Operating Agreement Invalidating S Corporation Election

Limited Liability Companies (LLC) are a very popular entity choice and structure for new businesses and closely held entities.  An LLC can be formed quickly and has a lot of flexibility regarding members, operations and taxation structure.  It is not rare for an LLC to eventually consider and perhaps decide to be taxed as an S corporation.  Although, an LLC converting to a Subchapter S corporation has benefits, such as potentially reducing self-employment taxes, these benefits may be mistakenly lost if the Subchapter S corporation status is invalidated.  A means by which to invalidate the S corporation status, which is many business owners may not consider is the LLC operating agreement.  Abiding by the LLC operating agreement may cause the entity to operate in a manner than invalidates the S corporation election.  The article below has been prepared by a tax attorney and business attorney to further discuss the risk of losing S corporation status by abiding by an operating agreement.  Please remember this article is for information purposes only, and is not intended to be legal or tax advice.

To properly evaluate how an S corporation could lose or invalidate the S corporation election, it is important to remember how a business qualifies and the requirements for an S corporation.  The qualify as an S corporation, the corporation must:

 

  • Have only allowable shareholders (no partnership, corporate or non-resident alien shareholders)
  • Have only 100 shareholders or less
  • Have only one class of stock
  • Be a domestic corporation
  • Not be an ineligible corporation (insurance companies and other disallowed companies)

Our focus will be on the one class of stock requirement.  The one class of stock requirement requires that all shareholders receive distributions and liquidation preferences pro-rata per their stock ownership.  An S corporation can have a different class of stock for voting rights, but the economic benefits and distributions to the shareholders must follow the ownership percentage, which is directly related to the number of shares each shareholder owns.  Many LLC operating agreements will contain clauses and language that actually require unequal or disproportionate distributions to the LLC members.  Thus, if the distributions are in accordance with the operating agreement, the issuance of disproportionate distributions could lead to the IRS claiming the corporation has multiple classes of stock, and therefore, the S corporation election is invalid.  Treasury Regulation Section 301.7701-(3)(c)(1)(v)(c) states that the S corporation election is valid only if ALL requirements are met.  Thus, an LLC electing be to be taxed as an S corporation should consider removal of certain clauses within the operating agreement relating to substantial economic effect, IRC Section 704 and any other clause that could create disproportionate distributions.  If the S corporation election was lost, the owners may be subject to additional self-employment tax, or the business, if taxed as a C corporation would be subject to tax at the corporate level, and the shareholder level, thus double taxation.

If you have questions related to your choice of entity, taxation matters and internal business documents, it is recommended you speak with a tax attorney and/or business attorney to review the documents, taxation matters and intended tax treatment.

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