When starting a business, one of your first big decisions is which type of business entity to form. Two of your options are a limited liability company (LLC) and a nonprofit. Both offer personal liability protection, which is a big help when running your own business.
But what are the differences between the two? For one thing, LLCs aim to make a profit, while nonprofits do not. As a result, there’s much more ground to cover, and lucky for you, this guide lays out all you need to know about LLCs and nonprofits to help you make an informed decision.
What Is an LLC?
An LLC is a popular business structure for startup companies due to its many benefits. An LLC provides personal liability protection, for example, so your assets are not at risk if your business is sued or cannot pay its debts.
An LLC is considered a “pass-through entity” in taxes, meaning that the LLC itself is not taxed. Instead, income passes through the company to the LLC owners or members, who report it on their tax returns.
LLCs also offer flexibility in management, as there are few requirements regarding organizational structure.
What Is a Nonprofit?
Nonprofits are formed to provide public services, such as combating climate change or reducing poverty. Legally, a nonprofit must have a goal that relates to one of the following types of causes:
- Literary or cultural
- Testing for public safety
- Children cruelty-prevention
- Animal cruelty-prevention
- Foster national/international amateur sports
Nonprofits are funded mainly by donations, driven by fundraising events. Since nonprofits work toward the common good, nonprofits are eligible for tax-exempt status.
Nonprofits are usually structured as corporations. But to qualify as a nonprofit, it can be structured as a corporation, trust, or association. Eligible organizations must apply for 501(c)(3) tax-exempt status through the IRS.
Does Nonprofit Mean the Same as 501(c)(3)?
These terms are often used synonymously, but it’s important to note that just because an entity is called a nonprofit doesn’t necessarily mean that it also has 501(c)(3) status.
A nonprofit is a business entity created for charitable, nonprofit purposes. Conversely, 501(c)(3) status indicates that the IRS has recognized that a business entity qualifies for tax-exempt status due to its charitable, nonprofit purposes.
What Are the Major Differences Between the Two?
LLCs and nonprofits differ in several ways, including:
- Ownership and management structure
- Income distributions
- Tax status
What is the Structure’s Purpose?
Most entrepreneurs form LLCs with the primary objective of making money, meaning LLCs must provide customers with something of value, which draws revenue.
Nonprofits, on the other hand, are formed to serve the public. Specifically, the IRS requires nonprofits to fill a clear purpose that benefits the common good.
Accordingly, nonprofit owners are legally barred from making any profits from business activities. Thus, when a nonprofit earns more money than it needs to cover expenses, the surplus funds must be reinvested in the organization or donated to the cause in its mission.
How Does Ownership and Management Work?
LLCs can be managed by their members or by managers. Some states require that when you register your LLC with the state, you declare whether your LLC will be member or manager-managed, so be aware that you may need to make this decision before you file.
In a member-managed LLC, members handle all management duties. Member-managed LLCs generally work best for LLCs with few members, all of whom can take an active role in day-to-day operations.
Most LLCs are member-managed, as they are small businesses that cannot afford a management team.
In a manager-managed LLC, non-member employees oversee operations and management duties. Note that with a manager-managed LLC, a member can be a manager, but only in cooperation with another manager who is not a member.
Manager-managed LLCs are best for LLCs with multiple members, some of whom want to be “silent” or passive members and not involved in day-to-day operations.
LLC Management and Operating Agreements
LLC management is more clearly defined in the operating agreement. Most states do not require an operating agreement, but it’s vital. It defines members’ ownership percentages and profit allocations and should also include the following:
- Each member’s rights and responsibilities
- Management structure and roles
- Voting rights of each member
- Rules for meetings and voting
- What happens when a member sells their interest, becomes disabled, or dies
You can find operating agreement templates online, but it’s best to have them drawn up or reviewed by an attorney. The language of an operating agreement is crucial and can often help determine how member disputes will be resolved.
Unlike an LLC, nonprofit organizations are required to have a board of directors to oversee their management and activities.
The owners of nonprofit organizations are generally not the organization’s founders, as you might expect. Instead, since the nonprofit works for the common good, the public is considered the organization’s owner, though it has no actual control.
Yet this doesn’t mean the founders are uninvolved. On the contrary, founders typically hold a managerial position in their nonprofit.
How Are Profits Distributed?
Most LLCs split profits based on owners’ capital contributions, but they have the option to specify in the operating agreement any profit-sharing plan they choose.
For instance, one member can take a share of profits greater than their interest while other owners take less. This may be based on the fact that one member is more involved in day-to-day operations.
Conversely, the owners of nonprofit organizations cannot receive any profits earned by the organization. Instead, owners must accept what the IRS defines as a reasonable salary.
Once expenses are covered, any additional income must be used to advance the nonprofit’s operations or donated to the relevant cause.
How is the Structure Taxed?
A distinguishing feature of LLCs is their taxation options. Owners can select how they would like their business to be taxed.
Unless the owners fill out forms requesting the IRS tax them in a different method, the number of members will determine how an LLC is taxed. Nevertheless, it’s important to note that business owners may also need to pay self-employment taxes.
If your LLC only has one member, it will be taxed as a sole proprietorship by default. If your LLC has more than one member, it will be taxed as a partnership by default. Both of these methods are subject to pass-through taxation.
This means the business’s income is not taxed but gets reported on the owners’ tax returns. Thus, taxes are paid at the individual tax rate of each member. Additionally, LLC members can deduct any business losses and operating expenses.
The IRS requires LLCs with more than one owner to file form 1065, which is the Return of Partnership Income. In addition, k-1 forms will be attached to the 1065 document for each partner to complete, which details their portion of the business’s income.
However, LLCs can also choose to be taxed as a corporation instead by filing the appropriate form with the IRS. There are two different types of corporations that an LLC can elect to be taxed as, and the type you choose determines which filing you will need to complete.
LLCs Taxed as C-Corporation
An LLC taxed as a C-corporation or C-Corp will have its profits taxed at the current corporation tax rate. As of late 2022, this is 21%, substantially lower than the typical individual tax rate.
C-Corp shareholders don’t have to pay self-employment taxes. But they are required to pay taxes on their distributions, and for an LLC, this includes all members. Therefore, entities taxed as C-Corps are subject to double taxation.
LLCs Taxed as S-Corporation
An S-corporation, or S-Corp, is also subject to pass-through taxation. This means that a company’s income is not taxed and instead gets handed off to the owners. In this situation, the tax rate is the same for individual taxpayers.
Entities classified as an S-Corp file taxes using the IRS’s Form 1120-S, which declares each shareholder’s income, losses, and dividends. Like a C-Corp, shareholders of an S-Corp aren’t required to file and pay self-employment taxes.
It’s vital to note that additional bookkeeping and payroll expenses are involved in running a business classified as an S-Corp. The main issue is that the tax benefits should outweigh the additional costs; otherwise, S-Corp status makes little financial sense.
For the most part, S-Corp status is only advantageous for businesses with at least $10,000 in annual member distributions and which pay members via a salary., enabling the business owners to be taxed as employees, meaning they can avoid self-employment taxes.
The bottom line is that LLC income is taxed, while nonprofit income is not.
Nonprofit organizations qualify for tax-exempt status at the federal level, as well.
To obtain federally recognized tax-exempt status, eligible business entities that satisfy all requirements must apply for a 501(c)(3) nonprofit, tax-exempt status with the IRS. However, nonprofit organizations may also need to seek additional tax-exempt status at the state level.
Can My LLC Also Be a Nonprofit?
Now for the big surprise – you don’t have to choose, because you can be both.
It’s rare, but there are nonprofit LLCs. For an LLC to obtain federal tax exemption, it must apply for 501(c)(3) status. However, nonprofit LLCs are only allowed in some states, and even to use, the LLC must satisfy specific requirements.
Remember that all LLCs that receive exemption approval from the IRS are automatically taxed as a corporation.
Qualifying Criteria: Federal-Level
The IRS requires all LLCs applying for 501(c)(3) status to provide copies of organizational documents, including the articles of organization and the operating agreement. Then, the information within these documents must satisfy the following requirements:
- The articles of organization and the operating agreement must specify and limit the purpose of the LLC to at least one that the IRS has deemed to be charitable.
- The articles of organization and the operating agreement must specify that the LLC’s assets are officially and permanently committed to charitable, tax-exempt purposes.
- A dissolution clause must also be included.
- All LLC operations and activities must be characteristic of the effort to advance the LLC’s specified charitable purpose.
Qualifying Criteria: State-Level
Every state is different, so if you own an LLC, you must look into the requirements and regulations of your state. For example, some states only allow the formation of LLCs with a non-charitable business purpose.
Applying for 501(c)(3) Status
As of late October 2021, LLCs seeking 501(c)(3) status must apply on the IRS website with Form 1023. The IRS also offers a streamlined application for smaller, qualifying entities – Form 1023-EZ. But LLCs are not eligible to apply with this form.
To repeat, LLCs applying for 501(c)(3) status must use IRS Form 1023.
To Sum it Up
The critical difference between LLCs and nonprofits is rooted in the entity’s purpose. LLCs can acquire nonprofit status, but they need to meet several requirements to do so. Since this tends to be rather complicated, nonprofit LLCs are relatively unusual.
Choosing which type of business to form is a crucial decision that should be made with professional guidance. If you’re unsure which is best for you, consult your attorney and tax advisor to weigh your options. You want to give your business the best chance of success.