LLC Operating Agreement Can Terminate an S Corporation Election

Limited liability companies (LLC) should be careful that their operating agreement does not contain language that violates the criteria required to make a small business corporation (S corporation) election. LLCs should also make sure the agreement does not contain language in any amendments or restatements that would cause an S corporation election to automatically terminate.

IRS code sec. 1361 defines an S corporation as an eligible domestic corporation, which does not have:

1. More than 100 shareholders;
2. A shareholder who is not an US resident individual (there are exceptions); and
3. More than one class of stock. (Code Sec. 1361(b)(1))

For an LLC, the concept of stock does not exist. Thus, the one class of stock requirement is determined by looking at each member’s rights with respect to distribution and liquidation proceeds. These must be identical, as determined by its operating agreement. If the operating agreement is not pro rata as required by Reg. §1.1361-1(l)(1), the election would be terminated. An LLC may have more than one class of membership interest (i.e. voting and non-voting) but all members, regardless of their class of ownership, must have identical rights with respect to distributions and liquidation proceeds.

On July 26, 2019, the IRS issued a Private Letter Ruling (PLR 201930023) on an S election inadvertently terminated by an operating agreement amendment. The LLC members agreed to amend the operating agreement to provide that distributions on liquidation would be made based on each member’s capital account balance rather than pro rata based on ownership percentage. The LLC very quickly amended the operating agreement to change the language so that distributions occurred on a pro rata basis. The LLC sought a private letter ruling, since the mere existence of bad language in the operating agreement terminates the S election. After evaluating the facts and assertions made by the LLC, the IRS ruled that although the S election was indeed terminated, the termination was inadvertent, which permitted the LLC to maintain its S corporation status. If the IRS did not conclude that the S election termination was inadvertent, the consequences would become expensive, time-consuming, and result in a tax position the company would not find ideal.

Consequences of Losing S Status:

• A corporation may not re-elect S corporation status until the fifth year after the year in which the termination or revocation became effective.
• The LLC becomes a C corporation for tax purposes.
  • The corporation would be subject to two layers of tax, one at the corporate level on income earned and another at the shareholder level when that income is distributed.
• It is very expensive to issue a Private Letter Ruling.
  • Costs can range from $250 to $50,000, not including the cost of preparation.

In addition, although the case previously mentioned ended with the IRS declaring the S election termination inadvertent, a taxpayer cannot use a PLR as part of a defense even if the facts are identical to those described in the PLR. However, a PLR does give an indication as to the IRS’ thought process, which is a valuable tool if confronted with a similar situation. Due to the difficulties of resolving the effects of a termination of an S election, it is important that all LLCs review their operating agreement to ensure that they are in compliance with Code Sec. 1361.

Many LLC operating agreements are boiler plate, especially the free documents found on the internet.  However, those documents typically include language in its tax section as if the LLC were a partnership under federal tax law. An LLC with such an operating agreement is not eligible to make an S corporation election. During a business tax audit, the agent always asks to see the company formation documents.  And five seconds later, the S election is disallowed. Those attempting a “do it yourself” cost-saving approach to forming an LLC will get exactly what they paid for.

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