IRS issues guidance on LLC eligibility for tax-exempt status: PwC

In brief

The IRS recently issued Notice 2021-56, which sets forth standards that a limited liability company (LLC) must satisfy to be recognized as tax-exempt under Section 501(c)(3). The Notice also requests comments from the public on specific issues relating to tax-exempt status for LLCs; these comments are due February 6, 2022.

Action item: The Notice does not affect the status of organizations already recognized as tax-exempt under Section 501(c)(3) and is not intended to alter the substantive criteria the IRS will use to evaluate a new application for an LLC’s tax exemption. Nor does the Notice address LLC eligibility for tax-exempt status for state income tax purposes. However, LLCs that apply for recognition of tax-exempt status for federal income tax purposes should review IRS criteria described in the Notice in light of applicable state LLC laws so that its application satisfies the criteria.

In detail

Tax-exempt organizations described in Section 501(c)(3) typically are formed as nonprofit or nonstock corporations under state law; some private foundations are formed as state-law trusts. Entities formed under state LLC laws may qualify as tax-exempt for federal income tax purposes, provided they meet the requirements outlined in the Notice. LLC applicants that satisfy these requirements should qualify for tax exemption if they are organized and operated exclusively for exempt purposes and their assets are dedicated to an exempt purpose and do not inure to private interests, as required for qualification under Section 501(c)(3).

The IRS will recognize an LLC as described in Section 501(c)(3) only if both its articles of organization and operating agreement include:

Provisions requiring each member of the LLC to be an organization described in Section 501(c)(3), a governmental unit described in Section 170(c)(1), or a wholly owned instrumentality of a governmental unit;
Express charitable purposes and charitable dissolution provisions;
Express Chapter 42 compliance provisions described in Section 508(e)(1) if the LLC is a private foundation; and
Contingency plans in the event that one or more members cease to be Section 501(c)(3) organizations or governmental units. An acceptable contingency plan could include suspension of membership rights until a member regains recognition of its Section 501(c)(3) status.

An organization established under a state LLC law that restricts the types of provisions that may be included in its articles of incorporation will meet the above requirements if its (1) operating agreement contains the required provisions and (2) articles of incorporation do not contain contradictory provisions.

The IRS is requesting public comments by February 6, 2022 on a number of issues, many of which focus on the interaction between state LLC laws and Section 501(c)(3) requirements. The IRS also is seeking input on other issues, including:

Potential advantages and disadvantages of forming an entity for exclusively charitable purposes under a state LLC law rather than under a state not-for-profit (or non-stock) corporation or charitable trust law;
Circumstances in which an LLC seeking recognition under Section 501(c)(3) should be permitted to have members that are not themselves Section 501(c)(3) organizations, governmental units, or wholly owned instrumentalities of governmental units;
Whether LLC managers should be treated as officers for exempt organization tax purposes generally, including excise taxes under Chapter 42 (Sections 4940-4968); and
Whether there should be special requirements or considerations for recognition of tax-exempt status for LLCs under paragraphs of Section 501(c) other than Section 501(c)(3).