If you make an S corporation election and do not fix the standard language that is typically included in the LLC company agreement, you’ll void the S corporation election. This is an issue that is usually identified by during an audit by the IRS.
Many taxpayers overlook this issue until it is too late (it is generally too late if the issue is not fixed before the end of the tax year). Then they have to request a ruling from the IRS (and pay a hefty fee for doing so) to fix it.
This exact fact pattern can be found in numerous IRS rulings. In each one, the S corporation has submitted a request to keep its S corporation election intact. The recent PLR 202010001 is an example. This ruling provides an opportunity to consider these rules.
Facts & Procedural History
The taxpayer is a limited liability company (“LLC”). The LLC’s company agreement included standard partnership tax allocation language.
This language included an allocation of profits with an allocation to eliminate negative capital accounts and a liquidation term that allocated the proceeds according to the capital accounts.
The LLC made an election to be taxed as an S corporation. The LLC filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for its first several years of operation.
At some point, the LLC realized that the partnership language in its company agreement terminated its S corporation election. The LLC then adopted a new company agreement and filed a request with the IRS to be treated as an S corporation.
About S Corporations
An LLC is an entity formed under state law. Once formed, the owners have a choice as to how they would like the entity taxed for purposes of Federal income tax.
They can make an election to be taxed as an S corporation. There are a number of reasons for making this election, such as reducing payroll taxes or various tax planning strategies (such as value freezes).
One Class of Stock and Partnership Allocations
To be taxed as an S corporation, the company and its owners have to meet certain criteria. As relevant here, the LLC cannot have more than one class of stock. This means that each stock confers the same right to distributions and to proceeds on liquidation of the company. It does not factor in the right to vote on issues that are important to the company.
For LLCs taxed as S corporations, this generally means that each membership unit or percentage gets an equal distribution and an equal amount of the distributions upon liquidation of the LLC.
Compare this to partnership tax allocations that are often included in LLC company agreements. As with the partnership tax allocations in the company agreement in this letter ruling (described above), partnership tax allocations focus on capital accounts.
These allocations generally say that distributions to one partner will cause that partner’s capital account to increase or decrease. Then, distributions that are made later would not be equal. The same goes for liquidation following disproportionate distributions.
This violates the one class of stock requirement for S corporations. Thus, it terminates the S corporation election. It is up to the LLC to then obtain a ruling from the IRS that the termination was inadvertent as the taxpayer did in this ruling.
It should be noted that this language may not be a problem if the LLC only has one owner. If there is one owner, then there can only be one class of stock as distributions would always go to that one owner no matter what the language said.
Fixing the Company Agreement
Taxpayers have to be careful when making an S corporation election or converting to an S corporation for a LLC. There are other considerations, but at a minimum, one should review the LLC company agreement and take out the standard partnership tax allocation language.
This language could be replaced with a simple statement that each member is entitled to an equal distribution for each membership unit (or percentage interest, depending on the language of the agreement) held. The liquidation language should say the same.
These changes can generally be made in the first year, if they are caught before the close of the tax year. The LLC should be able to make any correcting adjustments during the year to cure the problem. But if disproportionate distributions were made and at least one tax year has lapsed, one generally has to request a ruling from the IRS to correct this issue. The fee for the IRS to submit a private letter ruling is currently $10,000.
If the IRS catches this issue on audit, the IRS will treat the company as a C corporation. This will trigger two levels of tax for distributions, one at the corporation level and one at the shareholder level. It may void any tax elections made on the S corporation tax return. It will also result in late filing penalties for the corporate tax return.
Note: while fixing these issues, there may be other issues that should also be fixed. A Form 2553 not signed by both spouses to make a valid S corporation election is an example.
Planning for the S Corporation Election
Given the one class of stock requirement, it is often advisable to make pre-S corporation election transfers or to separate the business activities into different legal entities. This can help avoid the one class of stock limitation.
Since the one class of stock requirement does not factor in voting rights, it may also be advisable to create two classes of membership units–one with full voting rights and then one with limited or defined voting rights.