Choosing a business structure is an important step in forming any company. Startup businesses can choose among several structures, and two options are a limited liability company (LLC) or a nonprofit organization.
While both LLCs and incorporated nonprofits provide limited liability protection, they are very different regarding tax liability and purpose.
When considering an LLC versus a nonprofit structure, a startup must decide whether its purpose is to make a profit or to serve the public interest.
What Is an LLC?
An LLC, often used as an alternative to incorporation, combines many features of corporation and partnership structures.
- An LLC exists as an entity separate from its owners, who are called “members." Members cannot be held personally liable for the company’s debts.
- The number of members allowed in an LLC is unlimited. Members can be individuals, corporations, or other LLCs.
- The main purpose of an LLC is to earn a profit for its members.
Pros and Cons of LLCs
Flexibility with profit distribution
Members avoid double taxation
Fairly easy to operate
No formal meeting minutes or resolutions
Formation rules may differ across states
Fewer protections than corporations
More complex to set up and run
Pros of LLCs Explained
Since members cannot be held personally liable for the company’s debts, an LLC provides some protection against financial problems or lawsuits.
An LLC also has some flexibility when it comes to profit distribution. Unlike common partnerships that require an equal split, an LLC distributes its profits, losses, and expenses to each member depending on their ownership.
Because of this structure, members also avoid double taxation, which means paying both corporate and individual tax. Additionally, an LLC doesn’t require formal meeting minutes or resolutions on the record as corporations do.
LLCs can be fairly easy and flexible to operate. Members can manage an LLC’s operations themselves or mimic a corporation’s structure using a board of managers to run the company.
At termination, an LLC can be dissolved and remaining funds can be distributed to the members. Or, individuals or other businesses can buy the LLC. However, the LLC cannot live on in perpetuity like a corporation.
Cons of LLCs Explained
There are disadvantages when choosing an LLC. Although all 50 U.S. states allow the formation of LLCs, the rules may differ across states. This could create a problem should legal problems occur that cross state lines.
Investors might be less confident about an LLC since they are fairly new and have fewer protections than the standard corporation. Also, only corporations can go on to launch an IPO.
Also, setting up and running an LLC can be more complex than choosing other structures, such as a sole proprietorship or partnership. LLCs are taxed with profits and losses passing to the individual members.
What Is a Nonprofit?
The Internal Revenue Service (IRS) designates a nonprofit organization as a tax-exempt entity. Nonprofits do not pursue profit as a primary purpose, but instead serve the public interest. Nonprofits don’t pay federal income taxes in recognition of their mission to serve the public.
There are several types of tax-exempt nonprofits, but they generally fall into these categories:
- Charitable organizations: These groups are designated as 501(c)(3) charities. They adhere to specific purposes such as religious, charitable, scientific, testing for public safety, literary, and educational. They are largely funded by the public. Donors to these organizations may qualify for a tax deduction for their donations.
- Churches and religious organizations: These organizations are also designated as 501(c)(3) and receive a tax exemption.
- Private foundations: This tax-exempt category is also designated 501(c)(3), but they are typically funded by one benefactor or family, not the general public. They provide grants to other charitable organizations to support their programs.
- Other nonprofits: A variety of other nonprofits are also tax-exempt. They include social welfare organizations designated as 501(c)(4), social clubs designated as 501(c)(7), and business and civic leagues designated as 501(c)(6).
Many people think a nonprofit cannot earn a profit, but that is not true. Nonprofits, however, reinvest any profits back into their organizations to fund their purpose.
Unlike public and private companies that have owners or shareholders, when nonprofits bring in more money than their expenses, those profits do not “inure” to any person or group of people.
Pros and Cons of Nonprofits
Members not held liable for organization debt, lawsuit, or fine
Can solicit for public donations
Donors may get tax deductions
Can apply for grants
Contribute to social welfare
Lack of flexibility, must maintain original purpose
Can lose IRS designation for several reasons
Require considerable reporting, record keeping, and oversight
Lengthy process to become tax-exempt
Pros of Nonprofits Explained
Like LLCs, nonprofit organizations also have limited liability protection if incorporated. Most nonprofits of any size do incorporate. Thus, directors, executives, members, and employees are not held liable for the organization’s debts, lawsuits, or fines, as long as they have fulfilled their fiduciary and legal responsibilities.
Nonprofits can solicit the public for donations, and donors may receive a tax deduction for those donations. Nonprofits can also apply for grants from federal and state governments, private foundations, and corporations.
A nonprofit is a good fit when the founders want to contribute to social welfare, and their cause has wide public support.
Cons of Nonprofits Explained
Nonprofits can lose their IRS designation for several reasons, including too much political activity or too much unrelated business activity. Moreover, while a business can be sold or closed, a nonprofit’s assets must be given to another nonprofit if it closes.
Nonprofits also require considerable reporting and record keeping. Since the public supports a nonprofit, the IRS makes sure that everything is regulated and documented.
A nonprofit goes through a lengthy process to become a tax-exempt entity, starting with incorporating at the state level and then applying to the IRS for tax exemption. Also, a nonprofit must file annual reports known as Form 990s.
Nonprofits receive quite a lot of oversight from the states where they incorporate and from the IRS.
Can Nonprofits Register as an LLC?
One or more existing 501(c)(3) organizations may form an LLC as an ancillary entity to provide related or unrelated income to the nonprofit or group of nonprofits or to hold certain assets. Once certain conditions are satisfied, the LLC would be tax-exempt.
Individuals and non-501(c)(3) organizations may not use the LLC to form a tax-exempt 501(c)(3) nonprofit organization.
Nevertheless, there is a trend toward blending business and charitable activities, and several hybrid structures have been created to facilitate that movement.
Examples of hybrid business structures include:
- The low-profit LLC (also known as an L3C). This organizational structure requires a socially beneficial purpose.
- Benefit corporations (B Corporations). These are for-profit companies that achieve the extensive requirements to be certified as B Corporations. B corporations pledge to balance profit with purpose.
Which Business Structure Should You Choose?
Whether you choose an LLC, a nonprofit, or another structure for your business, it’s important to research the requirements for each based on where you plan to do business. Also, one must decide whether the pursuit of profit or providing for social welfare is most important.