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Current nonprofit sector research and recommendations for effective day-to-day practice from ASU faculty, staff, students, and the nonprofit and philanthropic community.
Cook & Cook
How Does Limited Liability Affect a Nonprofit?
Limited liability entities are often formed (at least in part) to protect the assets of for-profit business owners from the financial obligations of a particular business. In the case of a nonprofit, however, the entity is generally not permitted to have owners who are entitled to the profits of the organization. Rather, any profits earned by a nonprofit must be reinvested. So if a nonprofit cannot have owners who are entitled to its profits, why is it beneficial for a nonprofit to be structured as a limited liability entity, and whom does it protect?
While limited liability can protect the personal assets of owners of a for-profit business from creditors of the business, it can also protect the personal assets of both those who manage for-profit businesses and/or those who manage nonprofits from the debts that such businesses or nonprofits may incur. In the case of a nonprofit, this may include the board of directors, officers, members, etc.
Perhaps one of the most compelling benefits associated with the concepts of nonprofits is the potential for a nonprofit to be recognized as tax-exempt by the Internal Revenue Service (IRS), which means it is not required to pay federal income taxes on profits that it earns.
Although some people equate the term “nonprofit” with “tax-exempt”, they are not the same. In particular, “nonprofit” is a term associated with state law, while “tax-exempt” is a term associated with federal tax law. Nonprofits are not automatically tax-exempt; rather, they must apply for recognition of tax-exempt status with the IRS.
Can I Deduct It?
Charitable organizations, as described in IRC § 501(c)(3), are a subset of tax-exempt organizations. Many nonprofits can qualify as charitable organizations if they are willing to abide by the restrictions, as outlined below, imposed upon charities. In terms of federal tax law, the main advantage of charitable status pursuant to IRC § 501(c)(3) is the potential for donors to deduct the amounts of their qualifying donations on their federal income tax returns pursuant to IRC § 170. THIS IS A BIG DEAL IF SOLICITING DONATIONS because it gives supporters a large incentive to donate, potentially making fundraising easier and helping better ensure the long-term viability of a nonprofit.
Interested in learning more about financing an NPO?
Register now for NMI 103 Financial Management Principles, a Tucson course from January 24-25.
What Is a Charitable Organization According to the IRS?
With some exceptions, in order for organizations to be classified as charitable by the IRS (and thus enable federal income tax deductions for donors), they must be:
“Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.” 26 USC § 501(c)(3).
Aside from the restrictions as to the purposes that a particular nonprofit serves, perhaps the most important restrictions imposed by IRC 501(c)(3) are the broad prohibitions as to influencing legislation or participating in political campaigns.
Which Forms of Limited Liability Entitles Can Be Nonprofit and Tax-Exempt
The most common form of limited liability entity used to structure nonprofit organizations is a corporation. While there are advantages, including limited liability as discussed above, to incorporating a nonprofit corporation, there are various compliance requirements pursuant to state law, which may not be practical for small nonprofits. In particular, a corporation generally:
In order to help reduce, or even eliminate, the aforementioned compliance requirements, some states permit the organization of nonprofit limited liability companies (“LLC”). While LLC laws vary from state to state, an LLC generally:
In addition, members of small, i.e. member-managed, LLCs are often automatically authorized to individually manage and bind their LLCs, dependent upon state law and any relevant provisions of an operating agreement.
It is important to note that relatively few states permit the organization of nonprofit LLCs. These states include (but are not limited to):
Of particular importance, Arizona LLC law does not currently permit the organization of nonprofit LLCs.
A Corporation Bias
Although there are some potentially compelling advantages for small profit organizations that seek to be structured as nonprofit LLCs, there is at least one very large potential disadvantage: with some limited exceptions, the IRS will not issue a letter of determination for a nonprofit LLC confirming that it is a charity pursuant to IRC 501(c)(3), but it will issue such a letter for a nonprofit corporation, if it so qualifies.
Steve Cook is an attorney at Cook & Cook. He assists clients in the formation of limited liability entities to protect their personal assets from creditors of limited liability entities that they own or manage. He attended law school at Arizona State University. Before attending ASU, Steve worked as a web designer and software developer with a focus on creating web-based applications.
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Read Alex Levin's, "Nonprofits: The Legal Requirements of Starting Your Own"