Toby Mathis, Esq. explains the differences between entity types and the best entity to use when forming a nonprofit.
Can an LLC Be a Nonprofit?
In short, the answer is yes, but I wouldn’t recommend it. The reason for this is that, when you look at nonprofit activity and the actual Tax Code, the Code typically references corporations or trusts in regards to nonprofits.
One thing that’s important to keep in mind is that LLCs are a product of state law. To that end, LLCs aren’t covered by federal law. There is no such thing as an LLC in the eyes of the IRS. Thus, I can go to any state and set up an LLC, but the IRS will then ask, “How do you want us to tax it?”
This is where tax elections come into play. The tax election options for LLCs are partnerships, C corporations, S corporations and, technically, nonprofits. So yes, you could elect tax exemption status with the federal government for your LLC, but when you go through the exemption process, expect issues.
Using LLCs vs. C Corporations for Nonprofits
Ultimately, my answer to this question is yes, an LLC can be a nonprofit, but DON’T use an LLC if you want to get your tax-exempt approval sooner rather than later without a lot of agitation and rigamarole. This is because the IRS wants to see things done a certain way, so varying from their expectations is a cause for further investigation in their eyes. Furthermore, there is no real benefit to being an LLC taxed as a nonprofit. It’s much better to simply stick with what works: a C corporation.
There’s no difference between using an LLC and a C corporation as a nonprofit when it comes to taxation because neither would pay tax. In the for-profit world, the reason people use LLCs is the ability to an LLC’s tax status. Additionally, LLCs supposedly have fewer formalities than corporations in terms of compliance. With nonprofits, however, this is simply not the case.
With LLCs, it’s true that fewer meetings are required because LLCs only have one layer of management. However, with nonprofits, there are no shareholders or members. Instead, nonprofits only have a board of directors or board of trustees. This will be true regardless of whether the nonprofit is an LLC or corporation.
So, I would urge you to go with what works: file a corporation with the state, then file for exemption as a corporation with the federal government.
Can an LLC Apply for Tax-Exempt Status?
This is a brilliant question because it highlights the distinctions between federal and state law. At the state level, you file a “nonprofit entity.” For the federal government, you file for an exemption from taxation. Do you see this nuanced difference?
On the state level, you can file a nonprofit LLC. Despite this, at the federal exemption level, a nonprofit LLC asks the IRS to take you seriously using state-specific language not recognized by the IRS. Technically, you CAN apply for an exemption with an LLC, but you would need to be an LLC taxed as a corporation; then, you ask the federal government to treat it as a nonprofit or tax-exempt organization. Do you see how this creates unnecessary confusion?
Ultimately, for the highest likelihood of success when forming a nonprofit, you should file a corporation with the state and apply for exemption as a corporation with the federal government.
Can a Nonprofit Be an S Corp?
In short, no. An S corporation is a tax treatment election reserved exclusively for for-profit endeavors. To briefly break down the for-profit corporate options: with the state, you can either file an LLC or corporation. A corporation can then be taxed as either a C or S corporation.
On the nonprofit side, there’s no such thing as a C or S organization. It’s an exempt organization. You don’t file for C or S status, you file for exempt status. Thus, there’s a common misconception that there are only two types of corporations: C and S corporations. In reality, there are actually three types of corporations: C, S, or exempt. C corporations are separate legal entities that pay their own taxes; S corporations’ taxes flow through and are paid by the shareholders; exempt corporations pay no tax. Then, to break it down a bit further, even within an exempt organization there are different flavors: operating foundations, private foundations, and private operating foundations.
Ultimately, it’s more important to work with a professional who knows what they’re doing than trying to know every nuance of this complicated area of tax law yourself. When working with a professional, they’ll take a look at the activities you propose and work to make sure everything is documented properly to receive preferential tax treatment.
If you’d like to discuss your nonprofit questions with a knowledgeable professional in a no-cost and no-obligation setting, schedule a complimentary consultation with an Anderson Business Advisor now. You can schedule online or by calling 800.706.4741. We’ve formed over three thousand nonprofits and would be happy to answer any questions you may have.