LLC vs. Nonprofit: What Is the Difference?

Limited liability companies (LLCs) and nonprofits are both business structures that offer personal liability protection for owners. They do, however, have very different purposes and other key differences.

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?

A nonprofit organization 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 and fundraising activities. Nonprofits have tax-exempt status since they work for the public good. To obtain tax-exempt status they must request 501(c)(3) status from the IRS. 

A nonprofit is usually formed as a corporation, although an LLC can also be a nonprofit.

Key Differences

The two business structures have several key differences.

Purpose

An LLC is formed with the goal of making profits. LLCs perform some kind of business activity designed to make money for the owners by providing value to customers. 

A nonprofit is formed to serve the public and does not generate a profit for the benefit of owners. They must have a specific charitable purpose as defined by the IRS. Money generated by the nonprofit that exceeds expenses must be used for that charitable purpose or to grow the organization.

Taxation

LLCs are unique in terms of taxation as their owners have a choice about how the company will be taxed. By default, an LLC is taxed like a sole proprietorship if it has one member and a partnership if it has more than one member.

In both cases, business income “passes through” to the members, while profits and losses are reported on their individual tax returns. The LLC itself is not taxed, which simplifies the process for members. Also, losses and operating costs of the business can be deducted personally by the members. Taxes are paid at the personal tax rate of the members, although the owners may also have to pay self-employment taxes. 

Note that a multi-member LLC must also file form 1065 with the IRS, which is the U.S. Return of Partnership Income. Attached to this will be form K-1s for each member showing their share of the business income. 

But LLCs owners can instead choose to be taxed as a corporation. To do so, the LLC must file a document, referred to as an election, with the Internal Revenue Service (IRS). The LLC must then decide if it wishes to be taxed as an S corporation or a C corporation.

Regardless of how the LLC is taxed, the point is that profits are taxable. This is not the case for a nonprofit.

Nonprofits that are properly formed and operated are tax-exempt at both the state and federal levels. To get tax-exempt status, however, the nonprofit must apply for that status with the IRS. There are a few different types of tax-exempt statuses, but the most common is 501(c)(3) status. The nonprofit must meet all IRS requirements to obtain tax-exempt status.

Profit Distribution

LLC profits can be distributed to the owners or reinvested in the business. In contrast, nonprofit owners may not receive profits. The organization can have a profit, but the owners may not benefit from those profits. Owners can receive a reasonable salary, as defined by the IRS, but any profits that exceed expenses must be used to operate the nonprofit and to advance the charitable cause. 

Ownership and Management

LLC owners are called members. LLC owners can decide between two different types of management structures:

• A Member-Managed LLC is managed by the members of the LLC. This is usually chosen by smaller LLCs with few members who will be involved in various management roles. 
• A Manager-Managed LLC is managed by people who are not members of the LLC and are employees of the business. This structure is often used when an LLC is larger and has multiple members.

Non-profits, on the other hand, are not technically owned by the founders, but by the public, because they work for the public good. Founders and other individuals have various management roles within the organization. A nonprofit must also have a board of directors to oversee the nonprofit and its management, while an LLC does not. 

Nonprofit LLCs

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.

Conditions for Forming an LLC Nonprofit

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