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!

Please feel free to contact The McGuire Law Firm to schedule a free consultation with a business attorney or tax attorney.

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