and until such preapproval is granted, the L3C has no meaningful advantage over a traditional LLC. In fact, the ABA Business Law Section opposes L3C legislation. On the other hand, although the L3C originally was envisioned as a vehicle for PRIs, there is no requirement that an L3C be funded by a PRI or that an L3C have even one private foundation or other tax-exempt member. Hence, if our hypothetical retreat charged fees to attendees and served the purpose of educating men on their role in families and living a spiritual life, it could be organized as an L3C (including an SML3C) instead of an LLC (or SMLLC). Of course, an LLC with appropriate language in its governing documents regarding its educational role also would be sufficient to consider the LLC a social enterprise.
Another social enterprise form of the LLC—the benefit LLC—exists in two states: Maryland (at section 4A-1107(b)) and Oregon (at sections 60.750 to -.770). Oregon’s approach is slightly different than Maryland. Instead of having a separate statute applicable to LLCs like Maryland, Oregon’s statute sets forth the requirements for a “benefit company,” which includes both benefit LLCs and benefit corporations. The Maryland and Oregon benefit LLC statutes essentially mirror the respective statutes for a Maryland or Oregon benefit corporation. In particular, a Maryland or Oregon benefit LLC must have the purpose of creating a “general public benefit” through “activities that promote a combination of specific public benefits.” A “general public benefit” is defined for this purpose as “a material positive impact on society and the environment, taken as a whole.” A benefit LLC also may (but is not required to) adopt a specific public benefit purpose. Specific public benefits (if any) must be set forth in the LLC’s articles of organization and include, but are not limited to, the following: (i) providing low-income or underserved individuals or communities with beneficial products or services; (ii) promoting economic opportunity for individuals or communities beyond the creation of jobs in the normal course of business; (iii) preserving or improving the environment; (iv) improving human health; (v) promoting the arts or sciences or the advancement of knowledge; (vi) increasing the flow of capital to entities with a public benefit purpose; and (vii) accomplishing any other identifiable benefit for society or the environment.
Other requirements also are imposed upon Maryland and Oregon benefit LLCs—similar to the requirements imposed upon Maryland and Oregon benefit corporations. Importantly, the Maryland and Oregon benefit LLC statutes offer fiduciary liability protection to the managers of a benefit LLC when making decisions concerning the pursuit of profit versus the benefit purposes of the LLC. This added fiduciary liability protection might make the Maryland or Oregon benefit LLC especially attractive in some circumstances. On the other hand, most LLC statutes allow the operating agreement of an LLC to limit the fiduciary liability of the managers under any circumstances—regardless of any quasi-charitable purpose for the LLC. Uniquely, Maryland requires a benefit LLC to use the term “benefit” in its name.
Beyond the foregoing, the Maryland and Oregon benefit LLC statutes, like the L3C acts, leave the details of the economics, management duties, transaction approvals, voting, indemnification, and other matters of the LLC to the articles of organization and the operating agreement. In essence then, aside from the specific statutory provisions summarized above, Maryland and Oregon benefit LLCs should be treated just like regular LLCs.
For the same reasons that our hypothetical men’s group could be organized as an L3C, it similarly could be organized as a benefit LLC with a general public benefit and a specific public benefit of promoting the “advancement of knowledge” (i.e., the role of men in the family and living a more spiritual life).
As demonstrated above, an LLC in one of its many variations might be the best solution for our hypothetical men’s group. An LLC could provide liability protection, unlike an unincorporated nonprofit association, without imposing the added compliance burdens that accompany a standalone, tax-exempt nonprofit corporation. The table below summarizes the various choice-of-entity considerations discussed in this article.