When a LLC “checks the box” by filing a Form 2553 to elect to be treated as a corporation and simultaneously elect S status, it must live by all the S corporation restrictions. That includes the restriction on only having one class of “stock” issued by the entity during the time it wishes to remain an S corporation.
In reality, there is no such federal tax entity as an “LLC”—the structure was originally designed when the first statute was adopted by Wyoming decades ago to be an entity for which there was no federal tax treatment specifically mandated. To this day the IRC does not have provisions outlining the tax treatment of “LLCs” but rather, under the check the box regulations found at Reg. §301.7701‑2 the entity is treated for federal tax purposes as one of the entities that the IRC knows about.
If an entity is not one that does have a specified treatment under the IRC (for instance, a corporation chartered under state corporate law is taxed as a tax-law corporation) then it is allowed to choose between two treatments. If the entity has a single owner, it is either disregarded as entity apart from its owner (and thus treated for income tax purposes effectively as if it didn’t exist) or is treated as a tax-law corporation. If the entity has more than one owner, it is treated either as a partnership or as a tax-law corporation. [Reg. §301.7701‑2(a)]
The election of classification for such entities is controlled by Reg. §301.7701‑3. For a domestic LLC with more than one member the default classification is partnership [Reg. §301.7701-2(b)(1)(i)], though it can elect to be treated as a corporation. If the entity can meet the requirements for S status, the entity can simultaneously elect corporate status and make an S election. [Reg. 301.7701‑3(c)(1)(v)(C)]
Unfortunately some taxpayers and practitioners are not aware of the details of the above and this can lead to terminating the S election of an LLC due to ignorance. Specifically the problem occurs because the entity decides to take actions for issuing equity interests that are common in partnership contexts, believing that LLC equates to partnership for tax purposes—including, in some cases, where the parties are aware the entity is being taxed as an S corporation.
This lead to a need to request relief from the termination of entity’s S status in Private Letter Ruling 201505008 when the LLC decided to issue new classes of membership in the LLC.
In this case the LLC made the following changes to its operating agreement:
X’s operating agreement was amended and restated as of Date 3, to authorize the issuance of new classes of membership interests in X: Preferred Units, Class B Common Units, and Class C Common Units. The shares held by the original members were classified as Class A Common Units. The amended operating agreement provided that a holder of the Preferred Units would receive preferential distribution rights over the other members. Class A and Class B Common Unit holders would share in the distributions, income, and losses of X on a pro rata basis, though the Class A Common Unit holders would also receive preferential liquidation rights. The Class C Common Units holder would only receive a distribution upon the liquidation of X.
Under Reg. §1.1361-1(l) an S corporation is treated as having one class of stock outstanding only if all ownership interests (which will be treated as “stock” for an LLC taxed as an S corporation) have identical and proportionate rights to distributions and in liquidation. Merely making the above changes in the agreement was not itself a problem, since so long as only Class was issued there was no problem. But, of course, the whole point of creating these new interests was because they wanted to issue such interests.
And that lead to another problem. The Preferred Units were created to be issued to IRAs. The IRS held in Revenue Ruling 92-73 that IRA accounts are not eligible S corporation shareholders, a position upheld in a split decision by the Tax Court in the 2009 case of Taproot Administrative Services, Inc. v. Commissioner, 133 TC No. 9.
So when the S corporation issued the shares in the various classes and to the IRA accounts the S election was terminated as the tax-law corporation (which is what the LLC decided to be when it “checked the box”) was no longer eligible for S status. Of course, this was not what the parties intended and, likely, they undertook these steps because they were aware of other LLCs that had used a similar mechanism to bring in new ownership with varied rights and give ownership interests to IRAs.
The thing the taxpayer did not understand, though, was that while the steps they undertook would be no big deal for tax purposes for a tax-law partnership, their entity was not such a thing. The fact that it was an LLC under state law, as may have been other entities they were aware of that had done the same action, did not mean their entity would receive the same tax results as the LLCs that had not elected S corporation status.
However, all is not lost—at least if the taxpayer is willing to pay (a private letter ruling comes with a user fee) and is able to persuade that the termination was inadvertent. Under IRC §1362(f) the IRS is granted authority to determine that a termination was inadvertent and grant relief—though the IRS has the right to impose conditions on the grant of relief and generally the taxpayer must eliminate the problem. In that case the entity is treated as if it had never lost S status.
In this case the IRS granted relief conditioned on the taxpayer taking certain steps in addition to getting back to the point where they had a single class of stock and only eligible shareholders.
The conditions the taxpayer had to meet were:
As a condition for this ruling, for any tax periods between Date 3 and Date 7 in which X reported a net loss, shareholders who were IRAs will be treated as the shareholders of the shares of stock held by them at that time. For any tax periods between Date 3 and Date 7 in which X reported a net gain, the beneficiaries of the IRAs will be treated as the shareholders of the shares of stock held by IRAs.
Furthermore, this ruling is contingent on X making corrective distributions so that the shareholders of the Preferred Units, Class A Common Units, and Class B Common Units receive distributions proportionate to their interests in X from Date 3 through Date 7, within 120 days of the date of this letter if X has not already done so. Under these facts and circumstances, we are not requiring X to make corrective distributions to the holder of the Class C Common Units. For taxable years ending Year 1 and Year 2, X and the shareholders of the Preferred Units, Class A Common Units, and Class B Common Units agree to amend their tax returns consistent with the treatment described above. If X fails to make the corrective distributions or if X or these shareholders fail to treat themselves as described above, this ruling shall be null and void.
Obviously it would have been best had the taxpayers not gotten themselves into this situation, since there very possibly were various economic, non-tax reasons why the restricted interests were issued. Certainly the underlying transactions that lead to the new equity interests would have either had to have been structured differently or, perhaps, no new interests would have been issued. Thus, getting the equity interests back in a state where the entity is back in compliance with the rules may require some detailed and problematical negotiations among the affected parties.
But the good news is that if taxpayers can get the situation corrected and come forward to the IRS voluntarily, the IRS has most often been willing to grant relief. Such a result may very well not be obtained, though, if the issue first comes to the IRS’s attention during an exam—and almost certainly will not be obtained if it becomes clear the taxpayer was aware of the problem but decided to either “play the audit lottery” or simply correct things without asking for IRS relief for prior years.
The problem with a “quiet fix” (that is, getting rid of the bad equity rights or shareholders without asking for IRS relief) is that the terminating event still has taken place and the taxpayer therefore has been a C corporation since the date the problem first arose. The fact that it may be more than 3 years in the past isn’t relevant—so there is no legal statute of limitations on the IRS raising this issue in any later year if the matter comes to the agency’s attention.