LLCs and nonprofit organizations - for-profits, nonprofits, and hybrids.

• Author: Keatinge, Robert R.
• Position: Limited liability companies

"There is no reason why good cannot triumph as often as evil. The triumph of anything is a matter of organization. If there are such things as angels, I hope that they are organized along the lines of the Mafia."

Kurt Vonnegut, THE SIRENS OF TITAN (1959).

INTRODUCTION I. NONPROFIT ORGANIZATIONS A. General Concepts B. UBTI II. THE EFFECT OF MEMBERSHIP IN AN LLC ON THE EXEMPTION OF THE EXEMPT ORGANIZATION A. General Background B. Revenue Rulings 98-15 and 2004-51 III. LLCS AS EXEMPT ORGANIZATIONS IV. HYBRID ORGANIZATIONS A. B Corporations B. L3Cs C. Other LLCs as Hybrid Organizations V. DRAFTING CONSIDERATIONS IN ESTABLISHING A NONPROFIT OR HYBRID LLC CONCLUSION INTRODUCTION

The acceptance of the limited liability company (LLC) in 1998 afforded business owners and their advisors with a more straight-forward and flexible way of doing business than was available at that time. Two decades ago, there were two organizational forms under which business owners could obtain pass through taxation without vicarious liability for the obligations of the organization--the S corporation and the limited partnership with a corporate general partner. (2) The LLC eliminated some of the limitations attendant to each of these forms. Unlike the S corporation, the LLC has no limitation on the number and types of owners, the inability to have special allocations and other sorts of economic relationships, and the necessity to comply with state-law corporate strictures. Unlike a limited partnership with a corporate general partner, the LLC does not require the maintenance of two organizations, and unlike limited partners, members of an LLC are not subject to potential vicarious liability for participation in management or control of the organization. (3) In some respects it is remarkable that the simplicity and efficiency of the LLC would only come into existence after decades of increasing complexity in both corporate and unincorporated worlds. As Lord Buckley has put it, "it was so simple it evaded me." (4)

Had the LLC merely provided these benefits, it would have been a useful addition to the arsenal of legal entities available to the business community. But the LLC's flexibility and efficiency has been the occasion for rethinking many other aspects of organizational structures. Two of the most significant are the single-member LLC, discussed by Carter Bishop elsewhere in this journal, (5) and the elimination of the requirement that an unincorporated business organization be organized for profit. One result of this reconsideration of business entities is a reconsideration of the form and structure of organizations that are explicitly not organized to realize an economic profit (nonprofits) and the advent of new forms and structures designed to combine economic returns with non-economic objectives (hybrids). This article considers this aspect of the development of LLCs.

This article deals with the LLC in the context of nonprofit organizations, (6) both as a legal entity in which a nonprofit organization may be a member and as an organization that may, itself, be organized as a nonprofit organization, or a hybrid organization--one that may be organized for a purpose that is neither exclusively for-profit nor exclusively nonprofit. Most legal organizations are created pursuant to a state law, referred to in this article as an "organic statute." (7) Unlike partnerships (8) and business corporations under the Model Business Corporation Act, (9) LLCs (and, more recently, limited partnerships) do not need to be organized for profit. (10)

The rules applicable to most business organizations under the organic statutes under which they are created may be supplemented through documents (referred to herein as "organic documents") created by those organizing the organization, the organization's owners, or the managers of the organization. The organic documents have different designations in different organizations. (11) The organic statutes applicable to most LLCs afford great freedom to organize LLCs in the manner best suited to the objectives of those organizing the LLCs.

Part I of the article discusses the basic rules for the operation of organizations exempt from taxes under I.R.C. [section] 501(c)(3) (exempt organizations) and other nonprofit organizations, including the tax concepts as unrelated business taxable income. Part II discusses the effect that membership in an LLC has on the exemption status of an exempt organization. Part III considers an LLC organized as a nonprofit, particularly as an exempt organization. Part IV explores hybrid organizations, including B corporations and low-profit limited liability companies. Part V discusses drafting considerations when establishing a nonprofit or hybrid LLC.

1. NONPROFIT ORGANIZATIONS

   1. General Concepts

      There are three common types of organizations that are not organized for profit: (1) organizations that are organized for public benefit under I.R.C. [section] 501(c)(3) (commonly referred to as "charities" or "public benefit organizations"); (12) (2) organizations that are organized for the mutual benefit of their owners, although not for the financial profit of the organization (such as business leagues, homeowners associations, and the like, sometimes referred to as "mutual benefit organizations"); and (3) religious organizations. Each of these organizations may be "exempt," meaning that except for unrelated business taxable income (UBTI), which is discussed below, the income (often including contributions by members) is not taxed to the organization as a result of the exemption under I.R.C. [section] 501(a). The mere fact that an organization is "exempt" does not mean that contributions to the organization will be deductible. Only contributions to certain charitable organizations and religious organizations are deductible. (13) The Internal Revenue Service (Service) may treat a disregarded LLC owned by a charitable organization as a disregarded entity that can be included on the exempt organization's return, (14) but it is unclear whether a contribution to a disregarded entity will be tax deductible. (15) Some states will not treat an exempt LLC as a charitable organization for purposes of property tax exemption. (16) Contributions to other exempt organizations are not deductible as charitable contributions. (17) In addition to its federal tax treatment, an organization's status as a charitable organization is important to other rules applicable to it or to others dealing with it. For example, some charitable organizations are granted state property tax exemptions by virtue of that status. A charitable organization's status also makes it a permissible recipient of contributions from other charitable corporations or governmental agencies.

      In order to qualify as a charitable organization, an organization must be organized and operated exclusively for one or more exempt purposes. (18) Historically, most charitable organizations have been organized as trusts, foundations, or corporations. The choice of legal form will have some consequences, but there are also overriding policies that apply to charitable organizations of all types (or, in some cases such as health care, charitable organizations of particular types). (19) Under the laws of most states, corporate charitable organizations are organized under a separate nonprofit corporation statute, although charitable corporations in Delaware are organized as nonstock corporations under the Delaware General Corporation Law. (20) Neither the Revised Model Nonprofit Corporation Act (RMNCA) (21) nor the recently completed Model Nonprofit Corporation Act, Third Edition (MNCA) (22) limits the operation of a nonprofit corporation to nonprofit purposes, (23) although both proscribe interim distributions. (24) Under the nonprofit corporation statutes of many states, the attorney general is expressly given authority to regulate the affairs of nonprofit corporations. (25) The MNCA limits the attorney general's role in organizational governance. (26) This approach has drawn criticism from the reporter on the ALI Principles of Nonprofit Organizations. (27)

      It will satisfy this test only if it engages primarily in activities that accomplish one or more of the purposes specified in I.R.C. [section] 501(c)(3). (28) If more than an insubstantial part of the organization's activities is not in furtherance of an exempt purpose, the organization will not qualify as exempt. (29) In addition, such an organization must both (1) be organized and operated so that no part of its net earnings inures to the benefit of any private shareholder or individual (the proscription against private inurement), (30) and (2) not confer more than an incidental private benefit on any individual (the proscription against more than incidental private benefit). (31) The critical distinction between the private inurement and private benefit rules is that the proscription against private inurement is absolute. An incidental amount of private benefit will not jeopardize exempt status, but even the smallest amount of private inurement will. Possibly, as a result of the draconian effects of loss of a charitable organization's exempt status as a result of any private inurement, Congress adopted rules, (32) which are sometimes referred to as "intermediate sanctions," under which a tax is imposed on a "disqualified person" (the beneficiary of the wrongful transaction, referred to as an "excess benefit," rather than the organization) equal to 25 percent or 200 percent of the value of that excess benefit.

      In addition, there is a tax of 10 percent of the excess benefit transaction imposed on any "organization manager" who participates in an excess benefit transaction knowing that it is such a transaction, unless the participation is not willful and is due to reasonable cause. In a partnership or LLC, most general partners, managers, and members of a member-managed LLC will have the...