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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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Disregarded Entity Video by Denver Business Attorney

What is a disregarded entity?  This is a common question clients may ask a business attorney at The McGuire Law Firm.  The video below has been prepared by a business attorney to discuss what a disregarded entity is.

 

Contact The McGuire Law Firm to schedule a free consultation with a Denver business attorney and tax attorney.  We offer a free consultation to all clients and have offices in Denver and Golden Colorado.

Tax Issues Regarding Choice of Entity by Denver Tax Attorney

A Denver tax attorney at The McGuire Law Firm can assist you and your business with the tax implications of certain entities.  Additionally, we assist clients as they operate their business by drafting and reviewing contracts, analyzing the tax implications of specific transactions and assisting with the sale, transfer or disposition of business assets or interests.  Please feel free to contact The McGuire Law Firm to speak with a tax attorney at anytime!

Contact The McGuire Law Firm to schedule your free consultation with a tax attorney!

Entity Options Video by Denver Business Attorney

At The McGuire Law Firm a Denver business attorney can discuss what entities are available for your business to operate and the implications of such entities.  The video below has been prepared by a business attorney to discuss your general options such as a sole proprietorship, a partnership or a corporation.  Please feel free to contact The McGuire Law Firm to speak with a business attorney regarding any questions or issues your business may have.

Contact The McGuire Law Firm to schedule your free consultation with a Denver business attorney!  720-833-7705

 

Choice of Entity by Denver Small Business Attorney

What type of business should I be?  Should I form a limited liability company (LLC) or a corporation?  These are common questions business owners Denver Business Attorney Denver Small Business Attorneymay ask their business attorney, and they are good questions.  It is important for a business owner to understand their options when forming businesses and the implications.  Choice of entity is a very important question for any business and has implications from the formation of the business, during the operation of the business and when the business or business interests are sold or transferred.  The article below has been drafted by a Denver business attorney at The McGuire Law Firm to begin the discussion on choice of entity and provide a little background as to when pass through entities began to become a little more attractive to the business owner as opposed to the C corporation.

In many ways the 1986 act reduced the reasons and advantages for businesses to operate as a C corporation.  The General Utilities doctrine was repealed and thus made it more difficult for a C corporation to pass earnings and unrealized appreciation to the corporate shareholders without creating two levels of tax (double taxation) at the corporate and individual shareholder levels.  The double taxation of a C corporation does have some relief given that qualified dividends to non-corporate taxpayers will be taxed as capital gains as opposed to ordinary income.  See Internal Revenue Code Section 1(h)(11).  It is also important to note that the American Taxpayer Relief Act of 2012 made the preferential capital gains treatment of qualified dividends permanent, but raised the top capital gains rate.  Taxpayers in the 39.6 bracket have qualified dividends taxed at 20% as opposed to 15%.  Higher earning taxpayers must also consider the 3.8% net investment income tax under Internal Revenue Code Section 1411.  Thus, one could consider the rate to be closer to 24% on qualified dividends for higher earning taxpayers.

Another potential disadvantage to a C corporation was/is that for the first time, the highest marginal income tax rates for individuals was less than the highest corporate income tax rates, which made pass through entities such as an LLC or S corporation more attractive.  Later, the top marginal individual bracket was increased, so the rate differential was not apparent for too long of a time.

The 1986 act also replaced the corporate add on minimum tax with AMT or alternative minimum taxable income on C corporations after 1989.  One provision was that the alternative minimum taxable income of a corporation is increased by 75% of any excess of the adjusted current earnings of the corporation over the alternative taxable minimum income.  See IRC Section 56(c)(1).

Given certain detriments of operating a business as a C corporation, many new businesses considered and did form pass through entities such as an LLC or an S corporation as their choice of entity.  These business entities may be even more beneficial if start up losses are expected.  Existing corporations should at least consider restructuring to avoid potential double taxation.

A Denver business attorney at The McGuire Law Firm can assist you with your choice of entity, the formation of your business, legal issues & work as your business operates and the eventual sale and transfer of your business assets or interest.

Contact The McGuire Law Firm to schedule your free consultation with a Denver Business Attorney.