Boilerplate Provision in LLC Operating Agreement Found to Terminate S Election

Under the check the box regulations, an LLC may elect to be an S corporation.  But it is important to remember that the LLC must meet all of the requirements to be treated as an S corporation during its life, which includes the single class of stock rule.  PLR 201918004 details a case where an LLC was forced to ask the IRS for relief from inadvertent termination of its S status when a review of the operating agreement found that the agreement provided for the potential for a disproportionate distribution.

IRC §1362(b)(1)(D) provides that one of the conditions for S status is that the corporation does not have more than one class of stock outstanding.  However, the “class of stock” is not based on state law rules for what makes for different classes of stock.  Rather, Reg. §1.1362-1(l)(1) creates a federal S corporation test for what constitutes the existence of only a single class of stock:

(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.

Note that the regulations look at rights to distributions and not at actual distributions.  For this reason, if a corporation, contrary to its governing documents, issues distributions at different times that will not create a second class of stock, since the shareholder who did not receive a distribution to begin with has the right to receive that same distribution.  Only if the shareholders have an agreement that the other shareholder no longer has a right to the make-up distribution would there be a second class of stock issue.[1]

But even if every distribution has been strictly proportional, if the agreement provides circumstances under which the equity holders will not be entitled to proportionate distributions, then there exists a second class of stock and the entity will not be eligible to make an S election.

In this case, the LLC operating agreement provided for the following:

Section 10 of Y’s Operating Agreement provided that, “Upon dissolution of the Company…the proceeds from the liquidation of the Company’s assets shall be distributed…to the Members in accordance with their respective positive Capital Account Balances; and, the balance, if any, to the Members, in accordance with their respective Percentage Interests.”

That language, which is regularly used in partnership agreements to meet the substantial economic effect provisions of Reg. §1.704-1(b)(1) and help protect any special allocations of the partnership, does not require that the distributions be on the equivalent of a “per share” basis in all situations.  Regardless of whether such a disproportionate distribution has ever occurred during the life of the LLC or is likely to ever occur, the fact that the rights are not strictly proportionate terminate the S election. 

The PLR concludes that the LLC’s S election was terminated on the date the operating agreement containing that provision was adopted by the LLC.  This forced the LLC to apply for a private letter ruling to find that the termination had been inadvertent.

The PLR notes that the standard for finding that a termination is inadvertent is as follows:

Section 1.1362-4(b) provides that for purposes of § 1.1362-4(a), the determination of whether a termination was inadvertent is made by the Commissioner. The corporation has the burden of establishing that under the relevant facts and circumstances the Commissioner should determine that the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination was inadvertent.

It is important to note that the determination that a termination was inadvertent must be made by the Commissioner.  That is, the taxpayer can’t simply take the position that the termination was inadvertent and thus ignore the termination event.  Rather, to retain the S status, the entity must apply for and obtain a private letter ruling that will contain the IRS’s determination.  This means paying the user fee to obtain the ruling, as well as incur the professional fees involved in getting the ruling through the IRS National Office.

In this case the IRS did find that the termination was inadvertent and the taxpayer’s S status was retroactively restored.

[1] See Example 2, Reg. §1.1361-1(l)(4)(v)