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IRS Releases Guidance on Requirements for Limited Liability Companies to Qualify as Tax-Exempt Entities

On October 21, 2021, the Internal Revenue Service (the “IRS”) released Notice 2021-56 (the “Notice”), which sets forth the additional requirements a limited liability company (“LLC”) must satisfy to obtain a determination letter recognizing its tax-exempt status under sections 501(a) and 501(c)(3) of the Internal Revenue Code.[1]

The Notice also requests public comments by February 6, 2022 to assist the IRS and Department of the Treasury in determining whether further guidance is needed. Of particular interest are potential conflicts with state LLC statutes. For instance, the Notice requests comments on whether an LLC could be formed for exclusively charitable purposes in states that require LLCs to be profit-seeking, and whether other provisions of state LLC statutes could prevent an LLC from qualifying for federal tax exemption. In addition, the Notice asks whether an LLC seeking section 501(c)(3) status should be allowed to have members that are not themselves section 501(c)(3) organizations, governmental units, or wholly-owned instrumentalities of governmental units.

While the IRS has provided informal guidance in the 2000 and 2001 Exempt Organizations Continuing Professional Education articles, the Notice represents the first formal guidance from the IRS for LLCs seeking to qualify for federal tax exemption.

Very generally, the Notice requires an LLC to add language to both its articles of organization and operating agreement that demonstrates an entirely tax-exempt purpose. More specifically, to obtain a favorable determination letter from the IRS, the Notice requires the following standards to be met by an LLC that submits a Form 1023 (“Application for Recognition of Exemption Under section 501(c)(3) of the Internal Revenue Code”) after October 21, 2021:

Provisions required in LLC articles of organization and operating agreement*

  1. Provision 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 a wholly-owned instrumentality of such a governmental unit);

  2. Express charitable purpose and charitable dissolution provision in compliance with Treas. Reg. §1.501(c)(3)-1(b)(1) and (4);

  3. 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).

*Of note, the Notice provides that if an LLC is formed in a state that prohibits adding provisions to the articles of organization besides those mandated by that state’s LLC law, the above conditions are deemed to be satisfied so long as: (1) the operating agreement contains those provisions; and (2) the articles of organization and operating agreement do not contain inconsistent provisions.

Representation on Enforceability

The LLC must represent that all provisions in its articles of organization and operating agreement are consistent with applicable state LLC law and are legally enforceable.

The Notice is helpful for LLCs seeking to qualify for federal tax exemption under sections 501(a) and 501(c)(3). However, besides the LLC’s flexibility with respect to governance, it is unclear why tax-exempt organizations would favor this vehicle over the traditional corporation. Further to this point, in the Notice, the IRS requests public comments on the advantages and disadvantages of forming an entirely charitable organization as an LLC as opposed to a corporation or charitable trust. While the Notice may signal greater use of LLCs by tax-exempt organizations, it remains doubtful whether the Notice will lead to any significant changes in the market.

[1] All references to “section” are to the Internal Revenue Code of 1986, as amended.

© 2023 Proskauer Rose LLP. National Law Review, Volume XI, Number 341

About this Author

Amanda Nussbaum, Tax Attorney, Proskauer Rose Law Firm

Amanda H. Nussbaum is a Partner in the Tax Department and also is a member of the Private Investment Funds Group. Her practice concentrates on planning for and the structuring of domestic and international private investment funds, including venture capital, buyout, real estate and hedge funds, as well as advising those funds on investment activities and operational issues. She also represents many types of investors, including tax-exempt and non-U.S. investors, with their investments in private investment funds.

Stuart Rosow, Tax, Attorney, Proskauer Rose Law Firm

Stuart Rosow is a partner in the Tax Department and a leader of the transactional tax team. He concentrates on the taxation of complex business and investment transactions. His practice includes representation of publicly traded and privately held corporations, financial institutions, operating international and domestic joint ventures, and investment partnerships, health care providers, charities and other tax-exempt entities and individuals.

For corporations, Stuart has been involved in both taxable and tax-free mergers and acquisitions. His...

Law Clerk

Rita Halabi is a law clerk in the Tax Department.