Trendiness is a word not frequently used in conjunction with tax planning. Discussing the in-vogue corporate structure never will be the hot topic of a dinner party, nor will pictures of the organization chart trend on Instagram. But every once in a while, trendiness rears its head and presents us with an entity structure so avant-garde that every fashionable business owner feels ever so compelled. Lately, it seems like everyone has jumped on the bandwagon in an attempt to combine a limited liability company’s coolness and flexibility with an S corporation’s simplicity and fragility to create the delicate flower known as the LLC taxed as an S corporation.
However, trendiness often comes with a cost, and in the case of an LLC electing to be taxed as an S corporation, that cost could be corporate-level taxes. The fragility of the S status is inherent in the code section that birthed it—IRC §1361 very clearly defines the “cans” and “can nots” of S corporations by limiting the type of eligible shareholders, the number of shareholders, and most importantly, the classes of stock.
As you probably know, an S corporation can have only a single class of stock. What that means is each share of an S corporation’s equity needs to convey identical rights to distribution and liquidation proceeds. LLCs on the other hand are the Wild, Wild West of tax entities in their flexibility. In addition to their ability to offer units with distributions rights that differ like show ponies and workhorses, they can move in and out of various tax statuses depending on the elections made or not made. Inaction results in the LLC either being disregarded or treated as a partnership for federal income tax purposes. If action is taken by making an entity classification election, an LLC can be taxed as an association. Even without making an entity classification election, if an otherwise effective S corporation election is made, an LLC electing S corporation status is deemed to have made an entity classification election to be taxed as an association under IRC §301.7701-3(c)(v)(C). Anyone else starting to feel like they are standing in the middle of the O.K. Corral during a shootout?
These differences aren’t impossible to manage, but they do create a large ravine that requires guidance from an experienced tax advisor to navigate successfully. Tax advisors need to carefully review the LLC’s operating agreement to ensure that any provisions that facilitate the LLC’s ability to be taxed as a partnership (i.e., methods and manners of allocating income, losses, distributions and liquidation) don’t create a second class of stock concern. This is especially true because even if these provisions have not resulted in actual non-proportionate distributions, the mere existence of these provisions can result in a second class of stock. Specifically, the IRS has ruled:
- A partnership agreement is a governing provision for purposes of Treasury Regulation 1.1361-1(l)(2) because it is a binding agreement that defines the members’ rights to distribution and liquidation proceeds (IRS Ltr. Rul. 200450012).
- While no dissolution of the association had ever been made and no capital accounts had been kept, an association’s bylaws may have invalidated the company’s S election because at the time of the election, the company may have had more than one class of stock (IRS Ltr. Rul. 200301038). This occurred because the bylaws stated that upon dissolution and after paying the debts of the association, the assets were to be distributed to shareholders (1) to pay their capital accounts, and then (2) to be divided among them as a distribution of profits.
- An operating agreement, which provided for the maintenance of capital accounts in accordance with IRC §704—including allocations to be made to members first with positive capital accounts using curative allocations and distributions to be made in accordance with positive capital accounts—may have caused the company’s S election to have been ineffective because the company may have had more than one class of stock (IRS Ltr. Rul. 201528025).
The key takeaways from these rulings are that: (1) The application of the S corporation rules to operating agreements are complicated, and should you find yourself in a situation where you have both, it is best to consult an experienced tax advisor, and (2) if you do have a problem, fear not! Relief is generally available by seeking a private letter ruling under IRC §1362(f).
Warren Averett is an independent member of the BDO Alliance USA. This article was borrowed with permission from BDO USA, LLP.