LLCs Remain a Strategic Option for Tax-Exempt Health Care
A recent IRS notice has reinvigorated the discussion around utilizing limited liability companies (LLCs) in connection with Section 501(c)(3) tax-exempt organizations, including charitable health systems and related health care organizations. More specifically, last October, the IRS released Notice 2021-56, which provided more definitive guidance on LLCs obtaining their own Section 501(c)(3) tax-exemption, which, although not a new concept, could be a useful tool for tax-exempt health care.
Under the IRS “check-the-box” regulations, LLCs have flexibility to elect their federal tax status. By default, an LLC owned by a single organization is a disregarded entity for federal income tax purposes (i.e., disregarded as separate from its member) and an LLC owned by multiple members is treated as a partnership for federal income tax purposes (i.e., tax items are allocated proportionally to the members). Under such default treatment, an LLC is not separately taxable for federal income tax purposes and, thus, cannot obtain its own federal tax exemption (i.e., the LLC would need to elect to be taxed as a corporation to do so).
Single member disregarded LLCs are useful in tax-exempt health care because a tax-exempt organization can create an LLC subsidiary and achieve liability segregation but effectively extend its tax-exempt status to such subsidiary, assuming the subsidiary’s activities would otherwise qualify as tax-exempt (i.e., the parent tax-exempt organization would report subsidiary income on its IRS tax return as exempt function revenue in this scenario). Additionally, the IRS confirmed that a disregarded entity of a tax-exempt Section 501(c)(3) organization can directly receive tax-deductible contributions (see IRS Notice 2012-52). Finally, LLCs (as compared to corporations) provide significant flexibility in terms of governance, management and decision-making structure as well as other corporate formalities (e.g., an LLC can, but generally need not, have its own governing board, committees, officers, etc.).
Multiple member LLCs treated as partnerships for federal income tax purposes are also common in tax-exempt health care. Among other situations, such LLCs are used for joint ventures among tax-exempt health care organizations and/or with taxable organizations or private persons. If properly structured and operated for charitable purposes, a tax-exempt member of a multi-member LLC can treat its allocated income as tax-exempt even if the other members are not tax-exempt organizations.
However, less often considered are LLCs that use the “check-the-box” regulations to elect to be taxed as associations/corporations and apply for their own federal tax-exempt status. Obtaining a separate tax-exemption for an LLC would, among other things, provide assurance that, in the IRS’ view, the LLC’s organization/operations are consistent with Section 501(c)(3) requirements, allow for increased structural flexibility as compared to corporations, streamline fundraising, and grant activities, etc.
As described in IRS Notice 2021-56, in order to qualify for Section 501(c)(3) exemption, an LLC must include the following in its articles of organization and operating agreement (to the extent permissible):
- A requirement that each member of the LLC be either a Section 501(c)(3) organization, governmental unit or wholly-owned instrumentality of a governmental unit;
- Charitable purpose and dissolution provisions demonstrating that the LLC is organized and operated exclusively for exempt purposes and that the LLC’s assets will remain dedicated to an exempt purpose and will not inure to private interests;
- If the LLC is or may be a private foundation, the Chapter 42 compliance provisions specific to private foundations; and
- A contingency plan to address the situation where one or more members cease to be Section 501(c)(3) organizations, governmental units or wholly-owned instrumentalities thereof (e.g., suspension of membership).
The LLC must also represent that all of the foregoing provisions are consistent with state LLC law and are legally enforceable.
Finally, the IRS requested comments and input from the public as well as state regulators on various topics, which are due to the IRS by February 6, 2022, but which also may signal where the IRS is headed in future guidance. Some of those topics include the following:
- Advantages/disadvantages of tax-exempt LLCs instead of nonprofit corporations/charitable trusts
- Applicability of state law on protecting charitable assets
- Consistency of state LLC laws with tax-exempt purposes/requirements
- Permissibility of non-exempt and/or non-governmental members (if so, under what circumstances)
 If state law does not allow one or more of the required provisions to be included in the LLC’s articles of organization, then the IRS will instead grant exemption if the LLC’s operating agreement includes such provisions and neither the operating agreement nor articles contain any inconsistent provisions.