Partnership Provisions in LLC Operating Agreement Renders S Election Invalid

PLR 201624003 reminds us that when it comes to S corporations, the “check the box” regulations can be more complicated than they first appear.

Under the check the box provisions found at Reg. §301.7701-3 an entity that is not automatically classified as a corporation is allowed to elect whether to be treated as a corporation or, if it has one owner, a disregarded entity or, with two or more owners, a partnership. Since, once an entity elects to be treated as a corporation under check the box it is treated as a corporation for the entire IRC (IRC §7701 applies “for purposes of this title” which means the entire Internal Revenue Code found at Title 26 of the United States Code), if the entity is otherwise eligible it may elect to be treated as an S corporation.

In fact, Reg. §301.7701-3(c)(1)(v)(C) provides:

(C) S corporations. An eligible entity that timely elects to be an S corporation under section 1362(a)(1) is treated as having made an election under this section to be classified as an association, provided that (as of the effective date of the election under section 1362(a)(1)) the entity meets all other requirements to qualify as a small business corporation under section 1361(b). Subject to § 301.7701-3(c)(1)(iv), the deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election, under § 301.7701-3(c)(1)(i), to be classified as other than an association.

Unfortunately, some taxpayers and their adviser skip over that “otherwise eligible” clause and treat this provision to mean any LLC can become an S corporation simply by filing a Form 2553. The problem is that to be an eligible corporation to make an S election, the corporation must only have “one class of stock” as defined by the IRC.

For this purpose we are looking at federal definition. Generally “stock” becomes any sort of ownership interest in the corporation or the entity we wish to treat as a corporation. To see if we have only one class of stock, we look to the definitions found in Reg. §1.1361-1(l)(1) which provides:

(1) General rule. A corporation that has more than one class of stock does not qualify as a small business corporation. Except as provided in paragraph (l)(4) of this section (relating to instruments, obligations, or arrangements treated as a second class of stock), a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock. Thus, if all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.

Most “boilerplate” operating agreements for LLCs provide that rights in liquidation will be governed by the complex rules found in the regulations under IRC §704. Most LLCs with more than one owner end up electing to be taxed as partnerships and compliance with those regulations is mandatory to assure that the various allocations under the operating agreement will be respected for federal tax purposes. Those regulations mandate liquidation proceeds be distributed in accordance with “book capital,” a legal definition provided in those regulations that is similar, but not identical to, concepts of partners capital from a traditional accounting standpoint.

The problem is that such a set of liquidation rights sets up the possibility that liquidation payments would not go on a “per unit” basis. And the mere possibility of such a development is enough to cause the interests to be deemed multiple classes of stock if there is more than one owner.

We also may find that, for an entity that has operated as a partnership for some period of time, there already exist provisions that provide for allocations on a basis other than per unit, per day. Since that allocation would move on to the capital accounts, those provisions would also lead to significant problems.

One or more of these issues seems to have been the problem that led to this request for relief found in the letter ruling. As the ruling notes in the facts:

At the time of its S corporation election, X's operating agreement included provisions relating to partnerships that caused X to have more than one class of stock. When X's members later discovered the effect of the partnership provisions, they amended the operating agreement to remove the provisions and provide identical distribution and liquidation rights to X's members.

Based on these facts the ruling states “we conclude that X's S corporation election was ineffective for having more than one class of stock.” But the ruling goes on to note that the IRS concluded the circumstances that resulted in the ineffective election were inadvertent, and thus will treat the entity as always an S corporation under the following conditions:

X further represents that no federal tax return of any person has been filed inconsistent with a valid S corporation election having been made for X effective D2 . X also represents that all distributions and allocations of income to its shareholders have been made pro rata in accordance with their interests in X. X and its shareholders have agreed to make any adjustments required by the Service consistent with the treatment of X as an S corporation.

So all ends well—except for the cost of having to file for the private letter ruling (both the user fees and the professional fees).

Since this entity had more than one owner when it tried to make the S election it never became a tax corporation per the terms of the regulations cited above. Things are messier if the entity only had a single owner when the S election was filed (since there, virtually by definition, there is only one “class” of stock) but later gains additional owners. Under the regulations, the entity would have converted to a corporation on the S election effective date, and then would have had its S status terminated when another equity holder was brought in if the operating agreement had the §704 language in it. Normally having something the taxpayer thinks is an S corporation suddenly become a C corporation will not be a good tax result.

An adviser who is working with a taxpayer that wishes to have an LLC elect to be a corporation should make sure the operating agreement is reviewed to insure that no “special rights” can be found that could violate the identical rights rules. Normally that will require knowledge of both the tax law, the language in the agreement and the applicable of relevant local law, so quite often requires the tax adviser and the LLC’s counsel to consider the agreement in tandem.

If the adviser takes on a new client that is an LLC taxed as an S corporation (or claims to be), prudence suggests taking a look at the operating agreement to see if there appear to be any issues that could either put the initial election in question or might result in the entity now being treated as a C corporation. If there is a problem, the client needs to seriously consider applying for a private letter ruling rather than hoping the IRS never notices the problem.

Note that if the client wants to do the latter, the adviser may need to disengage, since the adviser would not be able to sign the return in question knowing it is asserting a position that is not true (this entity is not properly taxed as an S corporation). While there are numerous problems and violations of standards if the CPA signs that return, the simplest to understand is to simply read the jurat above the paid preparer’s signature—which is signed under penalties of perjury.