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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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Minimum Gain Chargeback Provisions

If you have reviewed partnership agreements or operating agreements for an LLC you have probably read provisions relating to Minimum Gain Chargeback.  That being said, the Minimum Gain Chargeback provisions may have put you to sleep, and may not even be practical based upon the facts and circumstances of the partnership.  However, Minimum Gain Chargeback provisions are important to understand if in fact they were to apply to your situation and circumstances.  The article below has been prepared by a tax attorney and business attorney from The McGuire Law Firm to provide an explanation of Minimum Gain Chargeback.

Minimum Gain Chargeback provisions deal with non-recourse debt and the allocations of non-recourse debt.  Such provisions are mandatory if the partnership wishes to allocate non-recourse deductions to the partners in any manner other than per the member’s pro-rata portion of capital interest in the partnership.  Therefore, it is important to identify when a Minimum Gain may be realized.  Minimum Gain occurs when deductions are claimed on property that decrease the partnership’s book basis in the property below the actual balance of the non-recourse debt on the property.  A situation whereby you may see Minimum Gain is when property is depreciated.  The depreciation will drive the partnership’s book basis of the property below the amount of the loan on the property.  When a partnership does have Minimum Gain, the Minimum Gain Chargeback is an allocation of the gain to the partners or members who have received the benefit of non-recourse deductions, or who may have received distributions from the partnership that can be attributed to the non-recourse loan.   In short, if a partner has received a benefit from the depreciation of property whereby they did not bear the economic risk of the loan to acquire the property (because the debt was non-recourse and not personally guaranteed), the benefit can be “charged back” to the partner.

So when does the “charge back” occur?  The deductions or distributions taken by the partners are charged back when the property that was subject to the non-recourse debt is sold, transferred or otherwise disposed of, or when there is a change in the character of the non-recourse debt.  A change in the character of the non-recourse debt could be the debt converted to a recourse liability or the debt being forgiven.

Now, the million dollar question: What is the amount of the charge back?  The partnership’s minimum gain is generally going to be the excess of the non-recourse liabilities over the adjusted tax basis of the property subject to or securing the non-recourse debt.  Perhaps an example will help illustrate this.   Assume J&J, LLC had purchased property for $200,000 and took $100,000 in depreciation on such property.  Thereafter, J&J LLC obtain non-recourse financing of $250,000.  The minimum gain would be $150,000, which is the non-recourse debt of $250,000 less the adjusted basis of $100,000.

It is important to remember that a partner is not subject to a charge back for monies they contribute to repay a non-recourse debt, and it is possible for the partnership to request a waiver of the chargeback under certain circumstances.

John McGuire is a tax attorney at The McGuire Law Firm whose practice focuses primarily on tax matters before the IRS, business transactions and tax issues as they apply to his individual and business clients.  In addition to his law degree, John holds an advanced degree in taxation (LL.M.).  Please feel free to contact John with any questions.

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Denver Business Attorney Video on Deficit Restoration Obligation

A Denver business attorney and tax and tax attorney at The McGuire Law Firm can assist you with your business and tax legal needs.  From business formation to the sale and transfer of business assets or interests a business attorney at The McGuire Law Firm can help you!  Below is a video discussing a deficit restoration obligation, which is typically a clause you may or may not find within a partnership agreement or operating agreement.  Please feel free contact our law firm at anytime.

 

Schedule a free consultation with a business attorney and tax attorney at The McGuire Law Firm!  Free consultation and law offices in Denver and Golden, Colorado.

Special Allocations Discussed by Denver Business Attorney

Partnership agreements or operating agreements may call for special allocations of items of income, gain, loss, deductions or credits to specific partners.  The video below has been prepared by a business attorney at The McGuire Law Firm to provide general information regarding special allocations.

 

Contact The McGuire Law Firm to speak with a business attorney or tax attorney.  The McGuire Law Firm has law offices in Denver, Colorado and Golden, Colorado- contact our firm today and schedule your free consultation!

LLC Operating Agreement Video by Denver Business Attorney

A multi-member LLC should have an operating agreement in place to outline the operations and rights of the LLC members.  A Denver business attorney at The McGuire Law Firm can assist you with the preparation of this document and other business documents and issues.

Contact The McGuire Law Firm to schedule a free consultation with a Denver business attorney.