Abiding by the LLC operating agreement may cause the entity to operate in a manner that invalidates the S corporation election. 

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 many business owners may not consider, is the LLC operating agreement.  

 The article below has been prepared by a tax attorney and Denver business attorney to discuss further 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.

Invalidating the S Corporation Election

Business owners often look forward to having the opportunity to elect Subchapter S corporation (Subchapter S Corp.) status. This type of entity offers many advantages over sole proprietorships and partnerships, including limited personal liability for partners and shareholders, greater flexibility in terms of how much money you are allowed to invest, and the ability to take advantage of the favorable tax treatment afforded to corporations.

The downside of electing Subchapter S status is that it requires compliance with certain limitations on (a) the number and types (e.g., individuals vs. entities) and (b) the types of shares (i.e., common vs. preferred). These limitations ensure the business maintains sufficient financial stability to continue operating. Suppose a business fails to meet one of those requirements. In that case, the IRS could revoke its election and require it to operate under the rules applicable to sole proprietorships and general partnerships.

To properly evaluate how an S corporation could lose or invalidate the S corporation election, it is essential 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)

One Class of Stock Requirement

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. Still, 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 requiring unequal or disproportionate distributions to the LLC members.  

Thus, if the distributions are per the operating agreement, the issuance of disproportionate distributions could lead to the IRS claiming the corporation has multiple classes of stock. 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 to be taxed as an S corporation should consider the removal of specific 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 might be subject to additional self-employment tax, or the business, if taxed as a C corporation, would be subject to tax at the corporate and shareholder levels, thus doubling taxation.

Not Sure Which Entity to Choose?

Suppose you have questions about your business entity choice, taxation matters, and internal business documents. In that case, you should speak with a tax attorney or Denver business attorney to review the documents, taxation matters, and intended tax treatment. Call us at 720-833-7705!

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.

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

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

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.