LLC’s Electing to be taxed as S Corporation

Limited liability companies (“LLC”) have become a popular entity for owning and operating a business. A multi-member LLC can elect to be taxed as a partnership, C corporation or an S corporation. It is common to see LLC’s elect to be treated as S corporations for federal tax purposes. An S corporation has certain limitations on the number of owners, the type of owners, and the classes of stock. This article will focus on the classes of stock limitation of an LLC electing to be taxed as an S corporation. An LLC typically does not issue stock, but rather issues membership interests to its members. The membership interests operate as stock for S corporation purposes.

Under the Internal Revenue Code, an S corporation can only have one class of stock receiving the same distribution and liquidation rights. The S corporation, however, may issue both voting and non-voting stock, and this will not cause the corporation to lose S election so long as the other rights remain the same, such as liquidation and distribution rights.

Should a multi-member LLC elect to be taxed as an S corporation, then the LLC must follow all of the S corporation requirements under the Internal Revenue Code. That is, the LLC, taxed as an S corporation, must only have members, who qualify as S corporation shareholders, no more than 100 members, and one class of membership interest.

The governing document for the management and operation of an LLC is usually governed by an Operating Agreement. Because a person may easily form an LLC online and obtain a draft Operating Agreement from the web, they do not look at the terms and provisions of the Operating Agreements to see if it does not inadvertently create a second class of stock. Most Operating Agreements found on the web or prepared by third parties are drafted in the context of partnership tax law or may include terms and restrictions on certain members resulting in a second class of stock.

For instance, the Operating Agreement may include common partnership tax language that upon liquidation, distributions will be paid to members with positive capital accounts in accordance with their respective positive capital account balance before other distributions to members. Or the Operating Agreement may have specific profit or loss allocation language. Such language may result in the LLC’s S election being inadvertently terminated because the members of the LLC do not have identical rights to distribution and liquidation proceeds as required under the Internal Revenue Code and Regulations. Therefore, the IRS will conclude that upon entering into the Operating Agreement, the LLC ceased being an S corporation for tax purposes and had become a C corporation. The loss of S corporation election will result in increased taxes, filing requirements and other limitations or potential liability, such as built-in gain tax.

To fix this inadvertent S termination and treat the LLC as an S corporation from the date of S termination, the LLC will need to formerly seek and obtain approval from the IRS to treat the LLC as an S corporation and to correct the error in accordance with the Internal Revenue Code.

We recommend that when forming or starting a business, the parties seek competent tax and legal counsel in choosing the best type of entity (partnership, LLC, S corporation, C corporation, etc.) for not only operating and managing the business, but also for the overall tax and costs benefits. Each entity has its own advantages and disadvantages. Even after you choose the type of entity, the governing documents, the Operating Agreement, need to be carefully drafted to conform to the type of business selected.

John J. Lancaster, LL.M is a shareholder with the law firm of Clark, Campbell, Lancaster & Munson, P.A., in Lakeland. Questions can be submitted to thelaw@cclmlaw.com.

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