By Mike Herold
March 02, 2017
Many nonprofit organizations utilize single member limited liability companies (SMLLCs) in their operations. SMLLCs are popular vehicles for holding real estate and are an easy way to conduct separate activities in different locations. For example, a skilled nursing or senior care corporation might consist of various locations or centers each held within its own SMLLC. This provides a vessel for managing the operations and profitability of each location more effectively and accurately.
Because a SMLLC is considered a disregarded entity for federal tax purposes, the IRS allows the SMLLC to operate as a tax exempt entity without seeking its own application for tax exempt status. This makes the SMLLC a relatively low cost entity to create while affording the parent an additional level of liability protection through an isolating entity.
Tax exempt entities can obtain a number of state tax benefits beyond income tax exemption. Generally, if an entity is exempt from federal income taxes the same exemption follows to the state level. In addition, many states allow a nonprofit to make purchases of goods and services sales tax exempt free from sales tax. There may also be property tax exemptions available for a tax exempt nonprofit.
Generally, sales by a nonprofit are taxed to the end customer unless an exemption applies. Typically, purchases by a nonprofit are also exempt. Possible sales tax exemptions include the ability to sell goods sales tax exempt when the nonprofit hosts a fund raising activity. The nonprofit might also qualify for other sales tax exemptions such as on the purchase of a vehicle, utilities or telecommunication services.
Many other states provide property tax exemptions or reduced rates for nonprofits. In some situations, these exemptions can even apply if the nonprofit is not the property owner but is only renting space. In this case, it might even be possible to extend a sales tax exemption to rent allocations for common area maintenance.
Based on the above, there are some real state tax advantages for the nonprofit. But what happens when a disregarded entity is owned and operated by a nonprofit parent? The logical presumption is that nothing changes since the entity is disregarded. However, logic is not always a component in state taxation. Therefore, a nonprofit renting space to a SMLLC may risk losing their property tax exemption and become subject to property tax.
While the SMLLC is treated federally as a disregarded entity, many states treat the SMLLC as a separate legal entity. If the SMLLC is considered a separate entity by a state, the question arises to what state tax exemption, if any, flows between the parent and the SMLLC? Not surprisingly, the answer varies and may be far from clear.
Wisconsin, for example, provides the same tax treatment to a SMLLC for income tax and sales tax as its parent. In this case, Wisconsin will allow the ownership and tax treatment for a SMLLC to be disregarded for both income and sales tax.
Minnesota takes a different approach. Minnesota does not treat the SMLLC the same for income and sales tax. While the entity may qualify as a nonprofit for income tax purposes, the Minnesota law requires the SMLLC to stand on its own for sales tax exemptions. Therefore, the SMLLC would need to apply for a sales tax exemption through the Minnesota Department of Revenue. Minnesota currently does not have a sales tax exemption for the transfer of property between the parent and subsidiary when the subsidiary is an LLC or SMLLC.
Even though an entity may be a federally tax exempt 501(c)(3), the states may still need to approve the entity for a sales tax exemption. This may require the nonprofit to provide proof of approval by the IRS. Therefore, if the IRS does not require the SMLLC to apply for tax exemption on its own, how does the SMLLC, if the state determines it is a separate legal entity, provide the state with proof of exemption? The SMLLC may need to file a separate IRS application or provide other proof required by the state.
This dissimilar tax treatment poises significant issues for nonprofits operating a SMLLC and the organization must be aware of these states rules in considering the activities of the SMLLC. In addition, it will need to consider and transactions between the parent and disregarded entity and in many states these transactions will be subject to sales tax.
While the use of a SMLLC has some significant advantages from a legal and federal tax standpoint, the nonprofit must be aware of the various state tax treatments of the SMLLC. This is especially critical when nonprofits are selling products through the internet and possibly exposing themselves to taxes in other states. The nonprofit status of a SMLLC may not be valid in all states and your sales may not be exempt.
It may be advisable for any nonprofit selling in multiple states to undergo a nexus study to determine where it is conducting business and then determine whether its current structure is taking advantage of the full income, property and sales tax exemptions available or whether it has some exposure.
The rules surrounding state taxes are complicated and each state should be viewed as a separate taxing jurisdiction. Knowing the rules and complying can eliminate a painful audit in the future.