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Limited Liability Companies as Exempt Organizations By Bradley T. Borden, Associate Professor of Law Washburn University School of Law, Topeka, KS. This commentary is derived largely from Borden, Real Estate Transactions by Tax-Exempt Entities, 591 T.M./883 T.M. The use of limited liability companies and exempt organizations has exploded over recent years. The combination of the two types of entities raises tax issues that deserves close attention. In particular, limited liability companies raise three issues in the exempt organization context. First, can a limited liability company be disregarded if it is owned by an exempt organization? Second, can a limited liability company be an exempt organization? Third, do contributions to disregarded limited liability companies wholly owned by exempt organizations qualify for the §170 charitable contribution deduction? IRS attorneys have addressed each of these issues,1 and the IRS has published a reference guide sheet in the Internal Revenue Manual to help process requests for information and exemption applications.2 These limited materials provide informal guidance about the position of the IRS regarding limited liability companies as exempt organizations. Disregarded Limited Liability Companies The regulations provide that a single-member limited liability company is disregarded for tax purposes.3 Further, IRS attorneys have stated that exempt organizations may be the sole members of limited liability companies that are disregarded for federal tax purposes.4 The exempt owner of a disregarded limited liability company must, however, treat the operations and finances of the limited liability company as its own.5 Furthermore, the §508 notice requirements apply to a disregarded entity in the same manner that they apply to a subordinate in a group exemption.6 The IRS does not require a disregarded entity's articles of organization to satisfy the §501(c)(3) organizational test, but nothing in the articles should prohibit the limited liability company from operating exclusively for exempt purposes.7 Thus, the disregarded entity's articles may allow the entity to operate “for all purposes for which limited liability companies may be operated” and provide that “the remaining assets upon dissolution are to be distributed to the members of the limited liability company.” Such provisions do not prohibit the limited liability company from operating exclusively for exempt purposes because any distributions will be to the disregarded entity's exempt parent. However, if the articles of the disregarded entity do not satisfy the §501(c)(3) organizational test, the IRS will likely closely scrutinize the past and planned, future activities of the disregarded entity to ensure the entire entity complies with the organizational test. For employment tax purposes, the disregarded entity should be recognized under Regs. §301.7701-2(c)(iv) with respect to wages paid after January 1, 2009.8 Thus, the disregarded entity will be liable for the employment taxes of its employees, and the single-member exempt organization should not be directly liable for the taxes. Although the law appears to require the IRS to disregard an exempt organization's single-member limited liability company, the IRS will likely obtain and review the governing documents and information regarding a disregarded entity in considering an application for exemption.9 In considering the application, the IRS will not disregard the activities of the disregarded entity. The operations of a disregarded entity may give rise to exemption problems, unrelated business income taxes, or excise taxes for the owner of the disregarded entity. Conditions for Limited Liability Company §501(c)(3) Exemption The IRS considers 12 conditions in determining whether it will recognize the §501(c)(3) exemption of a limited liability company.10 1. The organizational documents must include a specific statement limiting the limited liability company's activities to one or more exempt purposes. The members of the limited liability company can satisfy this requirement by including language in the activities and purposes clauses of the organizational documents that complies with the §501(c)(3) organizational test. Language such as the following should be sufficient to satisfy the purpose: “The company is organized exclusively for exempt purposes under §501(c)(3) of the Internal Revenue Code” or “The company may not carry on activities not permitted to be carried on by an organization described in §501(c)(3).” The members of the limited liability company should take care to ensure that such language is included because the IRS attorneys claim that they may not rely upon cy pres to meet the requirement.11 2. The organizational language must state that the limited liability company is operated exclusively for the charitable purposes of its members. 3. The organizational language must require that the limited liability company's members be §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 §501(c)(3) organization or government unit or instrumentality. In stating this condition, the IRS attorneys express concern about state laws that provide members of limited liability companies with ownership rights in the assets of the limited liability company. The granting of ownership rights in the assets of a limited liability company may result in inurement problems if non-exempt organizations are members of the limited liability company. As a result, to be exempt, a limited liability company cannot have private shareholders or individuals as members. Furthermore, the limited liability company's organizational documents must state that the purpose of the entity is to further the charitable purposes of the member entities. Because the mere presence of only exempt-organization members does not guarantee that the limited liability company will operate solely for exempt purposes, the members must ensure that the activities of the limited liability company are exclusively for charitable purposes.12 5. The organizational language must state that the limited liability company, interests in the limited liability company (other than a membership interest), or the company's assets may only be availed of or transferred to (whether directly or indirectly) any nonmember other than a §501(c)(3) organization or governmental unit or instrumentality in exchange for fair market value. 6. The organizational language must ensure that, upon dissolution of the limited liability company, the assets devoted to the limited liability company's charitable purposes will continue to be devoted to charitable purposes. Members of the limited liability company can ensure that they have satisfied this requirement with a standard dissolution clause that satisfies the §501(c)(3) organizational test. Such clause may provide, “Upon dissolution, all assets remaining after the payment of liabilities shall be distributed exclusively to exempt organizations or for exempt purposes under §501(c)(3).” The cy pres doctrine will not help taxpayers satisfy this requirement. 7. The organizational language must require that any amendments to the limited liability company's articles of organization or operating agreement be consistent with §501(c)(3). 8. The organizational language must prohibit the limited liability company from merging with, or converting into, a for-profit entity. This condition prevents limited liability companies from flipping between exempt and nonexempt status. 9. The organizational language must require that the limited liability company not distribute any assets to members that cease to be organizations described in §501(c)(3) or governmental units or instrumentalities. 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 §501(c)(3) or a governmental unit or instrumentality. An acceptable contingency plan may provide that the nonexempt member will forfeit its interest, or sell its interest to another §501(c)(3) organization or governmental unit or instrumentality. The contingency plan cannot provide that the limited liability company will distribute its assets to the nonexempt member. The plan should, however, ensure that the nonexempt member's interest is fully terminated within a reasonable time after the member loses its exemption. 11. The organizational language must state that the limited liability company's exempt members will expeditiously and vigorously enforce all of their rights in the limited liability company and will pursue all legal and equitable remedies to protect their interests in the limited liability company. 12. The limited liability company must represent that all of its organizational document provisions are consistent with state limited liability company laws and are enforceable at law and in equity. State laws lack conformity concerning whether the articles of organization or the operating agreement controls in the case of a conflict between the two documents. Thus, the IRS will require that both sets of documents satisfy the first eleven conditions. If the laws of a state prohibit including such provisions in the articles of organization, the operating agreement must include the required provisions.13 Contributions to Disregarded Entities IRS attorneys have indicated that they are uncertain whether contributions to disregarded entities are deductible. If the disregarded entity is not treated for §170 purposes as part of the single member exempt organization, then the disregarded entity must qualify in its own right under §170(c) or it must qualify as an agent of the exempt owner.14 As the use of limited liability companies continues to grow, more exempt organizations will undoubtedly form them either alone or with other exempt organizations. Tax advisors must be aware of the requirements the IRS imposes upon limited liability companies used by exempt organizations. This brief summary introduces advisors to those issues. For more information, in the Tax Management Portfolios, see Kaster, 591 T.M., Real Estate Transactions by Tax-Exempt Entities, and in Tax Practice Series, see ¶6510, Charitable Organizations. 1 See Richard A. McCray & Ward L. Thomas, Limited Liability Companies as Exempt Organizations--Update, Exempt Organizations Technical Instruction Program for FY 2001, 27-33, available at http://www.irs.gov/pub/irs-tege/eotopicb01.pdf (referred to hereinafter as “McCray & Thomas”). 2 Internal Revenue Manual, Part 7.20.4, Exhibit 7.20.4-12 (12-05-2006) (referred to hereinafter as “Internal Revenue Manual”). 3 See Regs. §301.7701-3(b)(1). 4 See McCray & Thomas at 27. 5 Ann. 99-102, 1999-2 I.R.B. 545. 6 See Rev. Rul. 90-100, 1990-2 C.B. 156, situation 3. 7 See McCray & Thomas at 28. 8 See Regs. §301.7701-2(e)(5). 9 See McCray & Thomas at 29. 10 The 12 conditions appear in McCray & Thomas at 29-32, and generally apply to limited liability companies that are not disregarded entities. As reproduced herein, the text uses “limited liability company” instead of “LLC” used in the original text. Otherwise, this Commentary restates the conditions verbatim. 11 See McCray & Thomas at 29-30 and Internal Revenue Manual. 12 See Rev. Rul. 72-369, 1972-2 C.B. 245 (ruling that an organization formed to provide managerial and consulting services to other exempt organizations is not exempt under §501(c)(3)); Rev. Rul. 71-529, 1971-2 C.B. 234 (ruling that an organization controlled by §501(c)(3) organizations may provide services to the members of the organization at below market rates without losing exempt status). 13 See McCray & Thomas, 32. 14 See McCray & Thomas, 28.

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