Avoiding Problems When Making S Election for LLC

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As you may know, an LLC with more than one member is treated as a partnership unless it elects to be treated as a corporation or S corporation.  When deciding whether to make an election for an LLC to be taxed as an S corporation, there are various tax issues to consider and pitfalls to avoid.

Why Elect S Status?  One of the most common reasons for electing S corporation status is to reduce the amount of social security and medicare tax that owner-employees of the LLC pay.  This reason to elect S corporation status was given a boost with the enactment of the additional 0.9% medicare tax imposed on the compensation of employees with income in excess of $250,000 (married filing jointly) or $200,000 (individual).

How to Elect S Status.  S corporation status is obtained by filing IRS Form 2553 indicating that the LLC elects to be treated as an S corporation for federal income tax purposes.  But filing the Form 2553 is not effective unless the LLC otherwise qualifies to be treated as an S corporation as of the election date.

S Corporation Requirements.  An S corporation is not permitted to have owners who are corporations or non-resident aliens.  An S corporation is not permitted to have more than 100 owners.  An S corporation may have only one type of ownership interest (cannot have both common and preferred stock).  If your LLC violates any of these requirements, the LLC cannot be treated as an S corporation for federal income tax purposes.

Governing Documents.   The main governing document for an LLC is its operating agreement.  Since  LLCs are by default treated as partnerships for federal income tax purposes, most off-the-shelf, boilerplate operating agreements are set up in the form of modified partnership agreements.  As such, the standard operating agreement contains many provisions whose only purpose is addressing federal partnership income tax issues.  Many of the partnership tax provisions are not required, or even permitted, if the LLC is intended to be treated as an S corporation for federal income tax . Many of these typical LLC operating agreement provisions are not permitted if the entity is to be taxed as an S corporation.

One Class of Stock.  S corporations may have only one class of stock (although voting differences are ignored).  Partnerships may have any number of different preferred classes of ownership interests.  S corporations are not permitted to have classes of ownership which have different rights to share in distributions of cash or assets, or in allocations of profit and loss.   Since LLC operating agreements are generally set up as modified partnership agreements, they often contain partnership tax language including , qualified income offsets, minimum gain chargebacks and other provisions that may override allocations and distributions that would otherwise be done on a pure ownership percentage basis.

State Law Defaults.  Under most state LLC laws, provisions that are not otherwise covered in the LLC operating agreement are governed by state law.  It is possible that the LLC default rules could result in the LLC failing to qualify for S corporation treatment.  For example, if there is no provision describing how cash is to be distributed or income allocated among the members, the Ohio default is that allocations and distributions by an LLC are to be made based on the relative capital contributions made by the members.  To the extent one member has contributed more or less to the LLC on a relative pro rata basis than his ownership percentage would otherwise dictate, such LLC could be found to have violated the “one class of stock” rule.

Fixing Operating Agreements.  Care needs to be taken to remove any language giving a member’s ownership interest priority over another member’s ownership interest.   References to IRC section 704 and other partnership tax provisions should be eliminated.  Any references to doing allocations or distributions in relation to capital account also need to be carefully analyzed and probably deleted.  Many LLC operating agreements provide for capital calls.  Capital call provisions are permissible for an S corporation, but the remedy for failure to meet the capital call must result in a change in the ownership percentage and not affect right to, or priority of, distributions or allocations.

Failure to Meet S Corporation Requirements.  If an LLC that has elected to be taxed as an S corporation fails to meet the S corporation requirements (and the LLC does not apply for and obtain late election or inadvertent invalid election relief) the LLC will be treated as a partnership (not a C corporation) under the entity status default classification rules.

Planning.   When setting up or converting an LLC to be taxed as an S corporation, you need to prepare and file the appropriate IRS election form.   But you must also carefully review and consider the various provisions of the LLC operating agreement and the state law LLC default provisions.  If you are setting up or converting an LLC to be taxed as an S corporation give Jeff Senney a call or email at 937-223-1130 or Jsenney@pselaw.com

AND ONE MORE THING.  The IRS has recognized that the delayed issuance and processing of income tax forms resulting from the income tax code changes contained in the 2012 Taxpayer Relief Act has impacted the ability of taxpayers to timely estimate and pay their 2012 tax liability.  The IRS has provided relief to taxpayers who request an extension of time to file a 2012 income tax return that includes one of the affected tax forms.  Taxpayers will be deemed to have demonstrated reasonable cause and lack of willful neglect, provided that the following requirements are met (1) a good faith effort is made to properly estimate the tax liability on the extension application; (2) the estimated amount is paid by the original due date of the return; and (3) any tax owed on the return is fully paid no later than the extended due date of the return.  When responding to an assessment notice, a taxpayer should submit a letter describing eligibility for this relief, identifying which of the affected form(s) below was included with the taxpayer's return as filed, and make reference to Notice 2013-24.  Call or email Jeff Senney at 937-223-1130 or Jsenney@pselaw.com if you would like to see a list of the affected forms or want help with seeking penalty abatement.