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Exempt LLC Rules Could Be Abused, State Officials Warn

UNDATED

Exempt LLC Rules Could Be Abused, State Officials Warn

UNDATED
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NEW HAMPSHIRE COMMENTS TO IRS NOTICE 2021-56

The notice recognizes that most states have enacted LLC laws and says that “In considering the requirements that an LLC must satisfy to qualify as an organization described in section 501(c)(3), the Treasury Department and the IRS reviewed state laws governing LLCs and the ways in which those laws may differ from the state laws governing not-for-profit (or nonstock) corporations and charitable trusts. It appears that, in a few states, the LLC law may not allow an LLC to be organized and operated exclusively for charitable purposes.”

The Notice asks the following questions:

(1) What are 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?

In New Hampshire, an LLC would avoid certain requirements applicable to nonprofit corporations that are charitable organizations, and thus would avoid certain requirements intended to improve organizational governance and promote public confidence in charitable organizations.

(2) Do 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?

In New Hampshire, registration of charitable organizations and trusts includes any person or entity that conducts charitable activities or that has received a 501(c)(3) determination from the IRS. So theoretically, a charitable LLC would be subject to registration in New Hampshire but would avoid requirements applicable to charitable organizations formed as corporations. For example, NH RSA 292:2-a subjects nonprofit corporations that are private foundations to specific requirements with respect to self-dealing, excess business holdings, or taxable expenditures. In addition, NH RSA 292:6-a requires nonprofit corporations that are public charities to have a minimum of five unrelated directors “in the interest of encouraging diversity of discussion, connection with the public, and public confidence.” The latter section also prohibits employees from serving as the chair of the board of directors. The requirements set forth in these statutes are inapplicable to LLCs.

(3) Most state LLC statutes specify that an LLC may be formed for any lawful purpose. In a few states, however, the LLC statute appears to require that an LLC be a profit-seeking enterprise. In those states, is it permissible as a matter of state law for an LLC to be formed exclusively for section 501(c)(3) purposes?

In New Hampshire, LLCs may be formed for “any legal purpose”. NH RSA 304-C:21.

(4) Most state LLC statutes appear to provide that, upon dissolution and after payment of creditors, an LLC may dispose of its remaining assets among its members or otherwise in whatever manner specified in its articles of organization (also referred to as a certificate of organization or certificate of formation) or operating agreement (also referred to as a limited liability company agreement). In those states, the state LLC statute merely provides default rules that apply in the absence of any provision in the articles or operating agreement.

In New Hampshire, the terms providing for distribution to members upon dissolution are default provisions, but the certificate can provide otherwise. NH RSA 304-A:31, 141.

Other state LLC statutes, however, appear to require distributions of net assets only to members upon dissolution, as immutable rules.

a. In a state in which the LLC statute appears to require distributions of net assets only to LLC members on dissolution, could LLC members at the time of creation of an LLC 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 §1.501(c)(3)-1(b)(4), notwithstanding the state dissolution requirements?

See above. Disclaimer not needed if included in certificate.

b. Would such a disclaimer be enforceable against the LLC members?

See above.

c. Would such a disclaimer be enforceable against creditors of the members?

N/A

(5) The organizational test regulations under §1.501(c)(3)-1(b) generally require certain language (in particular, stated charitable purposes and charitable distribution of assets upon dissolution) to appear in the articles of organization, defined as the written instrument by which the organization is created. Private foundations also must include certain language in their articles of organization to be in compliance with section 508(e). See § 1.508-3. State LLC statutes generally provide that an LLC is created upon filing its articles of organization with the state. between the members and the LLC.

a. Are there state laws that satisfy the dissolution requirements and section 508(e) requirements for charitable LLCs?

Not in New Hampshire.

b. Is there any reason why an LLC should not be required (except as provided in section 4.01(6)) to include appropriate charitable purpose and dissolution language (and section 508(e) language, if applicable) in both its articles of organization and its operating agreement?

An LLC certificate could contain appropriate charitable purpose and dissolution language in New Hampshire. However, the language is not required by statute, and we do not have confidence that the IRS Form 1023 review process would catch the lack of such language in the LLC formation document. As a result, the only entity in a position to be able to identify the deficiency would be the New Hampshire Attorney General's office, which would review the LLC's governance documents as part of its registration review. This situation could create a dilemma, however. Although the Attorney General's office could require an appropriate amendment as a condition for registration, if the organization refused to make the amendment, the Attorney General's office would be faced with an organization that has received classification as a 501(c)(3) organization without the proper organizational document.

(6) Most state LLC statutes do not restrict the ability of an LLC to include the language required under § 1.501(c)(3)-1(b) (and section 508(e), if applicable) in its articles of organization. However, a few states appear to strictly limit what provisions may be included in an LLC's articles of organization.

a. Should the regulations for the section 501(c)(3) organizational test and section 508(e) requirements be revised to accommodate LLCs organized in states that limit what provisions may be included in an LLC's articles of organization if the LLC includes the appropriate language in the LLC's operating agreement?

Not applicable to New Hampshire.

b. Should it matter 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?

Yes. The Attorney General's office would require that any such language appear in the organizational certificate, whether or not it appears in the operating agreement.

(7) 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. In such states, must a charitable LLC form under the state's nonprofit LLC law, or are charitable LLCs permitted to form under the state's general LLC law?

No such law in New Hampshire specific to nonprofit LLCs. Our charitable organization registration requirements are based upon an entity's activity, but not its structure, so there could be conflicts between allowable LLC provisions and disallowed charitable organization provisions.

(8) State laws generally provide an LLC's members with management authority unless the articles of organization (or in some states, the operating agreement) delegate management authority to one or more managers.

a. With respect to qualification for section 501(c)(3) status, should LLCs managed by managers be treated the same as LLCs managed by members?

No. While managers likely would owe fiduciary duties to the LLC, members may not. As a result, member management would be problematic, unless the member was another 501(c)(3) organization.

b. Should LLC managers be treated as officers for federal exempt organization tax purposes generally, including, for example, the compliance provisions of chapter 42?

(9) Are there any other provision of the LLC law in one or more states that may affect the ability of an LLC to qualify under section 501(c)(3)? those discussed in section 3.02 of this notice, to address particular provisions of state LLC law?

In New Hampshire, the default LLC statutory provisions are incompatible with 501(c)(3) classification, including allocation of profits, distributions, and liquidation. NH RSA 304-C:90, 94, 95, 141. But certificate provisions may alter the default provisions. NH RSA 304-C:31.

(10) Are there 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 this notice, to address particular provisions of state LLC law?

Yes. The articles of organization should include the provisions set forth in NH RSA 292:6-a requiring a minimum of five unrelated governing board members and prohibiting any employee from serving as board chair. In addition, the articles of organization should state that the managers and/or members shall be act as fiduciaries in accordance with RSA 7:28-e.

(11) Are there 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?

No. The New Hampshire Attorney General's office has reservations about permitting LLCs to become classified as 501(c)(3) entities because an LLC can avoid the requirements applicable to nonprofit corporations, requirements that are designed to improve organizational governance and promote public confidence in charitable organizations. In addition, in light of the privacy afforded LLCs, the New Hampshire Attorney General's office is concerned that permitting individuals to become members of a charitable LLC risks abuse.

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