Disregarded Entity Holding S Corporation Stock Terminated Election When Entity Obtained a Second Sharholder

LLCs were created by the state of Wyoming years ago to be an entity that the IRC had no way to classify.  That status has continued to today—an LLC is not an entity type for federal income tax purposes, even though it is an entity type for most other purposes under state law. Eventually the IRS decided to deal with the entity type issue by using what we refer to as a “check the box” election.

The check the box regulations, found at IRC §301.7703-3, allow the taxpayer to choose between certain entity types based on the number of equity holders of the LLC.  In essence, we pretend, for federal tax purposes, that the LLC is really some other entity.

Generally taxpayers have liked this flexible approach, but from time to time taxpayers are bitten by forgetting that the fact that even though the underlying legal entity doesn’t change, the pretend tax entity can end up changing when a new member is either brought into the LLC or acquires an interest in the LLC from an existing member.

That was the problem the taxpayer faced that led to the private ruling request (and costs) in PLR 201922002.[1] The problem arose due to the complications inherent when shares in an S corporation are held by an LLC.

For a corporation to retain an S election, all shares must be held by eligible shareholders.  Individuals, estates and certain trusts are among those that are eligible shareholders[2], but partnerships are not in that list. 


Mary purchases 100 shares of Kelly Manufacturing, Inc., an S corporation.  She is a U.S. citizen shareholder and holds the 100 shares personally.  The 100 shares represent all of the outstanding shares of Kelly Manufacturing.  In this case, all shares of Kelly Manufacturing, Inc. are held by shareholders eligible to hold S corporation shares.  Assuming all other requirements are met, Mary’s acquisition of all of the shares of Kelly will not, by itself, terminate Kelly’s S election.


If an LLC has only one owner, by default the entity is disregarded, and any assets held by the LLC (including shares of a corporation) are treated as held by that owner.  If that owner is an eligible S shareholder, having the shares held by the LLC is not an issue—because the tax law ignores the LLC, the shares are treated as being held by an eligible shareholder.


Mary hears about this LLC thing and reads about them on the internet.  She decides to form a domestic LLC of which she owns all of the interests.  She transfers the Kelly Manufacturing shares into this LLC.  Kelly does not make an explicit check the box election to have the LLC treated as a corporation.

Since, without an election to be treated as a corporation, this LLC is a disregarded entity, the shares continue to be deemed held by Mary and Kelly Manufacturing continues to be treated as an S corporation for income tax purposes.


However, if even a very small interest in the LLC is issued to or transferred to another party, the LLC’s default status changes to a partnership immediately upon the transfer.  Since a partnership is not an eligible S shareholder, an existing S election would be terminated when a second owner holds any interest in the LLC.  Only if the LLC holds 100% of the corporation stock, is itself eligible to and does make an S election on formation, and a QSUB election for the corporation owned by the LLC can the S election continue once there is a second interest holder in the LLC.


Mary continued her reading on the internet and learned that she could gift up to $15,000 worth of her interest in the LLC each year to her daughter, Denise, with no gift tax return required—and it would remove the interest and appreciation from her estate at her death.  Mary decides to not waste any time, and immediately transfers an interest in the LLC valued at $15,000 to Denise.  This gives Denise 1% of the LLC member interests.  Again, no check the box election is filed at this time.

Under the check the box regulations, the LLC is now treated as a partnership.  Under the make-believe world of the check the box rules, Mary is treated as having distributed a proportionate interest in the assets to Denise.  Denise then turned around and, with her mother, formed a new partnership with each member contributing their share of the assets to the new partnership.

As was noted earlier, a partnership is not an eligible S shareholder.  So Kelly Manufacturing is treated as having its S election terminated at the end of the day before the transfer, with Kelly now being taxed as a C corporation.


The S corporation in PLR 201922002 faced this problem—what had been a disregarded entity became a partnership when the entity gained a second interest holder.  Eventually the problem was noticed and it was decided to approach the IRS to obtain relief.

The good news is that the IRS is authorized to provide such relief for inadvertent terminations per IRC §1362(f).  In this case there was no intent to somehow gain a tax advantage that wasn’t otherwise available—rather, it appears to have been a matter of simple ignorance of the law leading to shares being held by an ineligible shareholder (the deemed partnership).

The previously disregarded entity (now a deemed partnership) agreed to transfer the shares to the individual who previously owned 100% of the disregarded entity.  The IRS agreed to grant the taxpayer relief as if the termination had never taken place.[3]

But now for the bad news—such relief can only be obtained by applying for a private letter ruling since the IRS’s consent must be obtained.  That will require the payment of a user fee for the ruling (based on the current year’s schedule of such fees), the preparation of the formal request and the additional time and expense involved in working with the IRS attorney assigned to the matter to negotiate the terms of any relief, as well as getting the IRS the attorney any information he/she feels is necessary to determine if the requested relief should be granted.


Mary now finds an article on the internet describing this issue and realizes that the S election hasn’t survived the transfer of an interest in the LLC.  Her daughter agrees to return the interest in the LLC to Mary.

Although Mary did not intend to terminate the S election and did not otherwise have a “tainted” reason to attempt to avoid S corporation restrictions, her actions do not serve to retroactively restore the corporation’s S election.  Unless she applies for the private letter ruling and obtains specific relief from the IRS, the corporation remains a C corporation.


Some may be thinking that they’ve never heard of the IRS ever catching something like this—the agent won’t look for evidence of any prior transfers and it is so costly to get relief it’s fine to just do what Mary did.  The argument is that such advice is “real world” advice and suggesting that anything else should be done is doing the client a disservice.

Not quite—while it may be true that the likelihood of the IRS catching this issue is small (but not zero, to be clear), there are other parties who might (and often do) discover the issue.  For instance, say Mary is contacted by a public company that is interested in acquiring Kelly Manufacturing to integrate it into their business.  All is fine—but they require Mary consent to having the corporation’s activities reviewed by a due diligence team.

A due diligence review will likely turn up this issue, either because the LLC still has its interests held by multiple people (which is highly likely—Mary discovering this problem is virtually zero if she continues to avoid paying for professional advice) or because the team specifically inquires of Mary regarding if there had ever been multiple owners of the LLC.  Once the issue is uncovered by the due diligence team, the sale will likely go “on hold” until Mary can provide assurance the IRS won’t attempt to assert there are unpaid C corporation taxes—and this triggers the need to obtain the PLR.  As well, in this case, the buyer will likely insist that their due diligence team must be involved in the PLR request, with all costs of the request (including the due diligence team’s billable hours) paid for by the seller.

[1] https://www.irs.gov/pub/irs-wd/201922002.pdf, retrieved from website on May 31, 2019

[2] IRC §1362(a)(1)(B)

[3] PLR 201922002.pdf, pp. 2, 4