LLC vs Nonprofit: Key Differences and Legal Considerations

Key Takeaways:

• An LLC is typically chosen for profit-generating ventures, whereas a nonprofit serves a charitable, educational, or public purpose.
• Nonprofits can obtain tax-exempt status under IRS 501(c)(3), while LLCs cannot unless structured as a disregarded entity under a nonprofit.
• Nonprofits face stricter regulatory requirements and must reinvest all earnings, while LLCs offer more operational flexibility and profit distribution.
• Funding sources differ: nonprofits rely on donations, grants, and fundraising, whereas LLCs depend on revenue, loans, and investors.
• Personal liability protection is available in both structures, but nonprofits often receive broader tax advantages, including property and sales tax exemptions.
• Choosing between an LLC and a nonprofit requires understanding long-term goals, funding strategies, and compliance obligations.
• Legal guidance can streamline the formation process and ensure compliance—attorneys on UpCounsel can assist with structuring decisions.

Should a nonprofit be an LLC or a corporation? Sometimes business owners have this question when deciding what form the business should take. Many factors can influence that choice, but you should undoubtedly have consideration of two business aspects in particular. Clearly define your business activities and identify potential funding sources for your venture.

An LLC might be an appropriate business form if you plan to:

• Participate in regular commerce.
• Facilitate profit payouts.
• Cultivate investment.

A nonprofit structure might be a better form for your business if you seek to:

• Solicit donations from others.
• Partake in charitable activities.

To simplify the terms defining nonprofits or LLCs by looking at business intent, you can say a nonprofit wants to serve the public with its business offerings. Members of an LLC wish to generate profit through business efforts.

What Does It Mean to Be Tax-Exempt?

Aside from the differences in business nature and ways of funding with an LLC versus a nonprofit, the most significant difference between the two forms is that it can only be possible for a nonprofit corporation to get recognized as a 501(c)(3) tax-exempt entity. The IRS gives a nonprofit organization this classification due to its charitable existence, which excuses the business from having to pay income taxes.

To qualify for tax exemption, an organization must be legally recognized as a nonprofit entity by the IRS. An LLC might engage in different charitable activities, but since it operates as a regular business, it is not eligible for tax-exempt status.

For liability protection, a nonprofit corporation benefits from the same lawful security as an LLC and a regular corporation. Just like those working at the for-profit companies, the employees, directors, members, and trustees of a nonprofit share no liabilities or responsibilities for the debts of the business.

Incorporating as a nonprofit offers the organization considerable advantages in state and federal taxation. Some kinds of tax exemptions that nonprofit corporations are eligible for do not get presented to an LLC. However, a limited liability company does not have limits placed on its political speech or company spending like those imposed on nonprofit corporations.

When forming a nonprofit organization, a specified charitable purpose must be established. Then, it is up to the nonprofit to uphold that same purpose each year it remains in existence.

Tax-Exempt Purposes and Eligible Activities

Nonprofit organizations must operate exclusively for tax-exempt purposes as defined by the IRS, such as charitable, religious, educational, scientific, or literary causes. Some key examples include:

• Supporting underprivileged communities through aid programs.
• Conducting educational workshops or providing free resources.
• Promoting environmental conservation efforts.
• Advancing medical research or funding healthcare for vulnerable groups.

Engaging in significant for-profit business activities can jeopardize tax-exempt status. While nonprofits can earn revenue from unrelated business activities, income from such ventures may be subject to Unrelated Business Income Tax (UBIT). Structuring operations to align with the nonprofit’s mission is essential to maintaining tax-exempt recognition.

Does Having Members as Owners Prevent LLCs From Tax Exemption?

Different from a non-stock corporation that has no stockholders, LLCs do not qualify to get a nonprofit, tax-exempt determination because its members are also the owners. 

An LLC can hold assets of a nonprofit corporation by becoming a qualified subsidiary of the nonprofit. The LLC becomes liquidated into the nonprofit entity, which becomes its only member. As a result, management of the limited liability company only does what its parent allows. 

The LLC's operating agreement would need to be changed to reflect how, as a qualified subsidiary, the LLC cannot go against the restrictions or bylaws of the corporation. Tax exemption comes at the cost to the LLC by relinquishing member-managed authority. 

Structuring an LLC for Philanthropic Purposes

Though traditional LLCs are profit-driven, it is possible to form a hybrid structure known as a Low-Profit Limited Liability Company (L3C) in certain states. This structure aims to bridge the gap between nonprofits and for-profits by focusing on social purposes while allowing for some profit distribution. Key features include:

• Primary goal must be a charitable or educational purpose.
• Profit generation must be secondary to the social mission.
• Eligible to receive Program-Related Investments (PRIs) from private foundations.

Additionally, an LLC can serve as a subsidiary of a nonprofit, as previously noted. This structure allows the nonprofit to conduct certain business activities while preserving tax-exempt status for the parent entity.

Benefits of Incorporating With Nonprofit Status

A corporation qualifies for nonprofit, tax-exempt determination when, by forming the business entity, at least one of the parties listed benefits from it:

• The membership of the nonprofit
• A particular group of people
• The public

All donations and funds must be tracked with careful attention. You must ensure that at no time any portion of the company's income gets handed to an individual or private shareholder. As a nonprofit, earnings cannot get distributed among shareholders, and no legally recognized ownership of the corporation should get offered to anybody.

It takes a significant amount of additional work to maintain, but when a corporation gets recognized by the state as having a charitable existence, the benefits earned should be worth the extra time and effort it takes. Some advantages of a nonprofit status include:

• Money donated is tax-free
• Personal assets protected from liability
• Exemption from property, sales, and income taxes
• Access to public and private grants given by federal government and private foundations
• Postage at low rates

Compliance and Governance Requirements

Nonprofit corporations are subject to strict compliance obligations to maintain their tax-exempt status. These include:

• Annual Filing: Submission of IRS Form 990 to disclose financials, program activities, and executive compensation.
• Board of Directors: Governance oversight typically requires a board composed of individuals with diverse, independent perspectives to prevent conflicts of interest.
• Record Keeping: Maintenance of accurate meeting minutes, bylaws, and financial records.
• Public Disclosure: Certain documents, like Form 1023 and Form 990, must be made available to the public upon request.

Failure to meet these requirements can lead to penalties, loss of tax-exempt status, or legal action. Working with a legal professional ensures that a nonprofit remains compliant.

Funding Opportunities for Nonprofits vs LLCs

The funding landscape for nonprofits and LLCs varies significantly:

1. Nonprofit Funding:
   • Grants: Available from government agencies, foundations, and corporations.
   • Donations: Individuals and businesses often contribute for tax deductions.
   • Fundraising: Events, crowdfunding, and sponsorships are common.
   • Membership Fees: Associations may charge for access to resources or networks.
2. LLC Funding:
   • Revenue: Primary funding source from selling products or services.
   • Investors: Equity partners invest in exchange for ownership shares.
   • Loans: Bank loans, lines of credit, and alternative lending options.
   • Venture Capital: Suitable for startups with high growth potential.

Understanding these distinctions is vital when evaluating the viability of an LLC vs nonprofit for your business goals.

Flexibility in Operations and Decision-Making

LLCs offer operational flexibility, enabling members to manage the business directly or designate managers. Key advantages include:

• Fewer Formalities: No mandatory board meetings, bylaws, or public filings.
• Profit Distribution: Members can split profits based on their agreements, not ownership percentages.
• Business Pivoting: Easier to change business models or pursue new opportunities.

In contrast, nonprofits operate under structured governance:

• Decisions often require board approval.
• Compensation must align with industry standards to avoid excess benefit issues.
• Revenue must be reinvested into the organization’s mission.

Entrepreneurs seeking autonomy may favor an LLC, while mission-focused leaders may find the nonprofit structure better aligns with their goals.

Frequently Asked Questions:

1. Can an LLC convert into a nonprofit later?
   • Yes, but it involves legal filings, IRS approval, and restructuring to meet nonprofit requirements.
2. Is it possible to pay employees in a nonprofit?
   • Absolutely. Nonprofits can pay reasonable salaries, but profits cannot be distributed to individuals.
3. What is an L3C, and how does it differ from a nonprofit?
   • An L3C is a hybrid structure combining profit-making with a social mission, but it does not qualify for IRS 501(c)(3) status.
4. Can a nonprofit own an LLC?
   • Yes, a nonprofit can create or own an LLC as a subsidiary to generate revenue while safeguarding tax-exempt status.
5. How do I know if LLC vs nonprofit is right for me?
   • Evaluate your mission, funding needs, tax considerations, and desired operational flexibility. Consulting an attorney through UpCounsel can provide personalized guidance.

If you need help with knowing when should a nonprofit be an LLC or corporation, you can post your legal need in UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.