501(c)(3) Exemption for an LLC

How an LLC Can Be Granted 501(c)(3) Status

Introduction

From 1979 through 2004 the IRS Exempt Organization Division annually published a series of articles of interest to tax-exempt organizations, known as the Exempt Organizations Continuing Professional Education Technical Instruction Program (or "EO CPE Text")

Below is an excerpt from 2001 EO CPE Text
(CLICK HERE for a pdf copy of the entire document)

B. 501(c)(3) Exemption for LLCs--12 Conditions

Last year's article posed the question whether an LLC can qualify for exemption under IRC 501(c)(3) (other than as a disregarded entity with a sole exempt organization owner). The Service has determined that it can, under certain conditions.

The Service will recognize the 501(c)(3) exemption of an LLC that otherwise qualifies for exemption if it satisfies each of the 12 conditions below. The conditions are designed to ensure that the organization is organized and will be operated exclusively for exempt purposes and to preclude inurement of net earnings to private shareholders or individuals.

1. The organizational documents must include a specific statement limiting the LLC's activities to one or more exempt purposes.

This requirement may be satisﬁed by standard purposes and activities clauses that satisfy the 501(c)(3) organizational test, such as "The organization is organized exclusively for exempt purposes under section 501(c)(3) of the lnternal Revenue Code," and "The organization may not carry on activities not permitted to be carried on by an organization described in section 501(c)(3)." Taxpayers may not rely upon the Q pres doctrine to meet this requirement for LLCs. 2.   The organizational language must specify that the LLC is operated exclusively to further the charitable purposes of its members.

3.   The organizational language must require that the LLC's members be section 501(c)(3) organizations or governmental units or wholly owned instrumentalities of a state or political subdivision thereof ("governmental units or instrumentalities").

4.   The organizational language must prohibit any direct or indirect transfer of any membership interest in the LLC to a transferee other than a section 501(c)(3) organization or governmental unit or instrumentality.

Because state laws generally provide LLC members with ownership rights in the assets of the LLC, the Service is concerned that allowing non-exempt members would result in potential inurement problems. Thus, the LLC cannot have private shareholders or individuals as members, and its organizing documents must state a purpose to further the members‘ charitable purposes. It should be noted, however, that the presence of solely charitable members does not ensure that the organization will be operated exclusively for charitable purposes. See, gg_., Rev. Rul. 72-369, 1972-2 C.B. 245 (organization formed to provide managerial and consulting services at cost to unrelated 501(c)(3) organizations not exempt under IRC 501(c)(3)); compare Rev. Rul. 71-529, 19712 C.B. 234 (organization controlled by a group of unrelated 501(c)(3) organizations and providing investment management services for a charge substantially below cost solely to that group qualiﬁes under IRC 501(c)(3)). 5. The organizational language must state that the LLC, interests in the LLC (other than a membership interest), or its assets may only be availed of or transferred to (whether directly or indirectly) any non-member other than a section 501(c)(3) organization or governmental unit or instrumentality in exchange for fair market value.

This provision helps ensure that the LLC and its assets are devoted exclusively to charitable purposes and that any dealings with private interests are at arm's length. Grants for exempt purposes to individuals or noncharitable organizations (as described in Rev. Rul. 68-489, 1968-2 C.B. 210) would also be permitted. 6. The organizational language must guarantee that upon dissolution of the LLC, the assets devoted to the LLC's charitable purposes will continue to be devoted to charitable purposes.

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7. The organizational language must require that any amendments to the LLC's articles of organization and operating agreement be consistent with section 501(c)(3).

8. The organizational language must prohibit the LLC from merging with, or converting into, a for-profit entity.

The idea here is that the LLC, like any other charitable organization, should intend to operate as a charity for its entire life and not ﬂip between exempt and nonexempt status. 9. The organizational language must require that the LLC not distribute any assets to members who cease to be organizations described in section 501(c)(3) or governmental units or instrumentalities. Such distribution would be inurement, unless the distribution is to a member other than in its capacity as a member, as where the member is the creditor on a loan to the LLC.

10. The organizational language must contain an acceptable contingency plan in the event one or more members ceases at any time to be an organization described in section 501(c)(3) or a governmental unit or instrumentality.

Forfeiture of the nonexempt member's interest is acceptable. A forced sale of the nonexempt organization's interest to another section 501(c)(3) organization or governmental unit or instrumentality would also be acceptable. The plan cannot involve a distribution of the LLC's assets to the nonexempt member, and should ensure that the nonexempt member's rights in the LLC are fully terminated within a reasonable time, g, 90 days from the date that a member's exemption is revoked. 11. The organizational language must state that the LLC's exempt members will expeditiously and vigorously enforce all of their rights in the LLC and will pursue all legal and equitable remedies to protect their interests in the LLC.

12. The LLC must represent that all its organizing document provisions are consistent with state LLC laws, and are enforceable at law and in equity.

Some states (California, Indiana, Iowa, Maryland, Minnesota, New York, North Dakota, Rhode Island, Texas, Utah, and Virginia) and the District of Columbia appear to require that an LLC be formed for a business purpose. In such states, it is questionable whether an LLC may be formed as a 501(c)(3) charitable organization. For the time being, however, absent state case law to the contrary, the Service is willing to recognize exemption based on the LLC's representation that its charitable status is permitted under state law, and that the provisions set forth above are enforceable. C. Organizing Documents

The question arises as to which organizing document must meet the conditions set forth above. Unfortunately, state laws lack uniformity in determining whether the articles of organization (referred to in some states as the certificate of organization or certificate of formation--to confuse matters more, some states use the latter terms to refer to a document issued by the state when the state approves the articles of organization upon submission) or the operating agreement (referred to in some states as the regulations) controls in the event of a conﬂict. In some states, the articles of organization are the controlling document. In other states, it appears that the articles of organization control as to third parties, and the operating agreement controls as to members. For administrative convenience, the Service will require that both the articles of organization and the operating agreement separately comply with the 11 conditions above (the 12th condition is met in a separate written statement from the organization).

Most states expressly allow provisions to be included in the articles of organization that are not inconsistent with law, at least if the provisions are permitted to be included in the operating agreement. A few states (Arkansas, Colorado, Idaho, Oklahoma, and Wisconsin) appear to prohibit the inclusion of any information in the articles of organization other than certain specified items (gg, name, address, whether the organization is managed by the members)--in these states, the 11 provisions set forth above may be included in the operating agreement only, so long as there are no conﬂicting provisions in the articles of organization.