The Problem With S-Corp LLCs

The Problem With S-Corp LLCs

While I do not disagree with Warren Kean that an S-Corp LLC may at times be a viable format based upon particular facts, I continue to view this structure as more often than not a “solution in search of a problem.”  See generally Rutledge,  S Corp LLCs – Planning Opportunity or Solution in Search of a Problem?, 15 J. Passthrough Entities 37 (July/Aug. 2012).

While is a highly-lawyered transaction the form may have a place, I see them in hugely unsophisticated deals and written by people who really do not understand what they are doing.

By way of example, I was recently sent for review an operating agreement which provides in part:

Section 4.4.  Counterpart of Code to Apply in Event of Subchapter S Election by Company

All references in this Operating Agreement to any provision found in Section 700 of the Code, including but not limited to references to same in Sections 4.2 and 4.3, supra and 5.7, infra, of this Operating Agreement shall be deemed references to the applicable Code provisions dealing with subchapter S corporations for such period of time as the Company is operated as a subchapter S corporation rather than as a partnership. 

My note as to this provision reads:

This section 4.4 should be deleted in its entirety. If this company is going to be governed by subchapter S rather than subchapter K, this agreement needs to be entirely rewritten. There is no general equivalency between subchapter S and subchapter K which could be carried over. Further, if this company were to elect to be an S corporation, there are provisions outside of 4.2, 4.3 and 5.7 which would in effect violate the S corporation rules, resulting in the LLC being classified, for tax purposes, as a C corporation.

Further, one of the original members to the LLC  is a corporation, and an S-corp with a corporation as one of several members will not be able to make an S-corp election.

That does not even get to “any provision found in Section 700 of the Code” – there is no such section.