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ABA Tax Section Members Comment on LLC Exemption Standards

MAR. 3, 2022

ABA Tax Section Members Comment on LLC Exemption Standards

DATED MAR. 3, 2022
DOCUMENT ATTRIBUTES

March 3, 2022

Hon. Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments on Notice 2021-56

Dear Commissioner Rettig:

Enclosed please find comments on Notice 2021-56 with respect to the standards for Section 501(c)(3) status of limited liability companies. These comments are submitted on behalf of the Section of Taxation and have not been reviewed or approved by the House of Delegates or the Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

The Section of Taxation would be pleased to discuss these comments with you or your staff.

Sincerely,

Julie A. Divola
Chair, Section of Taxation
American Bar Association
Washington, DC

Enclosure

cc:
Hon. Lily Batchelder, Assistant Secretary (Tax Policy), Department of the Treasury
Mark Mazur, Deputy Assistant Secretary (Tax Policy), Department of the Treasury
Krishna P. Vallabhaneni, Tax Legislative Counsel, Department of the Treasury
Amber Mackenzie, Attorney Advisor, Office of Tax Policy, Department of the Treasury
William M. Paul, Principal Deputy Chief Counsel and Deputy Chief Counsel (Technical), Internal Revenue Service
Rachel Leiser Levy, Associate Chief Counsel, Employee Benefits, Exempt Organizations, and Employment Taxes, Internal Revenue Service
Christopher A. Hyde, Attorney, Office of Associate Chief Counsel (Employee Benefits, Exempt Organizations, and Employment Taxes), Internal Revenue Service
Ward L. Thomas, Tax Law Specialist, Office of Associate Chief Counsel (Employee Benefits, Exempt Organizations, and Employment Taxes), Internal Revenue Service


AMERICAN BAR ASSOCIATION
SECTION OF TAXATION

COMMENTS ON NOTICE 2021-56, STANDARDS FOR SECTION
501(c)(3) STATUS OF LIMITED LIABILITY COMPANIES

These comments (“Comments”) are submitted on behalf of the American Bar Association Section of Taxation (the “Section”) and have not been approved or reviewed by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

Principal responsibility for preparing these Comments was exercised by Steven Chiodini, Kelly L. Hellmuth, Katherine T. LaBeau, and Maura L. Whelan. Substantial contributions were made by Jeffrey A. Slavin, J. Leigh Griffith, Jon Gaston, Janet Goelz Hoffman, and Robert Keatinge. These Comments have been reviewed by Rosemary E. Fei, Chair of the Exempt Organizations Committee, Ellen P. Aprill of the Committee on Government Submissions, and Kurt Lawson, Vice-Chair for Government Relations for the Tax Section.

Although members of the Section may have clients who might be affected by the federal tax principles addressed by these Comments, no member who has been engaged by a client (or who is a member of a firm or other organization that has been engaged by a client) to make a government submission with respect to, or otherwise to influence the development or outcome of one or more specific issues addressed by, these Comments has participated in the preparation of a portion (or portions) of these Comments addressing those issues. Additionally, while the Section's diverse membership includes government officials, no such official was involved in any part of the drafting or review of these Comments.

Contact: Rosemary E. Fei
(415) 421-7555
rfei@adlercolvin.com

Date: March 3, 2022


Table of Contents

EXECUTIVE SUMMARY

A. Recommendations Regarding Section 501(c)(3) Exemption Standards for LLCs

B. Background Information and Additional Considerations

DISCUSSION

I. Potential Advantages and Disadvantages to Using an LLC Form for a Section 501(c)(3) Charity

A. Background

B. Explanation

II. Applicability of State Laws Regulating Charitable Assets

A. Background

B. Explanation

III. State Law LLC Purposes

A. Background

B. Explanation

IV. Satisfaction of the Organizational Test

A. Background

B. Recommendations

C. Explanations

1. Revision of Treasury Regulations

2. Distribution of Assets Upon Dissolution

3. Public Availability of Operating Agreement

4. Additional Governing Document Provisions

V. State Nonprofit LLC Laws

A. Background

B. Explanation

VI. Treatment of Member-Managed LLCs and Manager-Managed LLCs

A. Background

B. Recommendations

C. Explanations

1. Manager-managed LLCs

2. Member-managed LLCs

VII. Treatment of LLC Managers as Officers

A. Background

B. Recommendation and Explanation

C. Explanation

VIII. Non-501(c)(3) Members

A. Background

B. Recommendation

C. Explanation

IX. Tax-Exempt Status for Other Section 501(c) LLCs

A. Background

B. Recommendation

C. Explanation


EXECUTIVE SUMMARY

On October 21, 2021, the U.S. Department of the Treasury (“ Treasury”) and the Internal Revenue Service (the “Service”) published Notice 2021-56 (the “ Notice”).1 The Notice sets forth the standards for a limited liability company (“LLC”) to receive a determination letter recognizing it as tax-exempt under section 501(a) and described in section 501(c)(3).2 It requests public comments on these standards as well as specific issues relating to tax-exempt status for LLCs to assist Treasury and the Service in determining whether additional guidance is needed concerning the standards that an LLC must satisfy to be exempt from taxation by reason of being described in section 501(c).

We commend Treasury and the Service for providing the guidance set forth in the Notice, which we believe is timely and will provide necessary clarity to the section 501(c)(3) sector as tax-exempt entities explore alternative organizational forms. Our Comments include recommendations and background information as well as areas for further consideration.

A. Recommendations Regarding Section 501(c)(3) Exemption Standards for LLCs

1. We generally support the exemption standards set forth in the Notice for LLCs with multiple members. We believe the fundamental standards for exemption should apply equally, regardless of entity form or organizing jurisdiction, with minimal accommodations made for the LLC as a unique organizational form. We recommend the following limited accommodations for LLCs seeking section 501(c)(3) tax exemption:

a. To permit an LLC formed under a state LLC law that prohibits the addition of provisions to articles of organization to be deemed to satisfy the organizational test if the LLC's operating agreement includes the provisions set forth in Section 3.02 of the Notice and if the articles of organization and operating agreement do not include any inconsistent provisions.

b. To permit an LLC with members that are not section 501(c)(3) organizations (“non-501(c)(3) members”) to qualify for section 501(c)(3) status only in limited circumstances when each of the following conditions are met to the Service's satisfaction: (i) the laws of the state under which the LLC was formed allow it to have members that are not entitled to a financial interest and its articles of organization or operating agreement (for LLCs formed under state law that prohibits the addition of provisions to articles of organization) prohibit any non-501(c)(3) member from having an equity interest; (ii) the laws of the state under which the entity was formed allow modification of any default statutory fiduciary duties that would be owed by LLC members and managers to non-501(c)(3) members; (iii) the modification of fiduciary duties permits the entity to comply with the operational requirements of section 501(c)(3) status in a legally enforceable manner; (iv) the applicant is otherwise able to satisfy the organizational and operational requirements; and, (v) as required by Section 3.03 of the Notice, the applicant represents to the Service in its exemption application under penalty of perjury that all provisions in its articles of organization and operating agreement are consistent with applicable state LLC law and are legally enforceable.

2. We recommend that, with respect to the qualifications for section 501(c)(3) status, LLCs managed by managers generally be treated the same as LLCs managed by members.

3. We recommend that, where the federal tax law imposes specific requirements with respect to the governing body of an organization for purposes of qualifying as an exempt organization described in section 501(c)(3): (i) for manager-managed LLCs, the manager(s) comprise the governing body; (ii) for member-managed LLCs with a single member that is an organization, the governing body of the sole member be considered the governing body of the LLC; and (iii) for member-managed LLCs with two or more members that are organizations, the governing body of the LLC be deemed to meet such requirements only if the governing body of each member of the LLC meets such requirements, and otherwise, the governing body of the LLC be considered to be the group of members.

4. We recommend presumptive treatment of LLC managers as directors, rather than officers, for federal exempt organization purposes, including for purposes of the compliance provisions of chapter 42, unless the facts and circumstances clearly indicate that managers instead have the authority or responsibility equivalent to officers, or equivalent to neither officers nor directors.

5. We recommend that Treasury and the Service issue guidance permitting an LLC to seek recognition as, or self-attest to, tax-exempt status under a paragraph of section 501(c) other than section 501(c)(3), so long as the LLC can otherwise satisfy all the existing federal tax law requirements applicable to that status.

B. Background Information and Additional Considerations

Our Comments provide information requested by the Notice and make suggestions for the Service's consideration on the following topics:

  • The potential advantages and disadvantages of forming an entity for exclusively charitable purposes under a state LLC law rather than under a state not-for-profit (or non-stock) corporation or charitable trust law.

  • The extent to which state laws regulating charitable assets apply to assets held by charitable LLCs to the same degree as such laws apply to assets held by trusts or state-law corporations formed for charitable purposes.

  • Whether it is permissible as a matter of state law for an LLC to be formed for exclusively charitable purposes under a state statute that appears to require an LLC to be a profit-seeking organization.

  • Whether, in states that have enacted special statutory provisions for nonprofit LLCs, a charitable LLC must form under the state's nonprofit LLC law or if it would be permitted to form under the state's general LLC law.

We appreciate the opportunity to make these recommendations concerning the Notice and we would be pleased to discuss our Comments.

DISCUSSION

I. Potential Advantages and Disadvantages to Using an LLC Form for a Section 501(c)(3) Charity

A. Background

The Notice solicits comments on the potential advantages and disadvantages of forming an entity for exclusively charitable purposes under a state LLC law rather than under a state not-for-profit (or non-stock) corporation or charitable trust law.3 We recommend examining the consequences of choosing to form a charitable entity under a state LLC law rather than the advantages and disadvantages, since any given consequence of such a decision could be either an advantage or a disadvantage (or neither) depending on the perspective and goals at issue. By examining the consequences, it also becomes clear why nonprofits sometimes find state LLC laws more appealing depending on their needs and circumstances.

The chief consequences of selecting a multiple member LLC structure over a nonprofit corporation or a charitable trust for a section 501(c)(3) organization fall into two general categories:

  • Economic: Unlike the voting members of a charitable corporation or the trustees of a charitable trust, the LLC members could be equity owners of the entity, potentially with rights to distributions from the company and to a portion of its assets; and

  • Structural: As LLCs are “primarily creatures of contract,”4 an LLC's organizers would have far greater freedom in structuring the entity than if they used a corporation or a trust.

Our present response here will focus on structural consequences as they pertain to governance. Our comments infra address economic implications.

B. Explanation

A corporation presents organizers of a section 501(c)(3) charity with a relatively constrained set of governance options. A nonprofit corporation, like its for-profit stock-corporation cousin, must have a board of directors. By law, this board can be selected in only a limited number of ways: by action of the board itself, by the vote of nonprofit “members,” ex officio by virtue of a person holding a specified outside office, or, in some states, by an act of designation by a specific person. Corporation statutes typically provide detailed governance standards, both default and mandatory. They delineate everything from the length of terms to which directors may be elected, to how director and member meetings are to be noticed and conducted, to which officer positions are required and who may fill them, to the procedures and regulatory notice or consent protocols required for corporate mergers, dissolutions, and transfers of substantially all the corporation's assets. If there are voting members, they may have unwaivable statutory rights, with statutorily mandated due process rights on removal. In addition, nonprofit corporation statutes often expressly provide a special oversight and enforcement role for state charity regulators in corporate affairs. For example, a statute might give a regulator standing to challenge director self-dealing transactions or require the consent of a charity regulator before certain major corporate changes such as mergers or dissolutions may be consummated.

A charitable trust may offer more governance flexibility than a nonprofit corporation in certain respects, and less flexibility in others. On the one hand, unlike most nonprofit corporation laws, trust law typically provides little in the way of procedural default rules for governance. As a result, there may be a wide degree of freedom in, for example, setting the terms under which trustees can be removed, establishing an officer structure under the oversight of trustees, or designing more minute protocols, such as notice and conduct requirements for trustee meetings. On the other hand, the default rules for trusts that do exist can be particularly stringent, such as requiring unanimous consent for trustees to take action,5 or restricting the ability of trustees to delegate their duties. Since it may be difficult to amend a trust instrument without the consent of the initial settlor (unless the instrument provides otherwise), a failure to opt out of these defaults in drafting the document may hamstring governance permanently, or at least until a court agrees to a modification.

An LLC structure offers far greater flexibility in structuring governance than either a nonprofit corporation or a charitable trust. First and foremost, an LLC can be either member-managed or manager-managed. In a multiple member context, member-management often resembles governance of a general partnership with members taking a more or less active role in running the organization and conducting its day-to-day operations. Each member can be given responsibility for a specific part of the LLC's activities, or the members can have collective responsibility for governing the LLC (or both). In a manager-managed structure, the members usually have more or less passive roles and delegate governance under the operating agreement to one or more managers. As such, managers in an LLC may tend to bear more resemblance, at least superficially, to directors in a traditional nonprofit corporation or the trustees of a charitable trust. Within these general categories, an LLC's organizers have a relatively vast degree of freedom in constructing the entity's governance mechanisms and protocols as they desire. Moreover, since LLC statutes are almost universally geared towards business enterprises, even if they do permit an LLC to pursue nonprofit purposes, a charitable LLC will not have the same mandated degree of regulatory involvement in its internal affairs that corporate law requires in many states.6 In and by itself, the relative structural freedoms described above may not present significant concerns for qualifying a charitable LLC under section 501(c)(3).

Nonprofit corporation statutes typically describe mandatory fiduciary duties for nonprofit directors, generally a duty of care or prudence and a duty of loyalty to the corporation itself.7 The fiduciary duties of charitable trustees under modern trust law are similar, although trust laws may enumerate trustee fiduciary duties in more detail, and in some instances, charitable trustees may be held to somewhat stricter default standards.8 Most LLC statutes describe default fiduciary duties of care and loyalty that are familiar in concept from the corporate and trust contexts. (Notably, Delaware's unique LLC statute does not describe the fiduciary duties owed in an LLC, instead referencing duties that may arise under law or equity.9 ) The duties owed in an LLC context are fundamentally different, however, in that they are by default owed to the members as well as to the LLC itself.10 Additionally, many LLC statutes permit the waiver or even elimination of default fiduciary duties. For example, under the RULLCA, both the duty of loyalty and the duty of care, whether held by a member or a manager, may be modified or eliminated, provided that doing so is not manifestly unreasonable and that a member's contractual obligation to act in good faith and with fair dealing is not waived.11 Delaware's frequently used Limited Liability Company Act goes even farther, allowing unconditional modification or waiver of any member fiduciary duties imposed by default under law or equity.12

The ability of an LLC to waive fiduciary duties raises possible concerns. While waiver of fiduciary duties owed to LLC members may be of little if any concern if all the members are section 501(c)(3) organizations themselves, the ability to modify or even eliminate fiduciary duties in an LLC may well pose concerns when non-501(c)(3) members are involved. For instance, it is difficult to see how the Service's stated desire for good charity governance13 could be met in a manager-managed charitable LLC where certain managers owed a fiduciary duty of loyalty only to the non-501(c)(3) members that appointed them. Although other aspects of state law are likely to impose at least some requirements on an LLC stewarding assets dedicated to charitable purposes,14 the potential for legally enforceable fiduciary duties that privilege private interests seems fundamentally at odds with the section 501(c)(3) requirements. In Part VIII of these Comments, we propose a recommendation for limited circumstances in which we believe it would be reasonable for the Service to permit LLC applicants with non-501(c)(3) members to qualify for section 501(c)(3) tax exempt status.

II. Applicability of State Laws Regulating Charitable Assets

A. Background

The Notice seeks input on whether state laws regulating charitable assets apply to assets held by charitable LLCs to the same degree as such laws apply to assets held by trusts or nonprofit corporations formed for charitable purposes.15 While we defer to the state attorneys general to interpret the scope of their authority over charities in their states, we are not aware of any limitation that would prevent attorneys general from exercising the same oversight over nonprofit LLCs as they do over nonprofit corporations, charitable trusts, and unincorporated nonprofit associations in their states.

Attorneys general have a broad range of specific authorities over nonprofit organizations operating in their states.16 For purposes of these Comments, we focus on the role of attorneys general in exercising general supervisory authority over charitable assets and charitable solicitation registration.

B. Explanation

The statutory supervisory authority that attorneys general possess over charities operating in their states varies, but at least 37 states have adopted statutes that provide the attorney general with some statutory oversight role.17 For example, the ABA's Revised Model Nonprofit Corporation Act gives attorneys general the power to stop ultra vires acts, remove directors, prevent conflicts of interests, appoint receivers, and even dissolve a nonprofit corporation.18 It also requires nonprofit corporations to notify the attorney general prior to significant events such as dissolution, merger, or sale of assets, and gives attorneys general standing to bring actions related to nonprofit governance and the misuse of charitable assets.19 At least four states with LLC statutes designed specifically for nonprofit LLCs have also explicitly provided the state attorney general with supervisory authority over nonprofit LLCs.20 Additionally, the Uniform Law Commission's Model Protection of Charitable Assets Act gives attorneys general oversight authority over all charitable assets held within a state, regardless of the vehicle in which the assets were held.21 Its Prefatory Note suggests that the goal of the Model Protection of Charitable Assets Act is to codify the authority already held by attorneys general over charitable assets in their states: “The goal of this Act is to acknowledge and protect the role of the states with respect to charitable assets, by clarifying the role of the state Attorney General.”22 Finally, in 41 states and the District of Columbia, a state regulator also exercises regulatory oversight of charitable assets by imposing a registration and reporting requirement on charities that solicit charitable contributions.23

While the attorney general's oversight role with respect to nonprofit corporations is often articulated by statute, this is not the case in every state.24 Under common law attorneys general have had longstanding supervisory authority over assets held in charitable trusts.25 Attorneys general have also asserted authority over the charitable assets of unincorporated nonprofit associations in their states, even though the Uniform Unincorporated Nonprofit Association Act does not includes a provision outlining the attorney general role with respect to the charitable assets of unincorporated associations.26 In the comments to the final draft of the Uniform Unincorporated Nonprofit Association Act, the drafters point out that attorneys general may have the authority to bring disgorgement claims in the event that unincorporated associations make unlawful distributions to members.27

As the Prefatory Note to the Model Protection of Charitable Assets Act explains, “the Attorney General may enforce the use of charitable assets for the purposes for which the assets were given; may take action to prevent or correct breach of fiduciary duty . . .; and may intervene in an action brought to correct a misapplication of charitable assets.”28 In fact, “[i]n most states only the attorney general has the power and standing to intervene and investigate misappropriations of charitable funds, breaches of fiduciary duty and self-dealing by directors, and fraud in charitable solicitations.”29 We are not aware of any precedent to suggest that the absence of express statutory jurisdiction over charitable assets held in an LLC would impede attorneys general from exercising their common law authority to intervene to protect those charitable assets. However, we acknowledge that attorneys general in states that do not have a statutory requirement for nonprofit LLCs to notify the attorney general prior to significant events such as dissolution, merger, or sale of assets, may have less visibility into the activities of nonprofit LLCs than nonprofit corporations or trusts that are subject to statutory notification obligations.

III. State Law LLC Purposes

A. Background

The Notice asks whether, in a state with an LLC statute that appears to require that an LLC be a profit-seeking enterprise, it would be permissible as a matter of state law for an LLC to be formed exclusively for 501(c)(3) purposes.30

B. Explanation

We believe that whether a “profit-seeking” LLC could form exclusively for charitable purposes under state law will be contingent upon the language of the particular state statute and how it is interpreted by state courts. The RULLCA permits an LLC to form for “any lawful purpose, regardless of whether for profit,”31 and some variation of this purpose language has been adopted in 24 states.32

For example, the Rhode Island Limited Liability Company Act allows an LLC to form for “any lawful business,” with “business” defined as “any trade, occupation or other commercial activity engaged in for gain, profit or livelihood for which a corporation can be organized [under the corporation statute].”33 Similarly, New York permits an LLC to form for “any lawful business purpose,” and defines “business” as “every trade, occupation, profession or commercial activity.”34 Because the definitions of “business” appear to encompass only “commercial” activities in these states, on the face of the statutes it seems that an LLC formed in Rhode Island or New York likely could not be formed exclusively for section 501(c)(3) purposes, and we are not aware of any precedent that suggests otherwise. Notably, while “commercial” activity is highly suggestive of a profit motive, these statutes are silent on whether “commercial” activity necessitates a for-profit endeavor.35 Thus, there may be at least some room for an interpretation that would capture charitable activities in states that impose a “business” or commerciality requirement upon LLCs. On the other hand, at least one state's statutory definition of business specifically provides “whether or not carried on for profit.”36

We support the requirement in the Notice that LLCs applying for section 501(c)(3) status certify to the Service in their exemption applications that all provisions in their articles of organization and operating agreement are consistent with applicable state LLC law and are legally enforceable in their states of formation. This requirement will place the burden on taxpayers to determine whether any applicable state LLC law purpose limitations are a barrier to section 501(c)(3) status.

IV. Satisfaction of the Organizational Test

A. Background

The Notice requests comments with respect to several inquiries regarding a multiple member LLC's satisfaction of the section 501(c)(3) organizational test.37 In order to be exempt as an organization described in section 501(c)(3), an organization must be both organized and operated exclusively for one or more of the exempt purposes specified in section 501(c)(3).38 An organization failing to meet either the organizational test or the operational test is not exempt.39

An organization will satisfy the organizational test only if its articles of organization limit the purposes of the organization to one or more exempt purposes and do not expressly empower the organization to engage, other than as an insubstantial part of its activities, in activities that are not in furtherance of one or more exempt purposes.40 An organization is not organized exclusively for one or more exempt purposes unless its assets are dedicated to an exempt purpose.41 An organization's assets will be considered dedicated to an exempt purpose, for example, if, upon dissolution, such assets would, by reason of a provision in the organization's articles or by operation of law, be distributed for one or more exempt purposes, or to the federal government, or to a state or local government, for a public purpose, or would be distributed by a court to another organization to be used in such manner as in the judgment of the court will best accomplish the general purposes for which the dissolved organization was organized.42 By contrast, an organization does not meet the organizational test if its articles or the law of the state in which it was created provide that its assets would, upon dissolution, be distributed to its members.43

For purposes of the organizational test, the term “articles of organization” or “articles” includes the trust instrument, the corporate charter, the articles of association, or any other written instrument by which an organization is created.44 The law of the state in which an organization is created is controlling when construing the terms of the organization's articles.45 Any organization contending that the terms of its articles have a different meaning under state law than their generally accepted meaning must establish such special meaning by clear and convincing reference to relevant court decisions, opinions of the state attorney general, or other evidence of applicable state law.46

In addition to satisfying the general organizational test for exemption under section 501(a) described above, a private foundation's governing instrument must include provisions requiring it to comply with sections 4941, 4942, 4943, 4944, and 4945.47 For purposes of section 508(e), the term “governing instrument” has the same meaning as the term “articles of organization” under §1.501(c)(3)-1(b)(2) and does not include an organization's bylaws.48 A private foundation's governing instrument will be deemed to comply with the requirements of section 508(e) based on provisions of applicable state law that require it to comply with sections 4941, 4942, 4943, 4944 and 4945 or treat the required provisions as contained in the private foundation's governing instrument.49

The Notice states that Treasury and the Service construe section 501(c)(3) and Treas. Reg. § 1.501(c)(3)-1 to permit the Service to issue a favorable determination letter to an LLC only where the LLC satisfies both the general requirements of section 501(c)(3) and the organizational requirements of the Notice. These requirements are intended to ensure that the LLC is organized and operated exclusively for exempt purposes.50

The Notice requires that both an LLC's articles of organization and its operating agreement include the following provisions (collectively, the “Organizational Provisions”): (1) provisions requiring that each member of the LLC be either (i) an organization described in section 501(c)(3) and exempt from taxation under section 501(a) or (ii) a governmental unit described in section 170(c)(1) (or wholly owned instrumentality of such a governmental unit); (2) express charitable purposes and certain charitable dissolution provisions in compliance with Treas. Reg. §§ 1.501(c)(3)-1(b)(1) and (4); (3) the express chapter 42 compliance provisions described in section 508(e)(1), if the LLC is a private foundation; and (4) an acceptable contingency plan (such as suspension of its membership rights until a member regains recognition of its section 501(c)(3) status) in the event that one or more members cease to be section 501(c)(3) organizations or governmental units (or wholly owned instrumentalities thereof).51

The Notice provides that where an LLC is formed under a state LLC law that prohibits the addition of provisions to articles of organization other than certain specific provisions required by the state LLC law, the requirement to include the Organizational Provisions will be deemed satisfied if the operating agreement includes the Organizational Provisions and the articles of organization and operating agreement do not include any inconsistent provisions.52

The Notice indicates that most state LLC statutes do not restrict the ability of an LLC to include the language required to satisfy the organizational test under Treas. Reg. § 1.501(c)(3)-1(b) (and section 508(e), in the case of a private foundation) in its articles of organization, but that a few states appear to strictly limit what provisions may be included in an LLC's articles of organization.53

B. Recommendations

In general, we recommend that Treasury and the Service maintain the highest standards for satisfaction of the organizational test, which is fundamental to section 501(c)(3) exemption and should apply equally regardless of entity form or jurisdiction of organization. We support the standards set forth in Section 3.04 of the Notice with respect to satisfaction of the section 501(c)(3) organizational test and we do not recommend that Treasury and the Service adopt additional standards that may (or may be perceived to) erode the requirements of the organizational test in order to accommodate varying state laws.

We acknowledge that some adjustment to the exemption requirements is necessary for the LLC organizational form. We believe that the Notice accomplishes this objective by permitting an LLC formed under state law that prohibits the addition of provisions to articles of organization to satisfy the organizational test by including the required provisions in its operating agreement. We do not find it material that the operating agreement is not filed with the state, since a section 501(c)(3) applicant will be required to include it with its Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, which is available for public inspection.

Ultimately, if a state's LLC laws would prevent an LLC formed there from qualifying for exemption under section 501(c)(3), then an LLC formed in that state should not be eligible for recognition of exemption. However, parties within those states seeking to establish a section 501(c)(3) organization would have various other options in the short term, including: (i) using an alternative organizational form (such as a corporation or trust) or (ii) establishing an LLC in another state. Furthermore, in the long term, state officials would be free to amend the applicable state LLC laws.

C. Explanations

1. Revision of Treasury Regulations

We support the standards set forth in Section 3.04 of the Notice with respect to satisfaction of the section 501(c)(3) organizational test, with the qualification that we also believe it would be reasonable for the Service to permit a charitable LLC to have non-501(c)(3) members under the narrow circumstances described in Part VIII of these Comments.

We support the accommodation described in Section 3.04 of the Notice for LLCs organized in states that limit what provisions may be included in an LLC's articles of organization where the LLC includes the appropriate language in its operating agreement. Specifically, we agree with the Service that the revised Treasury Regulations permit an LLC to satisfy the section 501(c)(3) organizational test and, where applicable, the section 508(e) requirements outside of its articles of organization only if and to the extent that:

  • Applicable state law prevents the LLC from including provisions in its articles of organization other than certain specific provisions required by the state LLC law;

  • The Organizational Provisions are included in the LLC's operating agreement; and

  • The LLC's articles of organization and the operating agreement do not include any inconsistent provisions.

Arguably, this approach does not afford any greater flexibility to an LLC than to a trust. Furthermore, an LLC's operating agreement is in many respects more analogous to corporate articles of incorporation than the articles of organization. In most states an LLC operating agreement is “the principal organizational document setting forth both the fundamental rules of the LLC — like the articles of incorporation of a business or non-profit corporation — and its general operational rules — like corporate by-laws.”54 On the other hand, LLC articles of organization “are more like the certificate of limited partnership: more of a notice document than a set of fundamental rules.”55 Thus, an LLC's operating agreement may more aptly be regarded as an LLC's “articles” within the meaning of Treas. Reg. § 1.501(c)(3)-1(b)(2) than its articles of organization, and accordingly, a more appropriate vehicle for the requisite section 501(c)(3) organizational language.

2. Distribution of Assets Upon Dissolution

The Notice requests comments as to several issues regarding state LLC statutes that appear to require distributions of net assets only to LLC members on dissolution. It asks whether, notwithstanding such a state dissolution requirement, LLC members could at the time of creation, effectively disclaim their financial interests in the LLC or assign or transfer their financial interests to the LLC or to another section 501(c)(3) charity as a means of satisfying the dissolution clause requirement under Treas. Reg. § 1.501(c)(3)-1(b)(4).56 The Notice further inquires as to whether such a disclaimer would be enforceable against the LLC members or creditors.57

As a threshold matter, we point out that member distributions should not raise a section 501(c)(3) compliance concern if all LLC members are section 501(c)(3) organizations because in that case distributions would be “distributed for one or more exempt purposes”58 and the distributions would not result in private inurement. More specifically, we believe that an LLC with members that are exclusively section 501(c)(3) organizations should be deemed to satisfy the organizational test even if its governing documents provide for member distributions, so long as the LLC retains clear variance power to redirect distributions from members that lose their section 501(c)(3) status or that are engaged in activities contrary to section 501(c)(3).59 Only in instances in which the member section 501(c)(3) organizations and the LLC have significantly incongruent exempt purposes would a distribution from the LLC to section 501(c)(3) members pose a potential issue for the LLC's section 501(c)(3) compliance. These circumstances would presumably be rare because the section 501(c)(3) members would need the LLC's exempt purpose to be consistent with their own purposes in order to maintain their own section 501(c)(3) statuses.

However, when not all members of a multiple member LLC are section 501(c)(3) organizations, we endorse the standards set forth in the Notice as a reasonable approach to the application of the organizational test. We would not recommend any further flexibility or restriction for LLCs organized in states that would permit members to contractually disclaim LLC interests. We also have no position on the state law enforceability of a contractual disclaimer of member financial interests. Thus, if one or more members of an LLC are not section 501(c)(3) organizations and the LLC is organized in a state that gives members immutable financial interests, then the LLC could not comply with Treas. Reg. § 1.501(c)(3)-1(b)(4). In these states, LLC members would have the option of using a different organizational vehicle (such as a nonprofit corporation or trust) or forming a nonprofit LLC in a state with more permissive LLC laws.

3. Public Availability of Operating Agreement

In requesting comment on whether the Treasury Regulations for the section 501(c)(3) organizational test and section 508(e) requirements should be revised to accommodate LLCs organized in states that limit articles of organization provisions, the Service asks whether it matters that the operating agreement (unlike the articles of organization) is not filed with the state.60

In general, we do not consider it material that the operating agreement (unlike the articles of organization) is not filed with the state, and therefore may not be readily available to the IRS and the public. A trust instrument is also typically not filed with the state, and still forms the basis of a trust's satisfaction of the organizational test. Likewise, the governing principles of an unincorporated association are generally not filed with the state, since an unincorporated association is by definition “unincorporated.” Yet many organizations recognized by the Service as tax-exempt under section 501(c)(3) have opted to use the trust or unincorporated association forms.

In seeking exemption and recognition under section 501(c)(3), an LLC would be required to submit its operating agreement to the IRS with Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code. The Form 1023, including all schedules and attachments, must be made available for public inspection by both the taxpayer and the Service.61 On an ongoing basis, the LLC would be required to report significant changes to its operating agreement on its annual Form 990 or Form 990-PF, as applicable. These filing and reporting obligations would afford the IRS and the public the same level of transparency as applies in the case of a tax-exempt trust or unincorporated association.

4. Additional Governing Document Provisions

The Notice seeks comment on whether there are any specific provisions that should be included in an LLC's articles of organization and operating agreement in addition to, or in lieu of, those discussed in Section 3.02 of the Notice, to address particular provisions of state law.62

We recommend that Treasury and the Service maintain the standards for satisfying the organizational test set forth in the Notice, including the Organizational Provisions, as the minimum requirements for an LLC to receive a determination letter recognizing it as tax-exempt under section 501(a) and described in section 501(c)(3). We consider the standards of the Notice to reflect a reasonable approach to the application of the organizational test to the LLC organizational form and would not recommend any further flexibility or restriction. We do, however, suggest a narrow accommodation for non-501(c)(3) members in limited circumstances, which is addressed in Part VIII of the Comments.

V. State Nonprofit LLC Laws

A. Background

The Notice points out that several states have enacted special statutory provisions for nonprofit LLCs (beyond a mere provision in the statute that allows an LLC to be formed for a nonprofit purpose), subjecting them to regulation as nonprofit organizations and, in some cases, limiting membership.63 It seeks input into whether, in such states, a charitable LLC must form under the state's nonprofit LLC law or if it would be permitted to form under the state's general LLC law.64 Our Comments in response to this question focus on the state nonprofit LLC statutes with which we have some familiarity and are not intended to be comprehensive.

B. Explanation

We believe the answer to the question posed by the Notice varies with the particular language of a state's statutes. For example, we read Tennessee law to require that a multiple member LLC seeking to be organized and operated under section 501(c)(3) would necessarily need to form under the general LLC statute because the state's nonprofit LLC statute only permits single member LLCs.65 An LLC formed under the state's general LLC statute may be formed for “any lawful purpose,” and we are not aware of any statute or precedent that would prevent a multiple member LLC from forming as a nonprofit LLC under the statute.66

In Kentucky, in contrast, there is no separate nonprofit LLC statute under which a nonprofit LLC is formed.67 The nonprofit provisions are incorporated through the state's general LLC statute, which requires that, for an LLC to be a “nonprofit limited liability company,” its articles of organization must state this fact and its nonprofit purpose.68 Thus, it seems that for an LLC to be recognized as a nonprofit by the state, it must comply with the statutory provisions applicable to nonprofit LLCs.

The Minnesota law calls for yet another conclusion. Its nonprofit LLC statute provides, “[a] limited liability company is a nonprofit limited liability company if it is organized under or governed by this chapter and its articles of organization state that it is a nonprofit limited liability company governed by this section.”69 The state's general LLC law — the Revised Uniform Limited Liability Company Act – then specifies that an LLC may be formed for any lawful purpose but must comply with the section of the statute governing nonprofit LLCs in order to qualify as a nonprofit.70 Therefore, Minnesota lawmakers seem to have foreclosed the possibility for an LLC formed under the general LLC statute to be a nonprofit organization.

North Dakota has taken the same approach as Minnesota. North Dakota's Uniform Limited Liability Company Act defines a “limited liability company” to expressly exclude a nonprofit limited liability company formed under the special nonprofit LLC statute, which would seem to foreclose the possibility of forming a charitable LLC under the general LLC law.71

In short, whether a charitable LLC could form under the general LLC law in other states that have adopted, or will adopt in the future, special nonprofit LLC statutes can be expected to be a function of the permissible purposes for which an LLC may legally be formed under the general LLC statute.

VI. Treatment of Member-Managed LLCs and Manager-Managed LLCs

A. Background

In the Notice, the Service requests comments on whether, with respect to qualification for section 501(c)(3) status, LLCs managed by managers should be treated the same as LLCs managed by members.72

An LLC generally has the option to be managed by its members (a member — managed LLC) or by one or more managers (a manager-managed LLC). State law typically provides the LLC's members with management authority as the default rule, unless the articles of organization or operating agreement delegates management authority to one or more managers.73 In Minnesota, for example, the nonprofit LLC statute requires nonprofit LLCs formed in the state to be managed by a governing body comprising individuals — foreclosing the possibility of member entities managing the organization.74 Similarly, North Dakota's nonprofit LLC statute requires managers to be individuals.75

With certain exceptions, the federal tax law with respect to organizations described in section 501(c)(3) does not impose any specific requirements on the composition of the body of the organization with management authority (the governing body), so long as the general requirements of section 501(c)(3), including the operational test and the prohibition against private inurement, are satisfied. The exceptions would include (i) an exempt health care organization, where a community board is a factor in determining whether the organization operates to benefit the community as a whole rather than private interests;76 (ii) an organization relying on facts and circumstances to avoid private foundation status, where a representative governing body is a factor in whether it meets such public support test;77 (iii) a supporting organization under section 509(a)(3);78 and (iv) a credit counseling organization.79

B. Recommendations

We recommend that Treasury and the Service issue guidance providing that, with respect to qualification for section 501(c)(3) status, LLCs managed by managers will generally be treated the same as LLCs managed by members. We further recommend that Treasury and the Service provide clarity on whether members or managers comprise the governing body, as detailed below. Specifically, we recommend the following:

  • For manager-managed LLCs, the manager(s) comprise the governing body of the LLC.

  • For member-managed LLCs with a single member that is an organization, the governing body of the sole member of the LLC be treated as the governing body of the LLC.

  • For member-managed LLCs with two or more members that are organizations, the governing body of the LLC shall be deemed to meet section 501(c)(3) governing body requirements only if the governing bodies of each member of the LLC meet such requirements; but by default, the governing body of the LLC should be the group of members.

B. Explanations

Below, we explain the basis for each of the recommendations set forth above.

1. Manager-managed LLCs

For manager-managed LLCs, the authority to manage the LLC is vested primarily in the manager(s). Where there is one manager, the manager has full authority to manage the LLC, similar to the trustee of a trust. However, in the case of a multiple member LLC, the LLC's governing documents will necessarily need to include additional provisions to describe the authority of the group of managers. A group of managers may or may not operate similarly to the board of directors of a nonprofit corporation and may or may not comprise the members of the LLC. For an LLC that will be managed by managers rather than members, it is clear that the governing body of the LLC is the manager or group of managers appointed by the members, and we do not believe any additional guidance is necessary on this point.

2. Member-managed LLCs

For member-managed LLCs, the authority to manage the LLC is vested in the member(s). As a result, such an LLC will not have a separate governing body. However, for certain types of section 501(c)(3) organizations, qualification as a section 501(c)(3) organization may depend upon, or include a factor that considers, the composition of the governing body. Thus, without additional guidance, an organization seeking such status would not be able to satisfy any requirements with respect to its governing body if formed as a member-managed LLC.

For a single member LLC, an LLC seeking recognition as, or claiming to be, a section 501(c)(3) organization is treated as having made an election to be classified as an association (and thus as a corporation) under Treas. Reg. § 301.7701-2(b)(2). The same LLC, if not making the election to be classified as an association under § 301.7701-2(b)(2), would be a disregarded entity whose activities would be treated as a branch or division of the sole member and whose governing body would be considered to be the sole member's governing body. The standards set forth in the Notice do not alter these classification rules for single member LLCs under section 7701 or the accompanying Treasury Regulations.80 Therefore, because a member-managed LLC with a single member will not have a separate governing body and the LLC's governing body would be the sole member's governing body but for making the election to be classified as an association, we believe it is appropriate to treat the governing body of the sole member as the governing body of the LLC for purposes of meeting the requirements for section 501(c)(3) status.

For a multiple member LLC which is seeking recognition as a section 501(c)(3) organization and which is member-managed, the situation is more complicated. Applicable requirements as to the governing body of an organization generally require the governing body to include individuals who are representative of the community being served by the organization.81 As a result, if the governing body of the LLC consists of the LLC members, and such members are themselves organizations rather than individuals, the LLC will not likely be able to satisfy these requirements. However, we believe it is appropriate for the governing body of a member-managed LLC to be considered as meeting the section 501(c)(3) governing body requirements if the governing body (i.e., the board of directors) of each of the members of the LLC meets such requirements.

Outside of these circumstances, we believe that a multiple member LLC seeking recognition as a section 501(c)(3) organization with non-501(c)(3) members should be required to be managed by individuals appointed by the members.

VII. Treatment of LLC Managers as Officers

A. Background

The Notice requests comments on whether LLC managers should be treated as officers for federal exempt organization tax purposes generally, including, for example, the compliance provisions of chapter 42.82

B. Recommendation and Explanation

We recommend that Treasury and the Service treat LLC managers presumptively as directors, rather than officers, for federal exempt organization purposes, including for purposes of the compliance provisions of chapter 42, unless the facts and circumstances indicate that managers have the authority or responsibility equivalent to officers, or do not have the authority or responsibility equivalent to either directors or officers.

C. Explanation

As discussed in Part VI of these Comments, an LLC generally has the option to be managed by one or more managers instead of by the LLC's members. In that case, the articles of organization and operating agreement of the LLC usually set forth governing provisions regarding who has the authority to do what. Particularly for manager-managed LLCs, where the LLC may have a group of managers acting similarly to a board of directors along with separate officers and employees, the provisions of the operating agreement will determine how managers are elected, how meetings of managers are governed, in what circumstances the managers must act unanimously or by a majority or a manager may act alone on behalf of the LLC, whether specific actions must be approved by the members, how vacancies among the managers are treated, etc. Thus, the governing documents of the LLC and the specific facts and circumstances pertaining to each LLC would determine whether a manager has authority that is similar to a director or officer or both or, as may be the case with member-managed LLCs, neither.

Chapter 42 (sections 4940-4968) includes several provisions that hinge on an individual's status as a director, trustee, or officer of an exempt organization. Generally, with respect to these provisions, directors, trustees, and officers are treated the same for federal exempt organization tax purposes.83 For example, the excess benefit transaction rules of section 4958, applicable to section 501(c)(3) public charities and section 501(c)(4) organizations, specify that a “disqualified person” includes “any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization” and that an “organization manager” means “any officer, director, or trustee of such organization (or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization).84 As another example, for purposes of subchapter A (sections 4940 — 4948) of chapter 42, a “disqualified person” is defined to include a “foundation manager” which means “an officer, director, or trustee of a foundation (or an individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation),” and “with respect to any act (or failure to act), the employees of the foundation having authority or responsibility with respect to such act (or failure to act).”85 Other sections addressing exempt organizations that similarly treat officers, directors, and trustees (as well as other persons with similar authority or responsibility) as a group include sections 4955(f)(2), 4965(d)(1), and 4966(d)(3).

However, section 4960, which imposes a tax on excess remuneration paid by an applicable tax-exempt organization or any related person or governmental entity with respect to the employment of a covered employee, makes a critical distinction between the directors and officers of a nonprofit corporation in the determination of whether an individual is an employee of such corporation and thus subject to the tax. Treas. Reg. § 53.4960-1(e)(1) provides in relevant part, as follows:

An employee generally also includes an officer of a corporation, but an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives, nor is entitled to receive, any remuneration is not considered to be an employee of the corporation solely due to the individual's status as an officer of the corporation. Whether an individual is an employee depends on the facts and circumstances.

In contrast, Treas. Reg. § 53.4960-1(e)(2) provides that: “[a] director of a corporation (or an individual holding a substantially similar position in a corporation or other entity) in the individual's capacity as such is not an employee of the corporation.” Thus, directors and officers may be treated differently for purposes of section 4960, with directors not treated as employees while officers generally are.

LLC managers, however, do not fall neatly into the categories of officer or director. The authority of an LLC manager depends entirely on the authority delegated to such manager in the operating agreement. Thus, a manager of a member-managed LLC may only have minimal authority to perform minor services such as to execute documents on behalf of the LLC at the members' direction. Alternatively, a manager of an LLC may have complete authority and responsibility for all assets and operations of an LLC, similar to a director or trustee, with only minimal rights being held by the member of the LLC. As another example, a group of managers acting similarly to the board of directors of a nonprofit corporation may further delegate authority to individuals acting similarly to officers and key employees of the LLC who are responsible for carrying out the day-to-day operations of the LLC. Accordingly, a manager of an LLC may or may not act in the capacity similar to an officer, and this determination will vary significantly from organization to organization.

As noted above, for most of chapter 42, there is no distinction made between directors, officers, and trustees. However, for purposes of section 4960, there is a critical distinction between officers and directors, with only the former presumed to be a “covered employee” whose remuneration may be subject to tax. Thus, we believe it is appropriate to make the same distinction among managers of LLCs who have the authority and responsibility similar to directors of nonprofit corporations and those who have the authority and responsibility similar to officers of nonprofit corporations, for purposes of applying section 4960 to an LLC that is a section 501(c)(3) organization.

Furthermore, the relevant provisions of chapter 42, other than section 4960, already subject managers of an LLC to the various rules by applying such rules to individuals having powers or responsibilities similar to those of officers, directors, or trustees of the organization. In that sense, the formal title of the individual does not affect whether or not the individual is subject to the rules. Thus, we believe it is not necessary for Treasury and the Service to issue guidance that treats all LLC managers as directors or officers in order for managers to be subject to the compliance provisions of chapter 42, other than with respect to section 4960.

Because of the need for that distinction with respect to section 4960, we suggest treating LLC managers presumptively as directors for federal exempt organization tax purposes, unless the facts and circumstances indicate either (1) that such managers have the authority and responsibilities similar to officers such that the managers should also be treated as employees for purposes of section 4960, or (2) that such managers do not have authority similar to that of directors or officers.

VIII. Non-501(c)(3) Members

A. Background

The Notice seeks comments as to whether there are circumstances in which an LLC seeking recognition under section 501(c)(3) should be permitted to have members that are not themselves section 501(c)(3) organizations, governmental units, or wholly owned instrumentalities of governmental units.86

B. Recommendation

We recommend allowing LLCs seeking section 501(c)(3) status to have members that are not themselves section 501(c)(3) organizations or governmental units or wholly owned instrumentalities of governmental units only when each of the following conditions is met to the Service's satisfaction:

  • The laws of the state under which the applicant was formed permit it to have members that are not entitled to a financial interest in the LLC;

  • The LLC's articles of organization or operating agreement (for LLCs formed under state law that prohibits the addition of provisions to articles of organization) prohibit any non-501(c)(3) member from having a financial interest in the LLC;

  • The laws of the state under which the applicant was formed permit modification of any default statutory fiduciary duties that would be owed by LLC members and managers to non-501(c)(3) members;

  • The applicant describes modifications made to default statutory fiduciary duties, if any, owed to non-501(c)(3) members that allow the applicant to comply with the operational requirements of 501(c)(3) status, including good governance practices, in a legally enforceable manner;

  • The applicant is otherwise able to satisfy the organizational and operational requirements; and

  • The applicant represents to the Service that all provisions in its articles of organization and operating agreement are consistent with applicable state LLC law and are legally enforceable.

The Service would determine satisfaction of these requirement based upon its review of the exemption application materials and representations made by the applicant under penalty of perjury.87 To promote a thorough review of multiple member LLC exemption applications, we recommend that the Service maintain the current requirement for LLCs that apply for section 501(c)(3) exemption to use the Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, rather than the Form 1023-EZ, Streamlined Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code.88

Under these limited circumstances, we believe an LLC with non-501(c)(3) members would be structured to prevent private benefit to the same degree as all other section 501(c)(3) organizations. However, in a state in which state law does not permit an LLC to form under these conditions, a multiple member LLC formed in the state would be required to have exclusively section 501(c)(3) members in order to qualify as charitable.

C. Explanation

Organizations and entities other than section 501(c)(3) organizations routinely engage in activities that qualify as charitable within the meaning of section 501(c)(3) and may wish to form a nonprofit LLC to house these activities for a variety of practical reasons.89 For example:

  • A foreign charitable organization may want to form an LLC that would qualify as a section 501(c)(3) organization (a so-called “friends-of” organization) to carry out fundraising activities in the United States, where the foreign charitable organization would be the sole member and the LLC would make the election to be classified as an association (and thus as a corporation) under Treas. Reg. § 301.7701-2(b)(2).

  • A group of section 501(c)(3) organizations and social welfare organizations described in section 501(c)(4) may wish to form an LLC as a section 501(c)(3) organization to engage in joint nonpartisan get-out-the-vote work, to allow unique branding for the programs.

  • A group of section 501(c)(6) business leagues may wish to partner with a section 501(c)(3) to provide innovative medical care to underserved members of a community, but neither entity is willing to take on the liability associated the activity.

  • A section 501(c)(4) social welfare organization and a section 501(c)(3) organization may seek to engage in a joint educational research project and jointly own the intellectual property rights from that research.

  • An affiliated section 501(c)(3) and section 501(c)(5) organization may choose to create an LLC to house a joint fundraising event that will raise money for other section 501(c)(3) charities that are aiding victims of a natural disaster, in order to shield the organizations from liability.

In any of the instances described above, the tax status of the individual members of the LLC should not matter so long as the entity itself can meet the requirements described in Part VIII.B above.

Under most state laws, an LLC generally has the ability to structure the rights and obligations of its members, its governing body, and its managers as it pleases. In some cases, state law may permit an LLC to have members that may retain certain rights, such as the right to elect the managers or the right to approve any amendments to the articles of organization or operating agreement, but that have no financial interests in the LLC or its assets.90 Thus, contingent upon state law, it may be possible to form a multiple member LLC under the general LLC statute with non-501(c)(3) members that do not hold financial interests in the LLC.91

Similarly, in keeping with the flexible nature of the LLC as an organizational form described previously in these Comments, many state LLC laws also permit the modification of default fiduciary duties, as described in Part I. Statutory fiduciary duties in the for-profit LLC context are often owed to the members as well as to the LLC itself.92 In addition, states that model their LLCs statutes on RULLCA may well permit modification or elimination of both the duty of loyalty and the duty of care, provided that doing so is not manifestly unreasonable and that a member's contractual obligation to act in good faith and with fair dealing is not waived.93 We recommend that the Service therefore require charitable LLCs with non-501(c)(3) members to modify any default fiduciary duties of members and managers towards non-501(c)(3) members in their operating agreements, provided the applicant certified to the Service that such a modification was legally enforceable under applicable state law.94 The Service could also consider requiring all 501(c)(3) multiple member LLCs to affirmatively include the fiduciary duties of loyalty and care in their operating agreements as contractual obligations owed by LLC members and managers to the LLC, to ensure consistent parity between the statutory fiduciary duties owed by nonprofit corporate directors to the organization and the flexible fiduciary duties owed to an LLC by its members and managers.

The Service has a history of permitting nonprofit corporations to form as membership organizations, regardless of whether the membership is informal (i.e., the “members” are not recognized as such by state law but may enjoy certain benefits such as free parking at a museum) or formal (i.e., the members have certain default rights under state law but these rights may be altered by the articles of incorporation or bylaws). Under our recommendation described above, a non-501(c)(3) member of a section 501(c)(3) LLC would be analogous to a member of a nonprofit corporation or membership association in that neither would hold an equity interest. In the section 501(c)(3) membership organization context generally, the Service has not required that each member be a section 501(c)(3) organization, governmental unit, or wholly owned instrumentality of a governmental unit. We interpret the section 501(c)(3) requirements to only require that an organization with members demonstrate that it does not use or distribute its assets in a manner that results in private inurement to members. We are unaware of any requirement in the Code or the Regulations that the member(s) of a section 501(c)(3) organization with members must be section 501(c)(3) organizations, governmental units, or wholly owned instrumentalities of governmental units.

The admission of non-501(c)(3) members in LLCs seeking section 501(c)(3) exemption may prompt heightened private inurement concerns with respect to the non-501(c)(3) members, who would likely be deemed insiders to the organization for purposes of the excess benefit transaction and self-dealing rules. However, we believe that section 501(c)(3) and the Treasury Regulations, along with state and judicial oversight, provide an adequate mechanism through which to prevent and mitigate the impact of these issues. Any organization seeking section 501(c)(3) tax exempt status, including an LLC, would not be organized exclusively for one or more exempt purposes unless its assets are dedicated exclusively to an exempt purpose, its articles specify that its assets must be distributed for these purposes upon dissolution, and this provision is otherwise enforceable under the state law in which the organization was formed.95 Section 501(c)(3) exemption is further conditioned on the requirement that “no part of the net income of [the organization] inures to the benefit of any private shareholder or individual.”96 These are fundamental requirements for section 501(c)(3) exemption and an LLC claiming to be charitable would necessarily need to meet this requirement regardless of the tax status of its members. The Service has the authority to deny or revoke the exemption of an entity that does not satisfy these requirements, and the excise taxes on excess benefit transactions and self-dealing provide additional teeth.97 Furthermore, state attorneys general and the courts have a longstanding history of taking action to ensure that charitable assets be dedicated to exempt purposes and not used to enrich insiders.98

For the reasons outlined above, we recommend that a multiple member LLC with non-501(c)(3) members be permitted to seek section 501(c)(3) exemption but only to the extent that it can comply with the criteria outlined in Part VIII.B to the satisfaction of the Service.

IX. Tax-Exempt Status for Other Section 501(c) LLCs

A. Background

The Notice requests input into whether there should be special requirements or considerations for recognition of tax-exempt status for LLCs under paragraphs of section 501(c) other than section 501(c)(3).99

B. Recommendation

We recommend that Treasury and the Service issue guidance permitting an LLC to seek recognition as, or self-attest to, tax-exempt status under a paragraph of section 501(c) other than section 501(c)(3), so long as the LLC can otherwise satisfy all of the existing federal tax law requirements for such status.

C. Explanation

As with section 501(c)(3) organizations, we believe that an LLC seeking exempt status under sections other than 501(c)(3) should be eligible for such status only if the state laws under which the LLC is formed permit the LLC to meet the existing exemption requirements. While perhaps less critical in the non-501(c)(3) context, we believe the standards for exemption are central to nonprofit tax law and should be upheld regardless of entity form. For example, an LLC seeking exemption as a section 501(c)(4) organization should be required to demonstrate in its governing documents that it is not organized for profit and is operated exclusively for the promotion of social welfare.100 Likewise, an organization claiming to be exempt under section 501(c)(6) must have governing documents that provide that it is not organized for profit and its net earnings do not inure to the benefit of any private shareholder or individual.101 Satisfying these fundamental exemption requirements will likely be easier for other section 501(c) organizations that form as LLCs, since the Code and Treasury Regulations do not prescribe language that must be included in the articles of these organizations. Thus, no accommodation by the Service would be necessary when state law does not permit additions to the articles of organizations.

In instances in which a state's laws do not permit an LLC to satisfy the exemption requirements — namely, when state law requires members to be provided a financial interest in the LLC and there are non-exempt members — then an entity formed under such laws would not qualify for tax-exempt status and would necessarily need to be formed under a different state's laws, or use an alternative organizational vehicle, in order to qualify.

FOOTNOTES

1Notice 2021-56, 2021-45 I.R.B. 716 (“Notice”).

2Unless otherwise indicated, references to a “section” are to a section of the Internal Revenue Code of 1986, as amended (the “Code” or “I.R.C.”) and all “Treas. Reg. §” references are to the Treasury regulations promulgated under the Code, all as in effect (or, in the case of proposed regulations which remain outstanding, as proposed) as of the date of these Comments.

3Notice § 4.01(1).

4Travelcenters of America, LLC v. Brog, 2008 WL 5272861, *2 (Del. Ch. Dec. 5, 2008); R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, CIV.A. 3803-CC, 2008 WL 3846318, at *1 (Del. Ch. Aug. 19, 2008) (“For Shakespeare, it may have been the play, but for a Delaware limited liability company, the contract's the thing. Ultimately, it is the contract that compels the Court's decision in this case because it is the contract that “defines the scope, structure, and personality of limited liability companies.”).

5Note that this rule has been modified in Uniform Trust Code § 703(a) (Unif. L. Comm'n, amended 2010), available at https://www.uniformlaws.org/HigherLogic/System/DownloadDocumentFile.ashx?DocumentFileKey=ae68 d637-6e52-0776-2e39-be6ce26f315f&forceDialog=0 (last visited Feb. 18, 2022).

6A charitable LLC's members and managers, as stewards of charitable assets, may well be closely regulated by other aspects of state law applicable to charities, such as mandated prudent-investment standards in managing charitable assets, the requirements of charitable solicitation statutes, and penalties for violating donor-imposed restrictions on contributed funds. Also, even with nonprofit corporations, it may be possible for organizers to avoid regulatory requirements prescribed by domestic nonprofit corporation statutes simply by incorporating in a state like Delaware that has no such requirements in its corporate law.

7Some states may also recognize a duty of obedience to the corporation's charitable purposes. See, e.g., Manhattan Eye, Ear & Throat Hosp. v. Spitzer, 715 N.Y.S.2d 575, 595 (Sup. Ct. 1999) (discussing a duty of obedience to preserve a charity's original mission).

8For example, the duty of care of a director in a nonprofit corporation is typically based on a standard of gross negligence or intentional misconduct, whereas the trustee of a charitable trust may face a simple negligence standard. See David S. Walker, A Consideration of an LLC for a 501(c)(3) Nonprofit Organization, 38 Wm. Mitchell L. Rev. 627, 657. However, in the Restatement of the Law of Charitable Nonprofit Organizations (Am. L. Inst. 2021), the American Law Institute opted to apply the fiduciary duties found in the ABA's Revised Model Nonprofit Corporation Act, infra note 18, to charitable fiduciaries, rather than the standard of care for trustees set forth in all of the versions of the Restatement of Trusts. See Restatement of the Law of Charitable Nonprofit Organizations, § 1.02, Comment d (Am. L. Inst. 2021).

9See Del. Limited Liability Company Act §§ 18-1101(c) & 18-1104.

10For example, under the Revised Uniform Limited Liability Company Act (Unif. L. Comm'n, 2006 version, amended 2013) (the “RULLCA”), members in a member-managed LLC owe default duties of care and loyalty not only to the company but also to one another; in a manager-managed LLC, the managers owe these duties to the members and to the company. See RULLCA § 409, available at https://www.uniformlaws.org/HigherLogic/System/DownloadDocumentFile.ashx?DocumentFileKey=0a06 fb33-7fa0-0e41-f494-ba174e5dc9c7&forceDialog=0 (last visited Feb. 18, 2022).

11See RULLCA § 105(d) and associated comment.

12See Del. Limited Liability Company Act § 18-1101(c).

13See I.R.S., Governance and Related Topics — 501(c)(3) Organizations (2008), https://www.irs.gov/pub/irs-tege/governance_practices.pdf (“[A] well-governed charity is more likely to obey the tax laws, safeguard charitable assets, and serve charitable interests than one with poor or lax governance.”) (last visited Feb. 18, 2022).

14See, e.g., Uniform Prudent Management of Institutional Funds Act (Unif. L. Comm'n 2006), §§ 3 & 4, available at https://www.uniformlaws.org/HigherLogic/System/DownloadDocumentFile.ashx?DocumentFileKey=d88f e964-fa49-9b1e-e197-2389fcc49990&forceDialog=0 (prescribing standards for the prudent investment of charity funds and the prudent spending from charitable endowment, respectively, which in any event can be modified or waived as to a specified donation by express provision in a gift instrument) (last visited Feb. 18, 2022); Cal. Gov. Code §§ 12585 & 12586 (prescribing detailed registration and reporting requirements with the Attorney General for any legal entity holding charitable assets in California).

15Notice § 4.01(2). Note that these Comments do not address the role of states attorneys general with respect to low profit limited liability companies, or L3Cs, which are hybrid nonprofit/for-profit entity structures that have been created by state law in roughly a dozen states. Because these entities are owned by private equity holders entitled to distributions and operate at least in part for profit, they are not eligible for section 501(c)(3) status.

16Robert Carlson & Caitlin Carter, Protection and Regulation of Nonprofits and Charitable Assets, in State Attorneys General Powers and Responsibilities 205 (Emily Myers, ed., 4th ed. 2018).

17See Model Protection of Charitable Assets Act (Unif. L. Comm'n 2011), at 3, available at https://www.uniformlaws.org/HigherLogic/System/DownloadDocumentFile.ashx?DocumentFileKey=82ab 28c8-1ffa-1f5e-09b5-54da5b7bcdd4&forceDialog=0 (last visited Feb. 18, 2022).

18Revised Model Nonprofit Corporation Act (American Bar Association, May 2021 Draft), available at https://www.americanbar.org/content/dam/aba/administrative/business_law/nonprofit/mnca.pdf (last visited Feb. 18, 2022).

19See Cindy Lott, et. al., Urban Institute, State Regulation and Enforcement in the Charitable Sector (2016), available at https://www.urban.org/sites/default/files/publication/84161/2000925-State-Regulation-and-Enforcement-in-the-Charitable-Sector.pdf (last visited Feb. 18, 2022).

20Walker, supra note 8 at 677; Ky. Rev. Stat. Ann. §§ 275.025(6) & 275.540; Minn. Stat. Ann. § 322C.1101, subd. 6; N.D. Cent. Code § 10-36-06; Tenn. Code Ann. § 48-101-705(d).

21See Protection of Charitable Assets Act, supra note 17.

22Id. at 2. Additionally, Hawaii has codified a provision outlining the attorney general's authority to protect charitable assets, without limitation based on the entity in which the assets are held. Haw. Rev. Stat. § 28-5.2.

23See National Association of State Charities Officials, State Charity Registration Provisions – As of May 15, 2020, https://www.nasconet.org/wp-content/uploads/2020/05/NASCO-State-Charities-Registration-Survey-5.15.20-.pdf (last visited Feb. 18, 2022); State Regulation and Enforcement in the Charitable Sector, supra note 19.

24See Walker supra note 8 at 673; see also American Law Institute Restatement of the Law of Charitable Trusts § 5.01 (The state attorney general . . . has the authority to protect charitable assets and interests within the jurisdiction of the state. . . .”). While the ABA's Model Nonprofit Corporation Act, supra note 18, does provide the attorney general with supervisory authority over nonprofit corporations formed in states that have adopted the Act, there are several states that have not adopted the Act in its original or revised form. For example, in Delaware, nonprofit organizations are formed under the state's General Corporation Law, and the attorney general's statutory role with respect to nonprofit entities is limited to nonprofit-to-for-profit healthcare conversions. See Del. Code Ann. tit. 29, §§ 2532 & 2533.

25See, e.g., Vidal v. Girard's Executors, 43 U.S. 127 (1844) (holding that a charitable trust is enforceable under common law).

26See Unincorporated Nonprofit Association Act (Unif. L. Comm'n, last amended 2011), available at https://www.uniformlaws.org/HigherLogic/System/DownloadDocumentFile.ashx?DocumentFileKey=3437 9091-21b1-10d0-83e6-8eefd39c2324&forceDialog=0 (last visited Feb. 18, 2022).

27See id.

28Protection of Charitable Assets Act, supra note 17.

29Carlson & Carter, supra note 16 at 215.

30Notice § 4.01(3).

31See RULLCA § 108(b).

32Uniform Law Commission, RULLCA Enactment Map, https://www.uniformlaws.org/committees/community-home?CommunityKey=bbea059c-6853-4f45-b69b-7ca2e49cf740 (last visited Feb. 18, 2022); Ribstein and Keatinge on Limited Liability Companies (2d ed., Dec. 2021 Update), Appendix 4-9 Purpose Limitations.

33R.I. Gen. Laws §§ 7-16-3 & 7-16-2(4). The state corporation statute enumerates business purposes for which a corporation may not be formed under state law. Id. § 7-1.2-301. See also Ribstein and Keatinge, supra note 32; Kenya Smith, Purposeful Ambiguity: A Case for Greater Clarity in State Law Treatment of the Nonprofit Limited Liability Company (as viewed through permitted purpose provisions), 95 TUL. L. REV 601, 625 (2021).

34N.Y. Ltd. Liab. Co. Law §§ 201, 102(e). See also Ribstein and Keatinge, supra note 32; Smith, supra note 33 at 625.

35Smith, supra note 33 at 625.

36See Tenn. Code Ann.§ 48-249-102(3).

37Notice § 4.01(5) & (6).

38Treas. Reg. § 1.501(c)(3)-1(a).

39Id.

40Treas. Reg. § 1.501(c)(3)-1(b)(1).

41Treas. Reg. § 1.501(c)(3)-1(b)(4).

42Id.

43Id.

44Treas. Reg. § 1.501(c)(3)-1(b)(2).

45Treas. Reg. § 1.501(c)(3)-1(b)(5).

46Id.

47I.R.C. § 508(e).

48Treas. Reg. § 1.508-3(c).

49Treas. Reg. § 1.508-3(d).

50Notice § 3.01.

51Notice § 3.02.

52Notice § 3.04.

53Notice § 4.01(6).

54Ribstein & Keatinge, supra note 32 at § 5:1.

55Id.

56Notice § 4.01(4)(a).

57Notice § 4.01.(4)(b), (c).

58Treas. Reg. § 1.501(c)(3)-1(b)(4).

59We recognize that the current language of Treasury Regulation § 1.501(c)(3)-1(b)(4) presents an obstacle to member distributions even if all members are section 501(c)(3) organizations, since it expressly provides that an organization does not satisfy the organizational test if its articles or state law require assets to be distributed to members upon dissolution. However, this rule predates the proliferation of the LLC form generally and the use of the LLC as an organizational form for nonprofit entities, which appears to be a more recent trend, and may be worth revisiting.

60Notice § 4.01(6)(b).

61I.R.C. § 6104(a)(1)(A), (d)(1)(A)(iii).

62Notice § 4.01(10).

63Notice § 4.01(7).

64Id.

65Tenn. Code Ann. § 48-101-702(3)(B) (defining a nonprofit limited liability company as an LLC that is disregarded and whose sole member is a nonprofit corporation).

66Id. § 48-203-101(a).

67Ky. Rev. Stat. Ann. §§ 275.001 to 275.540.

68Id. §§ 275.025(6) & 275.015(19) (defining “nonprofit limited liability company” in relevant part as an LLC that has included these provisions in its articles of incorporation).

69Minn. Stat. Ann. § 322C.0104, subd. 2.

70Id.

71N.D. Cen. Code Ann. § 10-32.1-02(28).

72Notice § 4.01(8)(a).

73See RULLCA § 407(a).

74Minn. Stat. Ann. § 322C.1101, subd. 5.

75N.D. Cent. Code §§ 10-36-03 (treating LLC “managers” the same as “officers” of nonprofit corporations) & 10-33-01.27 (defining an “officer” of a nonprofit corporation as an individual 18 or older).

76Rev. Rul. 69-545, 1969-2 C.B. 117.

77Treas. Reg. §§ 1.170A-9(f)(3)(iii)(C) & 1.509(a)-3(d)(3)(i).

78Treas. Reg. § 1.509(a)-4(g), (h), & (i).

79I.R.C. § 501(q)(1)(D).

80See Notice § 2.02 (describing the entity classification rules under Treasury Regulations §§ 301.7701-1 through -3).

81See Governance and Related Topics, supra note 13.

82Notice § 4.01(8)(b).

83The federal tax law often refers to directors, trustees, and officers of the exempt organization, as well as key employees with equivalent responsibilities, as managers of the entity. See infra, notes 77 and 78.

84I.R.C. § 4958(f)(1)(A) & (2).

85I.R.C. §§ 4946(a)(1)(B) & 4946(b).

86Notice § 4.01(11).

87I.R.C. § 7206(1).

88See Instructions for Form 1023-EZ (01/2018), https://www.irs.gov/pub/irs-pdf/i1023ez.pdf.

89This arrangement would be distinct from a traditional joint venture, because in this case, the objective of both participating entities would be charitable in nature.

90See, e.g., Del. Code Ann. tit. 6, §§ 18-301(d) (“Unless otherwise provided in a limited liability company agreement, a person may be admitted to a limited liability company as a member of the limited liability company without acquiring a limited liability company interest in the limited liability company”), 18-503 (“The profits and losses of a limited liability company shall be allocated among the members, and among classes or groups of members, in the manner provided in a limited liability company agreement”), &18-504 (“ Distributions of cash or other assets of a limited liability company shall be allocated among the members, and among classes or groups of members, in the manner provided in a limited liability company agreement.”)

91Among states that have adopted nonprofit LLC statutes, Tennessee requires the LLC's sole member to be a nonprofit organization, Kentucky and Minnesota prohibit a member that is not a nonprofit entity from having a financial interest in the organization or receiving pecuniary gain from it, and North Dakota law provides that an individual may not be a member of, or own any financial rights in, a nonprofit LLC. Tenn. Code Ann. § 48-101-702(3)(B); Ky. Rev. Stat. Ann. § 275.520(1); Minn. Stat. Ann. § 322C.1101; N.D. Cent. Code § 10-36-05.

92See supra note 10.

93See RULLCA § 105(d) and associated comment.

94Tennessee, Minnesota, and North Dakota, which have each adopted nonprofit LLC statutes, impose the fiduciary duties and standards of conduct applicable to nonprofit corporations to nonprofit LLCs formed in the states. Tenn. Code Ann. § 48-101-705(a); Minn. Stat. Ann. § 322C.1101, subd. 5; N.D. Cent. Code § 10-36-03.

95Treas. Reg. § 1.501(c)(3)-1(b)(4).

96I.R.C. § 501(c)(3).

97I.R.C. §§ 4958 & 4941.

98See generally People of God Community v. Commissioner of Internal Revenue, 75 T.C. 127 (1980) (finding that the petitioner nonprofit did not qualify under section 501(c)(3) because its net earnings inured to the ministers who controlled all of its affairs); Wendy L. Parker Rehabilitation Foundation, Inc. v. C.I.R., T.C. Memo. 1986-348 (affirming the Service's adverse ruling denying 501(c)(3) exemption for an entity whose funds were distributed solely to one coma victim who was the daughter of the organization's founders); District of Columbia v. Pavilion USA 2020, Inc. et al., 2021-CA-001855-B (D.C. Super. Ct. 2020) (lawsuit filed by D.C. attorney general against D.C. nonprofit recognized as tax-exempt under section 501(c)(3), seeking to recover funds that inured to the benefit of the organization's directors); People of the State of New York v. The National Rifle Association of America, Inc. et al., 451625/2020 (N.Y. 2020) (lawsuit brought by New York attorney general seeking dissolution of respondent partially on the grounds that millions of organizational dollars were diverted to unduly enrich organization executives).

99Notice § 4.02.

100I.R.C. § 501(c)(4).

101I.R.C. § 501(c)(6).

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