Mayer & Riser, PLLC -- Nonprofit LLCs: Time for a New Experiment?

(Revised 11/98)

MAYER & RISER , PLLC

(828) 526-3731

A TTORNEYS AT LAW H IGHLANDS, N ORTH C AROLINA

Nonprofit LLCs: Time for a New Experiment?

By Christopher M. Riser Mayer & Riser, PLLC Highlands, North Carolina Government operations tend to be everywhere alike. With individuals and voluntary associations, on the contrary, there are varied experiments, and endless diversity of experience." One might think that among the diverse and varied voluntary associations noted by John Stuart Mill would be similarly diverse and varied entities and management structures tailored to the individual needs of nonprofit organizations. While LLCs are popular joint venture entities, the LLC may not be an available choice of entity for nonprofit tax-exempt organizations in many states. As a result, many nonprofit tax-exempt organizations find themselves locked into the rigid structure of the corporation. If the LLC form were available to all nonprofit tax-exempt organizations, their management structures would be open to great variation. Existing LLC statutes, however, are silent on many issues of concern to nonprofit tax-exempt organizations that might consider organizing as LLCs. As a result, very few nonprofit tax-exempt LLCs have been formed. Current Choice of Entity for Nonprofit Organizations The lack of availability of the LLC form for nonprofit tax-exempt organizations in many states and the lack of assurances about nonprofit tax-exempt LLCs in states where nonprofit tax-exempt organizations may be able to organize as LLCs make the choice of entity for nonprofit tax-exempt organizations seem incomplete. The other choices generally available -- the nonprofit association, the charitable trust, and the nonprofit corporation -- have drawbacks or limitations that the LLC form may not have. The law surrounding nonprofit unincorporated associations is vague and uncertain. The members of such associations generally have equal rights and responsibilities, and all members of such associations generally face unlimited personal liability. The charitable trust is usually only appropriate for holding property for charitable purposes. Furthermore, the trustee of a charitable trust faces unlimited personal liability and is usually restricted by trust law from delegating authority to anyone else, even to another fiduciary. In some states, the charitable trust is defined so broadly that it can include an LLC organized with trust-like fiduciary relationships. While such charitable-trust LLCs might provide some liability protection for members, forcing the framework of trustee management on an LLC removes much of the flexibility of the LLC form. Although the nonprofit corporation provides the advantages of limited liability and established law, it can be an inflexible and cumbersome vehicle for nonprofit organizations that would prefer the flexibility and adaptability of the LLC form. Unlike most LLC acts, most nonprofit corporations acts are rigid with few opportunities for opting out of the statutory provisions. The tripartite structure of a corporation is often not what the members of the small nonprofit organization want, need, or even understand. Countless small, informally-run nonprofit corporations do not always hold proper meetings, keep proper minutes, or hold proper elections. Woe is the attorney who must tell a board member of such an organization that everything he owns could be at risk in a tort action because (1) the legitimacy of the corporation is in question due to the failure to comply with corporate formalities; (2) the corporation's directors' and officers' insurance policy may not be effective to cover him as a director because the board has not been properly elected; (3) the nonprofit directors' and officers' immunity statute may not apply; and (4) last week, a 35-year-old neurosurgeon was seriously injured in an accident on the organization's property. Advantages of Organizing as an LLC One of the most significant advantages of the LLC form over the corporate form is the flexibility available in
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Mayer & Riser, PLLC -- Nonprofit LLCs: Time for a New Experiment? (Revised 11/98)

structuring company management. However, some of this flexibility will be lessened for a nonprofit tax-exempt organization operating as an LLC because, as a practical matter, the tax rules applicable to tax-exempt organizations will dictate a good deal of the basic financial governance of the company. Nonetheless, for the nonprofit tax-exempt organizations that would prefer the structure of a general partnership in which everyone wears the hats of member/owner, manager/officer and director simultaneously, the LLC form would be ideal. A nonprofit tax-exempt LLC could be member-managed to function like a general partnership, or it could be manager-managed if the members preferred to vest authority in a single person or entity or in a limited group of members. A nonprofit taxexempt LLC could also design a hybrid management structure that would allow carve-outs of management authority for members with particular areas of expertise or interest. If desired, a nonprofit tax-exempt LLC could avoid the cumbersome corporate requirements of annual meetings and minutes. Another advantage of the LLC form is that many LLC statutes allow LLCs to effect mergers and conversions without the need to liquidate or without having to contribute its assets to a new entity. In most states, an LLC can merge with another LLC. In some states an LLC can merge with another entity, and in some states an LLC can convert to another entity. The merger and conversion opportunities available to LLCs could be important considerations for nonprofit taxexempt organizations that might be contemplating future conversion to for-profit operations or to nonprofit tax-exempt operations on a larger scale. It is likely that thousands of small, local nonprofit tax-exempt organizations would benefit the most from the availability of the nonprofit LLC form. Small local social clubs, sports organizations, and homeowners' associations often find the formalities of forming and running a corporation awkward. LLC statutes that allow the organization of nonprofit LLCs could make management structures of such organizations more user-friendly. Local charitable societies and political clubs might also find the flexibility of the LLC form advantageous. The LLC form might also be preferable in some property-holding situations in which a charitable trust might otherwise be used. This would be especially true in situations where the charitable nature of the trust might be challenged, resulting in the loss of tax exemptions and any special liability protections that might have existed for charitable trustees. Finally, over the long haul, organizing as an LLC may be less expensive than organizing as a corporation. Attorneys' fees associated with organizing a nonprofit corporation initially may be lower than those associated with organizing a nonprofit tax-exempt LLC, because of the level of sophistication required to draft an operating agreement for such an organization. However, the management and operation of nonprofit corporations often require an attorney's ongoing involvement, creating more expenses over the long term. Single-Member LLCs Under the check-the-box regulations, a single-member LLC is disregarded as an entity separate from its owner unless corporate tax treatment is affirmatively elected. (1) Absent such an election, the assets and activities of a singlemember LLC created by a nonprofit tax exempt entity will be treated for tax purposes as those of the parent. Under state law, however, the entity will be separate. This could be an important factor for nonprofit tax-exempt organizations that want to create subsidiaries. Unless there are strong reasons for establishing a separate tax-exempt organization, such as a purpose that may jeopardize the tax exemption of the parent or the intention to seek separate funding, the single-member LLC should be considered as a vehicle for creating separate liability-insulated subsidiaries under the umbrella of a nonprofit tax-exempt parent to segregate company properties and operations for asset protection purposes. Nonprofit LLCs under Existing Statutes The key statutory provision of a state LLC act for a nonprofit tax-exempt organization wishing to organize as an LLC is the purposes provision. These statutory provisions may be divided into three basic categories: (1) those that allow any lawful purpose; (2) those that restrict LLCs to business purposes; and (3) those that explicitly permit not-for-profit purposes. A few states which restrict LLCs to business purposes actually permit the organization of not-for-profit LLCs by defining 'business' to include not-for-profit activities. A majority of states permit an LLC to be organized for any lawful purpose.(2)

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Mayer & Riser, PLLC -- Nonprofit LLCs: Time for a New Experiment? (Revised 11/98)

In states that restrict LLCs to business purposes, a question arises as to whether a business purpose is inconsistent with the concept of a nonprofit organization. Traditionally, under the common law, 'business' has meant 'activity conducted for profit.' Consequently, in a business-purpose jurisdiction there is considerable doubt whether an organization formed to conduct activities without the intent of making a profit would be considered to be legitimately formed. This legitimacy concern further leads to some doubt about whether the members of such an LLC would then enjoy limited liability, since if not formed for a proper purpose, the organization would simply be an unincorporated association. The fundamental distinction, however, between a for-profit business organization and a nonprofit tax-exempt organization lies not in whether the organization actually earns profits, but in who may receive distributions of profits. No distributions of profits from a nonprofit tax-exempt organization may be made to members, directors, officers, or managers. This restriction does not mean that nonprofit tax-exempt organizations cannot earn profits nor does it limit nonprofit tax-exempt organizations to charitable purposes. In fact, many nonprofit tax-exempt organizations earn significant profits. So, perhaps it may be argued that nonprofit organizations can, in fact, conduct 'business.' In Delaware, where the LLC Act explicitly permits "not-for-profit" purposes,(3) and in states that apparently permit LLCs to be organized with a "not-for-profit" purpose, one must be careful to decide the meaning of 'not-for-profit.' The term 'not-for-profit' refers to an activity engaged in without a profit motive. The term 'nonprofit' refers to an organization of which the income is not properly distributable to members, officers, or directors. Despite the difference in meanings, the terms 'not-for-profit' and 'nonprofit' are often used interchangeably. Accordingly, care should be taken to determine which meaning the legislature intends the term "not-for-profit" to have in a particular situation. If a nonprofit LLC is formed on the premise that 'not-for-profit' means 'nonprofit,' and the legislative intent behind the purposes provision of the LLC act is otherwise, the LLC could be faced with the same types of legitimacy issues discussed above regarding the nonprofit LLC that forms in a business-purpose jurisdiction. Even if a nonprofit tax-exempt organization can make it past the business-purpose barrier, a nonprofit tax-exempt LLC will find many default provisions of the LLC acts at odds with its functions because LLC statutes were written to provide a for-profit structure. Many LLC act default provisions would be inappropriate for nonprofit LLCs. While most LLC acts are flexible enough to allow an operating agreement to switch a nonprofit tax-exempt LLC out of inappropriate defaults, traps for the unwary abound. A practitioner considering assisting in the formation of nonprofit tax-exempt LLCs would be well served to review carefully the pertinent LLC act with the peculiar needs of the nonprofit tax-exempt organization in mind. Some other problems cannot be addressed so easily as with an operating agreement provision, because they involve issues more fundamental than opting in or opting out of particular statutory provisions. Perhaps the most obvious problem is the general application of a statute that conceptualizes a 'member' as an owner rather than as an associate or affiliate. For example, because LLC acts are designed for for-profit businesses, the default provisions of most statutes generally provide for the distribution of dissolution proceeds, which can of course include accumulated profits, to the members. This is not what those who make charitable contributions think will happen to the dissolution proceeds of a public-benefit nonprofit organization. However, because it is also in contravention to the requirements for tax exemption, the articles of organization and operating agreement of a nonprofit LLC seeking tax exemption will prohibit the distribution of dissolution proceeds to members. Nonetheless, should states rely on federal tax exemption laws to fill in gaps in their nonprofit organizations laws? In response to past abuses and in order to curb future abuses of the use of nonprofit corporations and charitable trusts, many states have a number of special statutory provisions applicable only to nonprofit and charitable corporations and trusts. Such laws presumably would not apply to nonprofit tax-exempt LLCs. For example, under the many charitable trust laws and nonprofit corporations acts, the state attorney general has standing to enforce the public interest. There seems to be no good reason for the state attorney general not to have the same power over nonprofit charitable LLCs. Nonprofit public-benefit corporations are often required to meet certain accounting and reporting standards. Without statutory provisions, public benefit nonprofit LLCs would not be required to do the same. Some state nonprofit corporations acts set mandatory financially disinterested majority management requirements for public benefit nonprofit corporations that would not apply to similarly situated LLCs. (4) Many nonprofit corporations acts contain special notice and approval requirements for terminating, redeeming or canceling all memberships or a class of membership, which requirements would not apply to a nonprofit tax-exempt LLC. Many other deficiencies exist in
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Mayer & Riser, PLLC -- Nonprofit LLCs: Time for a New Experiment? (Revised 11/98)

LLC acts as applied to nonprofit tax-exempt LLCs. Tax Issues All of this discussion about nonprofit LLCs would be moot as a practical matter if LLCs were unable to qualify as tax exempt under the Internal Revenue Code. The check-the-box regulations acknowledge that an entity eligible to check the box, such as an LLC, may qualify as an exempt organization under 501(a), which covers all 501(c) and 501(d) exempt organizations. If such an entity has been determined to be or claims to be exempt from taxation under 501(a), it is treated as having made an election to be classified as an association taxable as a corporation.(5) Charitable organizations that qualify for tax exemption under IRC 501(c)(3) may also receive all-important deductible contributions. To qualify as a tax exempt organization under 501(c)(3), an organization must be a corporation, community chest, fund or foundation. (6) It is not entirely clear whether an LLC that has elected to be taxed as an association taxable as a corporation will qualify as a corporation for purposes of 501(c)(3). The Internal Revenue Service appears, however, to interpret the statute to allow tax-exempt LLCs. There are currently least eleven organizations organized as LLCs that have qualified as a tax-exempt organization under 501(c)(3) and one that has qualified under 501(c)(7). (7) Exemptions for state income, sales, use, property and other taxes for nonprofit corporations and unincorporated associations are generally conditioned on federal tax exemption. As LLCs have become more common, some states have specifically included references to tax-exempt LLCs in some of their exemption statutes, with the state tax exemption generally conditioned on 501(c) tax exempt qualification. Some types of nonprofit tax-exempt organizations discussed supra that may benefit from the LLC form are those that would qualify under subsections of 501 other than 501(c)(3). The requirements to qualify for exemption under these other subsections of 501 are not quite as strict as those for 501(c)(3) organizations, and could probably be met as easily by an LLC as by a corporation. Conclusion: The Future for Nonprofit LLCs An LLC with the proper language in its articles of organization and operating agreement should be able to qualify for federal tax exemption. Moreover, in many circumstances, the LLC form may be a more preferable entity for operating a nonprofit organization than a corporation or trust. Accordingly, state legislatures should clarify whether or not nonprofit organizations are to be given the option to organize as LLCs. To provide that option effectively, many state LLC acts must be amended to some extent to resolve the ambiguities that currently exist. Although there seems to be general agreement that some change needs to be made, there are four differing approaches to the problem. One approach is to make only minor adjustments, primarily to amend the purposes provisions explicitly to allow nonprofit LLCs. Another strategy is to effect a major overhaul of the LLC acts to add alternative default provisions for nonprofit LLCs to create a sort of "hybrid" act. There is the approach the drafting and enactment a separate nonprofit LLC statute -- perhaps even a model or uniform act. Finally, there is the proposition that a nonprofit and not-for-profit LLCs should be allowed the opportunity to choose to organize under one of two available acts - a highly flexible "anylawful-purpose" LLC act under which any for-profit enterprise, nonprofit organization, or not-for-profit enterprise could organize, and a "paternalistic" nonprofit LLC act designed with default provisions geared toward small, less sophisticated tax-exempt organizations. A well-drafted and thoughtfully implemented nonprofit LLC act would serve a useful purpose. Individuals should be able to organize a nonprofit tax-exempt entity with a simple common-sense organizational and management structure without having to pay a high legal fee for a lawyer to draft around the square-peg/round-hole defaults of the current LLC acts as they would apply to a nonprofit tax-exempt organization. If separate nonprofit LLC acts are contemplated, however, it is vital that organizations be allowed the option of forming under the existing "any lawful purpose" LLC acts, so that larger, more sophisticated organizations and nonexempt not-for-profit enterprises (such as enterprises that, while not organized for a profit motive, may or may not make a profit) are not unduly restricted by a paternalistic nonprofit LLC act. Until state legislatures address the unresolved issues, the actual use of the LLC form by nonprofit organizations should

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Mayer & Riser, PLLC -- Nonprofit LLCs: Time for a New Experiment? (Revised 11/98)

be undertaken only after careful review of current law in the applicable jurisdictions, and only with the assistance of qualified counsel with experience in drafting complex and detailed operating agreements and experience in the law of tax-exempt organizations. For more information, contact Chris Riser at 828-526-3731. 1. Treas. Reg. 301.7701-3(b)(2)(i). 2. Those jurisdictions requiring an LLC to have a "business purpose" include California, The District of Columbia, Indiana, Iowa, Maryland, Minnesota, Montana, New York, North Carolina, North Dakota, Oregon, Pennsylvania, Rhode Island, Tennessee, Texas, and Virginia. 3. Del. Code Ann. 18-106(a). 4. However, increasing IRS emphasis on and scrutiny of the control of exempt organizations, examined supra in the discussion of Rev. Rul. 98-15 and related issues, may make this a moot point. 5. Treas. Reg. 301.7701-3(c)(1)(v)(A). 6. IRC 501(c)(3). 7. The tax-exempt status of each of the following LLCs has been confirmed with the Service's Exempt Organizations Division; except as noted, all are 501(c)(3) organizations: ABC Building Blocks Day Care LLC, of Conrad, Montana; American Youth Hostels-Hostelling International Metropolitan-SD LLC, of San Diego, California; Endeavor Resources LLC, of Shelton, Washington; Hudson Ranch LLC, of Pueblo, Colorado, Lifefitness LLC of Chattanooga, Tennessee; Moving Mountains, a Limited Liability Company, of Martinsburg, West Virginia; Northern Arizona Senior Living Community LLC, of Flagstaff, Arizona; Overcoming Ministries LLC, of Indianapolis, Indiana; Pioneers LLC of Washington, D.C., exempt under 501(c)(7); Wasatch International Adoptions LLC, of Ogden, Utah; and Wishing Well Center LLC, of New Castle, Delaware.
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