Can You Really Treat Your LLC As An S-Corporation?
Maybe… If you organized it correctly with an S-corporation in mind. Many businesses organize as LLCs upon accountants’ advice that they can save on Social Security and Medicare taxes while avoiding double taxation. That may be true, but it was always advisable to run the numbers to be sure the savings is worth it. Now a recent IRS private letter ruling has made it clear there is an even bigger hurdle to overcome.
Most LLCs are organized by their owners using articles of organization and operating agreement templates from Legal Zoom® or other third parties, or may not even have an operating agreement. Even those who use attorneys to draft their documents and adopt off the shelf operating agreements with stock tax provisions may have blown their S-corporation election from the outset.
Fundamental to the definition of an S-corporation is that it can only have one “class” of shareholders. But an LLC organizing or converting to an S-corporation doesn’t have shareholders, you say. True, but the IRS treats LLC members, who are equity owners, as shareholders when it is appropriate. But an S-corporation can have both voting and non-voting “classes” of members, you say. Right again, but the one class of stock requirement means the members’ shares of distributions and liquidation proceeds must be identical.
The operating agreement typically governs such matters. Even though providing for only one “class” of membership interest, the Operating Agreement may have provisions for disproportionate distributions. For instance, an operating agreement prepared by an attorney with standard tax provisions may provide that distributions made upon liquidation would be paid to members with positive capital accounts in accordance with their respective positive capital account balances, as adjusted pursuant to Section 704 of the Internal Revenue Code. Consider provisions that require that distributions be made to maintain proportionate capital accounts, or that some members contribute assets and others contribute cash. The same provisions applied to a partnership would be perfectly appropriate but may cause an inadvertent termination of an S-corporation election.
This was just what the taxpayers had included in their operating agreement as described in the facts addressed by Private Letter Ruling (PLR 201930023) issued by the IRS on July 26, 2019. The operating agreement provided that distributions on liquidation were to be made based on members’ capital account balance as adjusted rather than on ownership percentage which would have remained pro-rata. The members apparently realized their misstep and quickly filed an application for a private letter ruling before filing of the LLC’s first income tax return, where they acknowledged the unfortunate language of the operating agreement terminating the S-corporation election was inadvertent. The IRS agreed and reinstated the S-corporation election.
The IRS private letter ruling could just as well have gone the other way, particularly if the corrective operating agreement amendment had been delayed a substantial length of time. Also if there is ever a tax audit, the first thing the agent will request is to examine the organization documents, and it’s game over! The amendment, in this case, saved the day but private letter rulings are not predictable and apply only to the applicant of that request, not to the facts stated in the request. Although a private letter ruling may indicate how the IRS may view a similar set of facts in another ruling application, it is not binding even if such facts are virtually identical and certainly not if there are material differences.
So, are you sure you have an S-corporation?
ABOUT THOMAS HICKS
C. Thomas (“Tom”) Hicks III has more than 35 years of business law practice experience in Northern Virginia. Mr. Hicks represents business clients in all their legal needs, working with the management team as outside general counsel, and otherwise coordinating the company’s general legal needs. Mr. Hicks assists the organizers with choice of business entity and organization, initial and private equity financing and debt financing. He advises the management team regarding corporate governance, executive employment and compensation matters, contract matters, business acquisitions, equity and asset sales and merger, and business breakups and dissolutions of business entities, among other legal areas. He also advises business executives and companies regarding stock and other equity benefit plans, and wealth planning and asset protection. Mr. Hicks has advised commercial real estate developers in all legal aspects of their business.
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