Harry Potter and the Disregarded Entity

What if you could form an organization that maintained a persistent and separate legal presence, protected its founders from liability, could receive tax-exempt contributions, but didn’t require the usual baggage of a nonstock corporate structure, an IRS tax ruling, an annual tax return, or a separate governing board? In short, what if you could garner the benefits of being a 501(c)3 exempt corporation without actually being one? Welcome, my friends, to the ‘disregarded entity’.

In essence, a ‘disregarded entity’ is a business that is separate from its owner for legal purposes, but not separate for tax purposes. It is ‘disregarded’ by the Internal Revenue Service because, as far as they’re concerned, all the money and responsibility flows to the owner, so only the owner has to file.

The disregarded entity has been around for a rather long while, although we don’t discuss it much because it’s, you know, disregarded. But if you formed a single-member Limited Liability Company and claim all income or loss on your personal tax return, you’ve got a disregarded entity (a sole proprietorship is not a disregarded entity, because it’s not considered separate in the first place). The term even started to show up in the good ol’ W-9 form from the IRS in their 2011 revision (this is exciting, yes?). If you filled one out recently, I bet you didn’t see it.

It’s an intriguing tidbit and a fabulous phrase, but things get really interesting when the sole member (kinda like an ‘owner,’ but don’t call it that) of a Limited Liability Company is a 501(c)3 nonprofit. For more than a decade, the IRS has determined that such an LLC could be a ‘disregarded entity’ — that it doesn’t need separate nonprofit tax status because it’s not considered separate for tax purposes. It can receive contributions under its own name (probably), and it can behave otherwise as a nonprofit even though it’s an LLC.

Of course, the LLC must behave like a nonprofit, claim similar constraints in its forming documents, and align with the mission and declared activities of its host organization. But it’s basically a business that’s visible for some purposes and invisible for others. And that’s rather cool.

In case you think this is all hazy and speculative theory, there are (at least) two arts-related entities formed strategically as ‘disregarded entities’ already.

One is ArtPlace America, that multi-foundation, multi-bank, mega-cool organization advancing ‘creative placemaking’. As part of their organizational evolution, they recently reformed as an LLC with a single nonprofit member (Rockefeller Philanthropy Advisors). Another is Brooklyn Community Supported Art + Design, a subscription service for creative work modeled on community supported agriculture, which is now a disregarded LLC with Fractured Atlas as its only member. Further, Fractured Atlas is in the process of fostering more such disregarded entities — to advance its mission and to explore the productive space between fully independent nonprofits and the often more project-focused alternative of fiscal sponsorship (full disclosure, I’m a board member for Fractured Atlas).

What’s the benefit of the disregarded entity among nonprofits? It’s a nuanced way to balance authority, accountability, and autonomy. The LLC, as a separate legal entity, can receive contributions, operate as a (reasonably) independent entity, and build and retain bundles of contracts, relationships, and property (physical and intellectual). And yet, for tax purposes, it’s essentially invisible (or, rather, all of its activities and resources are perceived to be part of its sole nonprofit member). It requires no independent governing board.

That means the LLC is flexible in its operations, portable in its affiliation (it can switch its current nonprofit member for another one if it serves everyone’s purposes), and durable in its lifespan (but not intractably durable as many corporate nonprofits can be). It can protect its host organization from liability, but also might advance its mission in more flexible and responsive ways.

For many, of course, the phrase ‘disregarded entity’ will summon the deep anxiety of high school, and those lonely lunches in the cafeteria. But for the structural and organizational geeks among us, this approach shows real promise as an alternate tool for advancing mission in a complex world.

RESOURCES, if you’re dying to learn more:

• Charity Owned Limited Liability Companies (Nonprofit Law Blog)
• IRS Exempt Organizations Continuing Professional Education Technical Instruction Program article on LLCs as Exempt Organizations (pdf format, you know you want to read this!)
• IRS EOCPE update on LLCs as Exempt Organizations (pdf format)