Governance Issues To Consider If Your LLC Is Taxed As An S-Corporation

March 29, 2017 by

Limited liability companies have the option to be taxed as a corporation for federal income tax purposes. Those companies that elect to be taxed as a corporation generally take it a step further and choose to be taxed as an S-corporation. The reasons why a limited liability company may make these elections are largely tax-based, and are beyond the scope of this article.

However, once you and your tax professional have decided that your company should be taxed as an S-corporation, there are certain structural and operational aspects of your company that you should consider in order to obtain and then maintain your desired S-election. Below are a few relevant tactical items that you should consider and review to help ensure that your company is eligible to file an S-election and thereafter avoids any inadvertent termination of such election.

  1. Type of Members

In order to make an S-election, all members of your company must be eligible. With limited exception, this generally means that all members of the company must be individuals who are citizens or resident aliens of the United States. If your company will have any foreign individuals or domestic or foreign entities as members, the company is ineligible to make an S-election. Therefore, it is important that you carefully consider the type of members that you will admit to your company, either at the time of formation or thereafter.

  1. Number of Members

Companies electing to be taxed as an S-corporation are also limited to having no more than one hundred (100) members in the company at any time. While this is not typically a problem for limited liability companies, an LLC is technically permitted to have as many members as it chooses under state law. As such, in the event that you intend to allow small investments in your company from a large number of investors, or otherwise believe that you will have anywhere near one hundred (100) members, you may need to reconsider making an S-election.

  1. One Class of Membership Interests

As discussed more fully below, this tends to be the most troubling aspect for limited liability companies filing an S-election. The Internal Revenue Code (the “Code”) states in no uncertain terms that S-corporations may only have one class of stock (or stock equivalents, such as membership interests). While a company’s membership interests may have varying voting rights, all rights with respect to distributions of profits and losses and liquidations of the company’s assets must be identical among all members. This precludes the existence of any preferred profit allocations or waterfall provisions in the company’s distributions to its members. Therefore, if you have potential investors in your company that are requesting preferential distributions or capital call treatment, you may be precluded from making an S-election.

  1. Establishment of Stock Equivalents

Unless you expect to seek outside investments into your company or otherwise have a reason to need clearly delineated pieces of ownership, it is unlikely that you will initially intend to authorize “units” or any other form of ownership in your company other than the standard “membership interest.” However, to aid in the maintenance of only one class of stock and to ensure that economic rights are the same across all owners, you may consider authorizing and issuing units to members of your company. Under the Code, these units will be afforded the same treatment as traditional “stock” in a corporation, and will therefore make overall compliance with the stock-based requirements easier for the governing body of you company.

  1. Obtain Representations and Warranties from New Members

It is very easy for one member of your company to make a mistake and cause an inadvertent termination of your S-election. It is therefore recommended that you ensure each member is aware of what his or her obligations and restrictions are with respect to any units or other ownership interest in the company. You may therefore consider including a general statement in any subscription or other agreements with members that each member understands that the company is to be taxed under subchapter-S of the Code, and that each member will act accordingly. You may also consider adding various other protections to the company agreement or any buy-sell agreement with members, which restricts transfers to ineligible members, permits the company to examine any trusts or other members for compliance with the applicable subchapter-S requirements, etc.

  1. Pay Careful Attention to Your Company Agreement

It is likely that you chose a limited liability company as the form of your company, at least in part, because of the flexibility that this form provides. This flexibility is typically reflected in the company agreement or other governing document for your company. The problem, however, is that this flexibility, if left unchanged, will likely lead to the inadvertent termination of your S-election. It is therefore important that you inform counsel for your company that you intend elect to be taxed as an S-corporation, whether that election is made at the formation of your company or later in your company’s life cycle.

The provisions of your company agreement that need the most attention will be those related to allocations and distributions of profits and losses, which directly affect whether or not your company will be deemed to have one or more class of stock. Specifically, the company agreement should expressly state that no member has priority over any other member with respect to any distributions made by the company. Further, all references to the capital accounts maintained for each member, and the allocation of profits and losses in accordance with the balance of each capital account, will need to be removed entirely from your company agreement. Instead, it is important that all profits and losses, regardless of capital account balance, be allocated among members in accordance with their relative number of units in the company. Additionally, most standard company agreements contain references to Section 704(c) of the Code for proper allocations of profits and losses among the members. This Section not only applies solely to entities taxed as partnerships, but its provisions are also in direct conflicts with the single class of stock requirement for S-corporations. These references should therefore be removed.

Ensuring compliance with each requirement of subchapter-S can be tedious. However, enlisting the aid of both tax and legal professionals will help ensure that you do not incur unnecessary tax burdens in the future from an inadvertent termination of your S-election. We are always available to answer any questions that you may have and to assist you in your compliance with subchapter-S.

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