A charitable organization is organized and operated exclusively for exempt purposes, under the relevant sections of §501(c) of the Internal Revenue Code. Key to this structure is that the earnings of the organization cannot inure to any private shareholder or individual. Secondly, the organization cannot take any political action. Traditionally, 501(c)(3) organizations are either private foundations, donor-advised funds (DAFS), or publicly funded non-profits.
A 501(c)(3) must engage in activities that accomplish one or more of its purposes. IRS Private Letter Ruling 963750. A single non-exempt purpose that is substantial in nature will destroy a claim for exemption, regardless of the importance of the truly exempt purpose. Better Business Bureau of Washington D.C. v. United States, 326 U.S. 270, 283 (1945). This restriction limits the options of a non-profit looking to diversify its income stream or pursue a project vastly different from its stated purpose.
A limited liability company is a corporate entity formed to provide flexibility to the owners of its membership interests. It is a hybrid between a corporation and a sole proprietorship or partnership. By default, LLCs are taxed as pass-through organizations, where the income (or loss) is directly attributable to the members. Alternatively, LLCs can choose to be taxed as S corporations after making the appropriate election with the IRS. The more common pass-through election gives the members the flexibility to take risks in the business. Most states allow LLCs to operate for “any lawful purpose”, providing flexibility to the organization and allowing it to morph as its needs change and evolve. This malleability means that the organization has very little responsibility to its members.
As a mechanism for charitable organizations to pursue alternative modes of income, the IRS has authorized charitable LLCs. A charitable LLC is neither a benefit LLC[1], nor a L3C. A benefit LLC is the LLC version of the benefit corporation; both are for-profit entities, but emphasize a commitment to public benefits, as delineated in their organizing documents. An L3C is a low-profit limited liability company, which is only recognized in a few states. A charitable LLC is an LLC where all of the members are tax-exempt organizations.
In IRS Information Letter 2010-0052, the IRS declared that “As a general rule, a disregarded limited liability company whose sole owner is exempt … is not required to pay federal taxes or file a federal tax or information return; that is the responsibility of its sole owner. The disregarded entity generally receives the benefit of its owner’s tax-exempt status, including exemption from federal income tax, federal unemployment tax, and other federal taxes where applicable.” This opened the opportunity for non-profit organizations to create limited liability companies. A follow-up IRS Notice 2012-52, provided guidance on the deductibility of contributions to domestic single-member limited liability companies wholly-owned and controlled by charitable organizations under the Code and for federal tax purposes such organizations are disregarded as entities separate from their owners under §301.7701-2(c)(2)(i) of the Procedure and Administration Regulations (a.k.a. SMLLCs).
A charitable LLC provides greater control and flexibility for the owner. A manager can make any decision allowed by the operating agreement, which means that the LLC can make investment decisions without relying on convening the non-profit members board, allowing the LLC to make riskier investments without jeopardizing the member’s financial wellbeing. It also allows the LLC to enter into contracts privately, without the same disclosure requirements of the non-profit organization. Further, the financial decisions of the charitable LLC are made as a business, and not as a non-profit. This allows the business to justify hiring top talent at competitive corporate rates rather than lesser non-profit rates or pursue a more desirable location than the non-profit’s finances would otherwise allow. The inherently flexible nature of the LLC allows for charitable entrepreneurship, allowing losses to offset the member non-profits’ investments. It also allows the non-profit to pursue for-profit ventures, or even allows the non-profit an avenue for making political contributions through the LLC. There is no public filing of the use of funds for the charitable LLC, inherently limiting oversight and accountability.
Non-profit organizations looking to create a charitable LLC need to be careful when crafting their organizational documents. There are twelve elements to include in the charitable LLC’s operating agreement, including restrictions on assignment and transfer that are not part of a typical LLC’s operating agreement. Further, different states have different requirements on fundamental language in an LLC operating agreement, giving rise to potential pitfalls when establishing a charitable LLC.
Offit Kurman’s Business Law and Transactions Group can assist your clients in choosing the best corporate structure for their venture, and can guide your non-profit clients in creating a charitable LLC, structuring its operating agreements, and navigating registration with state and federal agencies.
ABOUT KELCIE LONGAKER
klongaker@offitkurman.com | 301.575.0325
Ms. Longaker’s primary areas of concentration include general corporate advising, administrative hearings, and state and federal appellate litigation. She advises start-ups and small businesses during all stages of the business’s life-cycle. She regularly drafts organizational documents, reviews commercial leases, negotiates franchising agreements, and assists with the sale of corporate entities. Ms. Longaker represents many businesses that require liquor licenses, including restaurants, package goods stores, agricultural producers, and manufacturers. She represents clients before county agencies in their applications for new licenses, transfers of existing licenses, or defense of challenged licenses. She also handles land use and zoning matters, real property transactions, and homeowners’ association matters.
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