While nonprofits are traditionally organized as corporations, they can also be formed as limited liability companies in some states. There are benefits and drawbacks to each option. Because nonprofits are formed under state law and often apply for federal tax-exempt status with the Internal Revenue Service, it is important to understand that not all states allow nonprofits to operate as LLCs. Internal management flexibility is generally what makes this type of structure more appealing than a corporation.
The traditional and most common business structure for a nonprofit is a corporation. Nonprofit corporations are formed and regulated under state law, which varies by state. Generally, you may form a nonprofit corporation by filing articles of incorporation with the state business registrar. Many states require corporations to have a board of directors, which guides the overall direction of the nonprofit. The board will draft bylaws to establish the internal rules for the nonprofit, such as how new board members may be added.
Read More: How to Convert From an LLC to a Nonprofit Corporation
The Internal Revenue Code allows nonprofits to apply for 501(c)(3) status, also known as tax-exempt status. Many nonprofits pursue tax-exempt status because it allows them to avoid federal corporate income tax, and donations to 501(c)(3) organizations are tax-deductible for the donor. Further, many states allow 501(c)(3) organizations to avoid sales tax, property tax, and other state taxes. The law does not specifically allow for limited liability companies to qualify for 501(c)(3) status, but instead limits qualifying business types to corporations, community chests, funds or foundations.
Nonprofit Limited Liability Companies
As limited liability companies become increasingly popular, some states are updating their laws to allow LLCs to be formed for nonprofit purposes. By organizing as an LLC instead of a corporation, you have a lot more flexibility in terms of management options. An individual may act as a board director would, and also as a manager. Some states specifically allow for nonprofit LLCs, such as Delaware, which specifies that an LLC may be organized for a not-for-profit purpose. Conversely, other states provide that an LLC must be organized for a "business purpose," which some consider to mean the LLC must exist to make a profit.
Because the Internal Revenue Code does not list the LLC as a type of organization that can apply for 501(c)(3) status, there has been some confusion as to whether an LLC may qualify as an exempt organization. The IRS appears to have interpreted the law to allow for tax-exempt LLCs, but with certain conditions. The LLC must elect to be treated as a corporation for the purposes of taxes. Further, the LLC must have a charitable, nonprofit purpose, which some states may not allow. As with corporations, the LLC's formation documents must include certain provisions, such as a statement that if the LLC closes, its assets will be distributed to another nonprofit.
Elizabeth Rayne earned her J.D. from Penn State University and has been practicing law since 2009, advising clients on issues ranging from employment law to nonprofit management. For two years, she served as a contributing editor for the "Vermont Environmental Monitor."