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Can an LLC Be a Tax-Exempt Controlled Entity?

Section 501(c)(3) of the Internal Revenue Code allows the IRS to designate certain types of organizations as tax-exempt entities if they engage in certain types of nonprofit activities that benefit the public at large. However, there are restrictions that affect a limited liability company’s, or LLC’s, eligibility for tax-exempt status, as well as those entities controlling it.

 

501(c)(3) Eligible Entities

The federal tax law includes an exclusive list of legal entities that may be eligible for tax-exempt status under 501(c)(3). Only corporations, community chests, funds and other foundations are eligible. However, the IRS excludes individuals and partnerships, which means they are ineligible to obtain tax-exempt status. Since the IRS automatically treats an LLC as either a sole proprietorship or partnership for income tax purposes, an LLC must satisfy additional requirements before it’s eligible to apply for tax-exempt status.

LLC Tax Designations

One of the benefits of operating an LLC is the income tax flexibility it provides members. The members of an LLC have the option to change its automatic tax designation from a sole proprietorship or partnership to a corporation. To accomplish this, the LLC makes a formal election on Form 8832 to be taxed as a corporation. Once an election is made, corporate taxation will apply to the LLC and all members for at least five years, after which time a new election can be made. However, members of an LLC should be aware that making a corporate election on Form 8832 doesn’t mean that the entity will be successful obtaining tax-exempt status under 501(c)(3) – it’s merely the first, but an essential step.

Tax-Exempt LLC

To obtain tax-exempt status, the LLC must expressly state in its formation documents that the sole operating mission is to promote one or more of the activities listed in Sec. 501(c)(3). These activities can include promoting religious, literary, educational, scientific, charitable and humanitarian causes. In addition, LLC members that control the LLC must also satisfy the eligibility requirements for tax-exempt status. This means that individuals and partnerships cannot control the LLC.

LLC File Form 1023

Once all members of an LLC are confident that all requirements can be satisfied, filing a tax-exempt application with the IRS on Form 1023 is the next step. The form requires disclosure of all LLC financial and operating information, including information about its members. Form 1023 will also ask questions about the tax-exempt activities of the LLC and requires numerous attachments from the LLC’s operating agreement. Remember, tax exemption isn’t automatic – the IRS review applications on a case-by-case basis, so it’s sometimes difficult to predict the outcome.

Reference: IRS Publication 557-Tax-Exempt Status for Your Organization