Structuring your nonprofit: The differences between incorporation and LLC

In one way, starting a nonprofit business is very much like starting a regular for-profit business. You begin by picking the most appropriate business structure.

However, because a nonprofit has a different, nonprofit purpose, as compared to a for-profit organization, the steps to take to form a nonprofit are different from those required for starting up a for-profit business.

Corporation vs. LLC

If you've spent time researching the LLC vs. corporation (or LLC vs. inc.) issue, it may have occurred to you that an LLC, in many ways, appears to be an ideal business structure for the nonprofit organization, particularly a smaller one.

For example, an LLC offers a great deal of flexibility when it comes to management of the company, while a corporate structure comes with a set of more rigid requirements.

Within an LLC, company management can be structured so that members can be managers, directors, or officers—or whatever combination of roles would best aid their function within the organization. And while formalities such as meetings and minutes are always recommended, the LLC can choose to forgo such formalities, as they are not required.

Yet when most people think about a nonprofit company, they think of a nonprofit corporation, rather than a nonprofit LLC. Indeed, it's true that many nonprofits choose the incorporation route. However, more and more these days, when people start a nonprofit, they begin by exploring the potential of using an LLC as their business structure. This is due, in part, to the continually evolving use of the LLC within the world of nonprofits.

The nonprofit corporation

The nonprofit corporation is the traditional business structure among nonprofit organizations, and as such, it is also the most common. Nonprofit corporations are formed under state law, and as a result, are subject to state rules and regulations after their formation.

Requirements may include the election of a board of directors and the drafting of corporate bylaws. In addition, compliance with a number of internal formalities is typically required, such as holding meetings and recording minutes.

After incorporating, many nonprofit organizations also apply to the IRS for recognition of tax exemption under section 501(c)(3), also known as 501(c)(3) status.

The nonprofit LLC

While an LLC may seem like the better business structure for the new nonprofit, there are a number of factors that require careful consideration.

State law

An LLC is a creature of state law, and as such must comply with state rules and regulations.

One of the most important provisions is that of an LLC's purpose. While some states directly provide for a nonprofit or not-for-profit purpose, others require a lawful purpose, and still others stipulate that an LLC must have a business purpose. It is this latter stipulation that may be problematic and presents an obstacle for a nonprofit wishing to establish itself as an LLC.

Other provisions in state LLC laws may also be problematic for the nonprofit, particularly the nonprofit that intends to seek federal tax exemption as a 501(c)(3) organization. Such state LLC rules serve as default rules: Where an LLC's operating agreement is silent concerning an issue, these rules step in to provide governance. Because of this, care must be taken in the drafting of the LLC's operating agreement to make sure the LLC adheres to federal 501(c)(3) requirements.

Federal law

Once a nonprofit has passed any hurdles presented by state LLC regulations, there is still the matter of applying for 501(c)(3) status. Under federal tax laws, an LLC may be recognized as tax-exempt under the following circumstances:

• It is owned by a sole member that is a 501(c)(3) organization. In this case the LLC serves as a disregarded entity and its income flows through to its tax-exempt sole member.
• It is owned by two or more members that are all 501(c)(3) organizations. In this case, the LLC functions as a partnership, and is considered a pass-through entity, with income flowing through to its tax-exempt members.
• It files IRS Form 1023 to apply for recognition of exemption under section 501(c)(3). It's important to note the requirements imposed on an LLC filing Form 1023, as stated on the IRS website:
  • "A limited liability company that files Form 1023 is treated as a corporation rather than a partnership. As a corporation, it may file Form 1023. Note, however, that a limited liability company should not file an exemption application if it wants to be treated as a disregarded entity by its tax-exempt parent. The IRS will only recognize a limited liability company under section 501(c)(3) if all its members are section 501(c)(3) organizations."
  • Therefore, a nonprofit LLC that chooses to file Form 1023 is effectively electing to be treated as a corporation rather than a partnership. It will also only be recognized under section 501(c)(3) if all of its members also have 501(c)(3) status.

Hybrid LLCs

As mentioned earlier, the use of LLCs within the nonprofit world continues to evolve, as it's generally recognized that the LLC structure can be a particularly appropriate business structure for the smaller nonprofit, of which there are many.

As a result, a number of states have created various hybrid structures. One example is the low-profit LLC, also known as an L3C. The L3C, which is offered in a handful of states, is structured like an LLC, but is also required to have a socially beneficial purpose.

When considering the choice of business structure for a startup nonprofit, you may also want to research the various hybrid forms that may be available to you.