Failed S-Corporation Election by LLC with Partnership Tax Provisions in its Operating Agreement

Failed S-Corporation Election by LLC with Partnership Tax Provisions
in its Operating Agreement

      A recent Internal Revenue Service Private Letter Ruling (“PLR”) considered the circumstance of a limited liability company that filed an election to be classified as an S corporation. As the LLC’s operating agreement contained numerous provisions driven by partnership taxation, provisions that are inconsistent with classification as an S-Corporation, the Service held the election to be invalid. It did, however, confirm the election for the period after the operating agreement was revised. Private Letter Ruling 202010001, released March 6, 2020, dated November 29, 2019.

      First, a bit of background. It is almost axiomatic that LLCs will, for purposes of at least federal income taxation, be classified as partnerships. Assuming the LLC has two or more members, that is the default rule. However, it is subject to modification. An LLC that is otherwise taxed as a partnership may elect to be classified as a corporation, in which instance it will be subject to Subchapter C of the Internal Revenue Code. Then, assuming its various requirements are satisfied, the LLC, now taxed as a corporation, may elect into Subchapter S of the Internal Revenue Code, with the intention of thereafter being classified as an S-Corporation.

      In this instance, the LLC’s operating agreement, as initially adopted, provided for “Capital Accounts” and that certain allocations and distributions be made in accordance therewith. One requirement of being an S-Corporation is that there be only a “single class of stock” to the effect that every shareholder, in proportion to their share ownership, will share equally in both the allocation of tax items and both interim and liquidating distributions. Under the operating agreement as originally drafted, that requirement was not satisfied. 

      In addition, shares in the LLC were issued to an Individual Retirement Account (“IRA”). An IRA is not, however, a permitted shareholder in an S-Corporation. At some point in time, those shares were reacquired from the IRA, thereby terminating its status as a shareholder.

      Ultimately a new operating agreement was approved and submitted to the IRS. While the PLR does not recite the language in that amended agreement, it seems fair to assume that it eliminated the concept of a “Capital Account” and provided for strict pro-rata allocations and distributions amongst the “shares.”

      After reciting the applicable law, both statutory and regulatory, dealing with a valid S-Corporation election and the mechanism by which inadvertent failures to satisfy the requirements may be resolved, in this PRL, the IRS held: 

·                   as of the time of formation, the company had more than one class of stock;

·                even had the single class of stock rule not been violated at the initial operating agreement, from the time the IRA was a shareholder, any election would have terminated;

·                  the creation of the second class of stock under the original operating agreement was inadvertent; and

·              had there been a valid S-Corporation election in place at the time the IRA was issued shares, any termination of S-Corporation status consequent thereto would have been inadvertent.

      In consequence, from the date that the shares will be repurchased from the IRA, that date being subsequent to the approval of the new operating agreement that is consistent with the S-Corporation rules, the LLC will be treated as an S-Corporation. For the prior periods, it will be subject to Subchapter C of the Internal Revenue Code.

      The fact situation set forth in this PRL is all too common, and I on numerous opportunities gotten to address the same circumstance. Again, most LLCs contemplate being taxed under Subchapter K, it governing partnership taxation. For that reason, there will be significant discussion of taxation in the operating agreement. An election to be classified as an S-Corporation may still be appropriate for the LLC, but not until a new operating agreement, one drafted to conform to the S-Corporation rules, is put in place. The drafting of an operating agreement that is consistent with the S-Corporation rules is not a simple task; it requires affirmative overwriting of provisions of the Kentucky LLC Act. Put another way, the Kentucky LLC Act is not consistent with S-Corporation tax status unless there is a specialized operating agreement put in place that expressly overrides the conflicting provisions of the LLC Act.