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www.HartfordBusiness.com November 22, 2016 • Hartford Business Journal 7 G I V I N G G U I D E 2016 Disregarded Entity LLCs Join the Nonprofit Mainstream L imited liability companies (LLCs) are generally thought of as a form of for-profit business entity, taking off on the legal scene in the 1990s when all 50 states passed authorizing legislation. They have since become the for-profit "entity of choice" because they combine two desirable operating features: limited liability (a feature of corporate law where the owners are not responsible for the LLC's liabilities) and pass-through taxation (a feature of partnership tax law where the LLC's income is reported only on the tax return of its owners). LLCs have now acquired a permanent place in the nonprofit sector and the IRS has helped "pave the way" by explicitly sanctioning nonprofits' use of LLCs in a variety of settings. We will discuss one of these situations: the single member LLC, wholly owned by a nonprofit and "disregarded" as a separate entity for federal tax purposes. Many nonprofits are complex enterprises, balancing real estate, employee benefit plans, debt, operational risks and the like. To prudently navigate this labyrinth, we commonly recommend creating an organizational structure in which discrete activities or assets are conducted or held by separate subsidiaries under the control of a nonprofit "parent." Traditionally we recommended creating subsidiary stock corporations (to house unrelated business activities) and subsidiary nonstock corporations with separate IRS tax exemption rulings (to house exempt function activities). However, over the past decade disregarded entity LLCs have emerged as an attractive alternative. In 2002, the IRS began paving the way for nonprofits' use of disregarded entity LLCs when it confirmed that: (1) the Section 501(c)(3) qualifying activities of a disregarded entity should be reported on the nonprofit parent's Form 990 annual informational return and (2) the disregarded entity did not need to obtain a separate IRS determination letter. In 2012 the IRS confirmed that donors could make tax deductible contributions directly to disregarded entities of qualifying nonprofit organizations. Earlier this year, the IRS confirmed that employees of a disregarded entity are permitted to participate in the nonprofit parent's Section 403(b) and Section 457 employee benefit plans. However, despite the IRS' guidance, we have found that disregarded entity LLCs continue to present a metaphysical paradox, perhaps best illustrated with a quick hypothetical. Assume that a nonprofit provides services to people with intellectual disabilities and has created a wholly owned LLC to operate a gift shop providing jobs for its disabled clients. If a liability arises at the gift shop (for example, a slip and fall accident), the LLC's separate existence under state law should help insulate the nonprofit from monetary liability associated with the claim. From a federal tax perspective, however, the LLC is disregarded, which means that all of the gift shop's income and expenses will be reported on the nonprofit parent's Form 990. If the income- generating activity is substantially related to the nonprofit's exempt purpose (which it should be in this example), the income reported on the Form 990 will be exempt function income. If the LLC's activities constitute an unrelated trade or business, the income and expense would be reported on the nonprofit's Form 990-T. What if, in the above example, the LLC was so successful that its unrelated business income dwarfed that of the nonprofit's exempt function income? The IRS has consistently stated that the activities of disregarded entities are deemed (or attributed) to be the activities of their owners. The IRS has not, however, clearly delineated the point at which the LLC's unrelated business income represents a "substantial" non-exempt purpose of the nonprofit parent which could jeopardize the nonprofit's tax exemption. Thus, we regularly advise nonprofit clients to monitor the activities of their disregarded entities as they would monitor their own activities to ensure unrelated business income does not become such a substantial portion of their overall revenue. An advantage of conducting unrelated business income generating activities through an LLC (as opposed to the nonprofit directly conducting those activities), is that it will be easier to subsequently convert the tax status of the LLC (i.e., establish the LLC as a separately-taxable entity) in order to proactively address the concern of the IRS attributing the LLC's unrelated business activities as those of the nonprofit and revoking the nonprofit's tax exemption. Let's quickly consider how state property tax laws would treat the LLC using the gift shop example again. The applicable Connecticut property tax exemption statute [Conn. Gen. Stat. Section 12-81(7)] has been subject to inconsistent interpretation by property assessors (through no fault of the assessors). This subsection of the statute exempts from tax real and personal property owned or "held in trust for" Section 501(c)(3) organizations (provided the property is exclusively used for the applicable 501(c)(3) purposes). Almost no authority or guidance has yet to emerge as to whether "held in trust for" covers property held by an LLC wholly owned by a nonprofit organization and disregarded for federal income tax purposes. The ultimate answer to address this lacuna would be a statutory amendment, one that we would argue is a "revenue neutral," but could be controversial given recent calls to tax nonprofit property owners emanating from certain members of the State legislature. In summation, disregarded entity LLCs have joined the nonprofit mainstream but should be used with caution. Reid and Riege has been committed to our clients' success and guided by their priorities since 1950. Whether closely held businesses, large financial institutions, individuals or corporations, all Reid and Riege clients receive undivided attention, access to integrated resources, and legal solutions crafted to meet their business or personal objectives. 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