IRS Provides Standards for LLCs to be Recognized as Tax Exempt Under Sec. 501(c)(3)

(Parker Tax Publishing October 2021)

The IRS issued a notice setting forth the current standards that a limited liability company (LLC) must satisfy to receive a determination letter recognizing the LLC as tax-exempt under Code Sec. 501(a) and as an entity described in Code Sec. 501(c)(3). The IRS will issue a favorable determination letter to 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, only if the LLC satisfies the requirements set forth in the notice in addition to the general requirements under Code Sec. 501(c)(3). Notice 2021-56.

Background

Code Sec. 501(a) generally provides that an organization described in Code Sec. 501(c) is exempt from federal income tax. Code Sec. 501(c)(3) refers, in part, to corporations, and any community chest, fund, or foundation organized and operated exclusively for certain purposes (i.e., "charitable purposes" or "exempt purposes"), where no part of the net earnings of such entity inures to the benefit of any private shareholder or individual. Code Sec. 7701(a)(3) generally provides that the term "corporation" includes associations. To be an eligible Code Sec. 501(c)(3) organization, an organization must be both organized and operated exclusively for one or more of the purposes specified in Code Sec. 501(c)(3). If an organization fails to meet either the organizational test or the operational test, it is not exempt.

Reg. Sec. 1.501(c)(3)-1(b), which sets forth the organizational test, was issued in 1959, before the enactment of the first limited liability company (LLC) statute in the United States. As a result, the regulations under Code Sec. 501(c)(3) do not specifically address LLCs and the IRS has not issued any formal guidance addressing the requirements for recognition of LLCs as organizations described in Code Sec. 501(c)(3). Historically, the standards that the IRS has applied for purposes of issuing determination letters have generally included a requirement that all the members of an LLC must themselves be Code Sec. 501(c)(3) organizations, governmental units, or wholly-owned instrumentalities of a state or political subdivision thereof.

Notice 2021-56

Last week, the IRS issued Notice 2021-56, in which it construes Code Sec. 501(c)(3) and Reg. Sec. 1.501(c)(3)-1 to permit the IRS to issue a favorable determination letter to an LLC that submits Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, after October 21, 2021, only if the LLC satisfies the requirements set forth in Sections 3.02 and 3.03 of Notice 2021-56 in addition to the general requirements under Code Sec. 501(c)(3). According to the IRS, the requirements in Sections 3.02 and 3.03 of Notice 2021-56 are intended to ensure that the LLC is organized and operated exclusively for exempt purposes, including that its assets are dedicated to an exempt purpose and do not inure to private interests. Notice 2021-56 does not affect the status of organizations currently recognized as described in Code Sec. 501(c)(3).

Under Section 3.02 of Notice 2021-56, the IRS generally will issue a determination letter recognizing an LLC as exempt from tax and as being an entity described in Code Sec. 501(c)(3) only if both the LLC's articles of organization and its operating agreement each include:

(1) provisions requiring that each member of the LLC be either (i) an organization described in Code Sec. 501(c)(3) and exempt from tax under Code Sec. 501(a), or (ii) a governmental unit described in Code Sec. 170(c)(1) (or wholly-owned instrumentality of such a governmental unit);

(2) express charitable purposes and charitable dissolution provisions in compliance with Reg. Sec. 1.501(c)(3)-1(b)(1) and (4);

(3) the express chapter 42 compliance provisions described in Code Sec. 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 Code Sec. 501(c)(3) status) in the event that one or more members cease to be Code Sec. 501(c)(3) organizations or governmental units (or wholly-owned instrumentalities thereof).

Under Section 3.03 of Notice 2021-56, 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. In addition, Section 3.04 of Notice 2021-56 provides that, if 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 requirements of Section 3.02 of Notice 2021-56 will be deemed satisfied if the LLC's operating agreement includes the provisions set forth in Section 3.02 and if the articles of organization and operating agreement do not include any inconsistent provisions.

In Section 4 of Notice 2021-56, the IRS requests public comments on these standards as well as specific issues relating to tax-exempt status for LLCs to assist the IRS in determining whether additional guidance is needed concerning the standards that an LLC must satisfy to be exempt from tax by reason of being described in Code Sec. 501(c).

For a discussion of Code Sec. 501(c)(3) organizations, see Parker Tax ¶60,502.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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