Starting a nonprofit organization is a noble mission, but it involves many steps. One is choosing your business entity type.
Most nonprofits are formed as nonprofit corporations, but you can form a nonprofit limited liability company (LLC) if you meet certain conditions. It’s a complex process, however, so you should be aware of what’s involved.
What is an LLC?
An LLC is an increasingly popular business structure for startups, offering liability protection for ownership and greater flexibility than a corporation, particularly in terms of taxes. The LLC itself does not pay taxes. As a “pass-through” entity, income passes through the business to the owner or owners, who report it on their personal tax returns. An LLC is created by filing paperwork with your state, and nominal fees are involved.
An LLC offers its owner or owners, who are called members, considerable flexibility in terms of management. You can choose your management and operational structure and decide how you want to be taxed. Your LLC can have a single member or multiple members, all of whom have personal liability protection, meaning your personal assets are not at risk if you cannot pay business debts or are involved in a lawsuit.
What is a Nonprofit Organization?
A nonprofit organization, whether formed as an LLC or corporation, is formed not to make profits but to serve the public in some way. Nonprofits must work for religious, scientific, charitable, educational, literary, public safety, or cruelty-prevention causes or purposes.
They receive money from donations or through fundraising activities. Nonprofits have tax-exempt status since they are working for the public good. To obtain tax-exempt status they must request 501(c)(3) status from the IRS.
What is a Corporation?
A corporation is a legal business entity that is separate from its owners. Corporations, like individuals, can enter into contracts, pay taxes, hire employees, be involved in legal action, loan or borrow money, and own assets. Corporations offer personal liability protection for their shareholders, and shareholders benefit from the profits of the corporation.
A corporation is created when it is incorporated by a single shareholder or group of shareholders who have ownership of the corporation in the form of common stock. A corporation can be for-profit or non-profit. Shareholders pay money for the common stock but have no further financial responsibilities to the company.
A corporation must have a board of directors, which is responsible for implementing and executing the company’s business plan. The board of directors is elected by the shareholders. A corporation pays taxes on its profits, and shareholders pay taxes on their dividends, which is sometimes referred to as “double taxation.”
For an LLC to be nonprofit, it must receive 501(c)(3) status. To obtain this status the LLC must meet the following requirements:
- The LLC must be owned by a single member which is another 501(c)(3) organization. The member cannot be an individual.
- Two or more members that are also 501(c)(3) organizations must own the LLC.
- The LLC obtains tax-exempt status by filing Form 1023 with the IRS. The form instructions contain a worksheet that you can fill out to see if you will be eligible for tax-exempt status. The members must still be 501(c)(3) organizations.
If the nonprofit LLC is owned by a single member, it will be treated as a sole proprietorship for tax purposes. If it has more than one member it will be treated as a partnership. If the nonprofit LLC obtained tax-exempt status with form 1023, it will be treated as a corporation for tax purposes.
Nonprofit LLC Conditions
To obtain tax-exempt status the LLC must meet conditions that the IRS has laid out. These conditions are intended to ensure that the LLC qualifies for 501(c)(3) status under the tax code. The LLC must be formed for exempt purposes and cannot engage in activities not allowed by 501(c)(3)s. The articles of organization must contain language that specifies that the LLC will meet the following conditions:
- The LLC’s activities are limited to tax-exempt purposes
- The LLC operates for a charitable purpose
- The members of the LLC must be 501(c)(3) organizations, meaning they have 501(c)(3) status. The members are not individuals; the members are 501(c)(3) organizations.
- A plan will be followed in case one or more members are no longer 501(c)(3) organizations. This means if one of the member organizations loses their 501(c)(3) status, provisions are made for the member to be removed or replaced, and what happens to their interests.
- Membership interests cannot be transferred to non-501(c)(3) organizations
- The transfer of interests (other than membership interests) to a nonmember other than a 501(c)(3) organization can only be done for fair market value
- Assets used for charitable purposes will continue to be used for charitable purposes upon dissolution of the LLC
- Any amendments to the organizational documents must be consistent with section 501(c)(3)
- The LLC cannot merge with or become a for-profit entity
- The exempt members will protect their rights and interests by exercising their LLC rights. This means that the LLC gives the members certain rights that protect their interests, and in this case, the members are organizations. The LLC members are required to protect the rights of the member 501(c)(3) status.
- All provisions in the organizational documents are consistent with state law and are enforceable
Due to the complexity of forming a nonprofit LLC, most nonprofits are formed as corporations. There are no real advantages to choosing an LLC rather than a corporation for your nonprofit, and getting 501(c)(3) status will take longer. It’s highly recommended that you consult an attorney when forming your nonprofit to determine which option is best for you.