A tax-exempt LLC is a limited liability company that is exempt from paying federal income taxes. An LLC is a legal business formation owned by at least one owner, called a member.

Can a Limited Liability Company be a Tax-Exempt Organization?

Many business owners choose to form LLCs because they offer limited liability protection, which offers an advantage over other business types. Limited liability protection means that the LLC members are typically not responsible for any business obligations and debts beyond what they invested.

Although certain states don't allow for the formation of non-profit LLCs, business owners can form tax-exempt LLCs. Some people refer to tax-exempt LLCs as non-profit LLCs or non-profit limited liability companies. Some of the states that are exceptions to the non-profit LLC rule include:

  • Kentucky
  • Tennessee
  • Minnesota

A philanthropist may wonder whether they can form a non-profit LLC, also referred to as a 501(c)(3). The regulations from the IRS don't allow an LLC to have a direct tax-exempt status. One way around these regulations is to form a non-profit corporation, which then can wholly own an LLC. In the past, an organization had to be a foundation, fund, community chest, or corporation to qualify as an organization under Section 501(c)(3). A trust is a foundation or fund, so it would have qualified under the previous rules, but partnerships and individuals would not qualify.

An LLC has become one of the top choices among small business owners as they form their businesses, thanks to the ease of forming this type of entity. However, an LLC is not a separate taxable entity under IRS regulations. A single-member LLC is treated as a sole proprietorship by default, which means the owner must report all business income on Schedule C of their personal income tax return. Single-member LLCs are treated as disregarded entities, which means they don't exist as separate entities from their members.

If an LLC is owned by at least two people, it is treated as a partnership by default. All business income must be reported by the members on IRS Form 1065. The legal structure of the LLC requires that all losses, gains, expenses, income, and other tax attributes will pass through the business to the members. Those amounts must be reported by each member on their personal tax return.

Corporation Taxation

Although an LLC isn't a legal corporation, the members of an LLC can elect for taxation as a C corporation. This election is made by filing IRS Form 8832. After filing form 8832, the next step is filing IRS Form 2553 to elect for treatment as an S corporation. An LLC doesn't exist separately from its members unless it elects for taxation as a corporation. The IRS will not recognize it as a separate legal entity.

Membership Types and Options

When considering if a tax-exempt organization could be structured as an LLC, different membership types and scenarios may apply. One of the least complex scenarios is an LLC owned by a single person. The IRS would treat this LLC as a disregarded entity, which means the business could not be tax-exempt. Under Section 501(c)(3), an individual can't be an organization that is exempt from paying federal income taxes.

One of the more common scenarios involves an LLC with at least two individuals who own it. The IRS would treat this business structure as a partnership by default. Partnerships cannot operate as tax-exempt organizations, so a request for tax exemption would be denied.

If the members of an LLC elect for taxation as a corporation before applying for tax exemption, they might assume the request would be approved. A corporation is an acceptable business formation under Section 501(c)(3) for tax exemption.

However, this scenario still wouldn't allow for tax exemption because certain laws within the states provide members of an LLC with the rights to own business assets. The concern from the IRS is that non-exempt members of an LLC could distribute net earnings or use assets in ways that aren't exclusively charitable in nature. The IRS must ensure that every LLC operating under the tax-exempt status exists exclusively for purposes that qualify it for tax exemption.

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