IRS Defines Standards for LLCs to Obtain 501(c)(3) Status

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The Internal Revenue Service (IRS) recently issued Notice 2021-56, which better defines the standards for limited liability companies (LLCs) to obtain 501(c)(3) status. The IRS last issued guidance on this issue 20 years ago, shortly after LLCs emerged as a new business entity form. That guidance was nonbinding, which has led to a lack of clarity surrounding IRS acceptance of LLCs as tax-exempt under 501(c)(3).

Procedures for LLCs to Become Tax-Exempt

The Treasury Department and the IRS interpret 501(c)(3) of the Internal Revenue Code (IRC) and § 1.501(c)(3)(1) of the Income Tax Regulations to allow the IRS to issue a favorable determination of tax-exempt status to an LLC under appropriate circumstances. Specifically, the LLC must submit Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code. The LLC also must meet specific requirements as outlined in 501(c)(3) and the provisions of Notice 2021-56.

Requirements for LLCs to be Tax-Exempt

Consistent with the general principles that govern all 501(c)(3) tax-exempt organizations, LLCs seeking exemptions must meet four requirements designed to show that they are organized and operated exclusively for 501(c)(3) tax-exempt purposes. LLCs must include specific statements in both the articles of organization filed their jurisdictions of formation and their operating agreements, as follows:

  • All members of the LLC must be charitable organizations, governmental units, or wholly-owned government instrumentalities described in Sections 501(c)(3) or 170(c)(1) of the Internal Revenue Code.
  • The LLC has charitable purposes, and any assets left upon the LLC’s dissolution will be distributed for charitable purposes.
  • If the LLC is a charitable foundation, the LLC will comply with various Chapter 42 excise tax rules required for nonprofit corporations that also are charitable foundations.
  • The LLC has an acceptable contingency plan if any member of the LLC ceases to be a charitable organization, governmental unit, or wholly-owned government instrumentality.

Previous informal continuance education guidance that the IRS provided to tax practitioners in 2000 and updated in 2001 provided that LLCs had to meet 12 different requirements to qualify as 501(c)(3) tax-exempt organizations. As a result, the 2021 IRS Notice has greatly simplified these requirements. The move recognizes the popularity of the LLC as a business entity, including in the nonprofit arena.

Consistency with State Laws Regarding Formation of LLCs

Notice 2021-56 also provides that LLCs must acknowledge that their articles of organization and operating agreements strictly comply with state law and are legally valid. This provision recognizes that state laws vary widely on their requirements for creating LLCs.

Nonetheless, some state laws prohibit adding provisions to the articles of incorporation of an LLC other than those prescribed by state law. To the extent that state law conflicts with IRS requirements to qualify as tax-exempt under 501(c)(3), LLCs can comply with IRS requirements by including the necessary provisions in their operating agreements. However, their operating agreements must not conflict with their articles of organization.

Notice 2021-56 Open for Public Comment

The IRS and the Treasury Department are requesting written comments on the standards outlined in Notice 2021-56. They will accept comments submitted by February 6, 2022. They mainly are interested in comments concerning how these standards would affect or conflict with existing state laws concerning the formation of LLCs.

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