10 good reasons why LLCs should not elect to be S corporations.

• Author: Iannone, Paul N.
• Position: Limited liability companies

Since 2004, the IRS has administratively made S elections for limited liability companies (LLCs) very easy. An LLC that is otherwise eligible to be an S corporation that is classified as a partnership or a disregarded entity can simultaneously elect to be classified as both a corporation and an S corporation by timely filing Form 2553, Election by a Small Business Corporation, without the need to also file Form 8832, Entity Classification Election. The Treasury regulations treat the "one-stop-shop" rule as a "deemed election" under the entity classification regulations. (1)

The authors find that tax advisers frequently recommend an S election due to the uncertainty under the law regarding what portion of LLC earnings (i.e., LLCs that are treated as partnerships or disregarded entities for tax purposes) are subject to self-employment tax to its member(s). Provided that the salary of a shareholder in an S corporation is not unreasonably low and is considered "reasonable," payroll taxes, including Federal Insurance Contributions Act and Medicare taxes are imposed on the amount of salary only rather than the entire amount of the trade or business income that would otherwise be subject to self-employment tax.

Further, many tax advisers find Subchapter K of the Internal Revenue Code too complex and prefer to deal with Subchapter S. Many corporate attorneys find that organizing an entity as an LLC under state law is much simpler and less expensive, requiring only a state organizational certificate and a simple operating agreement, than an actual incorporation that requires bylaws, corporate resolutions, and stock certificates. The corporate attorneys then leave the tax classification to the tax advisers. For these reasons and possibly additional ones, many LLCs have elected to be classified as S corporations.

This article discusses some of the negative aspects of electing S corporation tax classification for LLCs and the practical problems the election can present. This article is not intended to be a comprehensive and thorough discussion of the proper choice of business entity. It is limited to those situations where the accountant or attorney is making a choice whether to elect Subchapter S status for an LLC. For purposes of this article, LLCs with more than one member will be emphasized.

The following are 10 good reasons why LLCs should think twice before electing S corporation tax classification.

Reason 1: Operating agreements can invalidate the S election

Many LLC operating agreements can result in the termination of the S election. Even if the LLC operating agreement does not terminate the S election, many of its provisions are inapposite to a corporation, as explained below.

An LLC operating agreement is the foundational governing document for LLCs, similar to the articles of incorporation and the bylaws for corporations. In many cases, the tax adviser is not the first professional who is consulted for the choice of business entity. Business clients concerned with personal liability seek the advice of an attorney who invariably recommends and organizes an LLC for the client and prepares the operating agreement. In the authors' experience, it seems in recent years, for small to medium-size business, LLCs are the chosen legal vehicle rather than corporations.

The default tax classification for a domestic multimember LLC is a partnership. (2) The default classification for a domestic single-member LLC is a disregarded entity. (3) LLC operating agreements are written under the applicable state statute and tend to conform to partnership tax law in the case of a multimember LLC. Operating agreements for single-member LLCs are typically much shorter without much of the partnership tax language but can still contain language that is not appropriate for corporations.

The important issue here is that operating agreements written with partnership tax law in mind have provisions that can invalidate an S election due to the Subchapter S prohibition of having more than one class of stock. (4) It is critical that before making the S election for an LLC, the tax adviser read and provide recommendations for revisions to the operating agreement to conform to the S corporation rules. This article is not intended to create a comprehensive list of provisions in an operating agreement that would require review and revision; it highlights some of the more common provisions.

First, a corporation that has more than one class of stock is ineligible to become an S corporation. (5) The Treasury regulations provide that "a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds." (6) Further, the Treasury regulations provide that:

The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).

Therefore, the operating agreement is the governing instrument of the LLC for purposes of establishing whether the LLC has only one class of stock.

Most, if not all, operating agreements that are not structured for the S election have many references to capital accounts, which can be problematic. Equity interests in corporations are represented by capital stock and paid-in capital; not capital accounts. Partnerships are required to maintain capital accounts for the partners in order to meet the safe-harbor provisions of the substantial-economiceffect regulations under Sec. 704(b). (8) Capital accounts can be the measuring device that determines which members receive distributions, the amount of the distributions, and when distributions are made.

For example, many operating agreements, for both business reasons and to meet the safe harbors under the substantial-economic-effect regulations under Sec. 704(b), provide that upon liquidation of an LLC, liquidating distributions are to be made to members according to the positive balance in their capital accounts. Such positive balances do not always correspond to the members' proportionate membership interest in the LLC. Such a provision would violate the singleclass-of-stock rule and would invalidate the S election.

For an LLC electing S status, liquidating distributions are required to be made in proportion to the owners' membership interests in the LLC in order to satisfy the requirement to "confer identical rights to distribution and liquidation proceeds." If the operating agreement is silent with respect to liquidating distributions, the state LLC statute will be the default, which may not always be proportional. (10) Accordingly, for LLCs treated as S corporations, all references to capital accounts should be removed from the operating agreement, and liquidating distributions should be proportionate to the ownership percentages.

Other provisions that will cause distributions, income, and deductions to be made or allocated disproportionately to the member's ownership percentage should also be removed. Many of these provisions are tax boilerplate and are critical for entities classified as partnerships but, nevertheless, present serious problems for LLCs classified as S corporations. For example, some of the more complex operating agreements have distribution "waterfalls" that provide for priority of distributions to certain members before other members receive distributions or provide for a guaranteed rate of return on capital. These provisions could result in a second class of stock. Operating agreements that create more than one class of membership interest are problematic (see reason No. 9, "Investor Opportunity Is Limited," for further discussion).

Examples of other provisions that should be removed include any special allocations of income and deductions, references to Sec. 754 elections, allocations of contributed built-in gains or losses under Sec. 704(c), the deficit restoration obligation and qualified income offset under the Sec. 704(b) substantial-economic-effect regulations, (11) and provisions dealing with allocations of nonrecourse deductions. (12)

Another issue that arises is whether a multimember LLC that makes an S election, but fails to qualify as an S corporation because of a defective operating agreement, would be classified as a partnership or a C corporation. The regulations under the one-stop-shop procedure of merely filing a Form 2553 and the preamble to the temporary...