Will Your Client’s LLC Operating Agreement Make an Election Under Subchapter S Invalid?

Organization of a business enterprise as a limited liability company (LLC) has a number of advantages. In addition to ease of formation, state LLC acts dispense with many of the formalities required for corporations and wide latitude is given to LLC members in drafting operating agreements.ⁱ Under the check-the-box regulations, LLCs are eligible to elect tax status as an association and thus be treated as a corporation. A domestic LLC’s timely election under Subchapter S of the Internal Revenue Code (IRC) is also treated as a deemed entity classification election, eliminating the requirement to separately file Form 8832, Entity Classification Election. ⁱⁱ The ease by which a domestic LLC can elect S corporation status does not mean the LLC operating agreement can be ignored.

An LLC operating agreement may include provisions that will result in the single class of stock requirement for S corporation eligibility to be violated.ⁱⁱⁱ When an operating agreement is silent on distributions and/or rights to liquidation proceeds, default state law provisions can have the same result.^iv For an LLC that has already made an S corporation election, IRC §1362(f) gives the Internal Revenue Service (IRS) the authority to grant relief from an inadvertent invalid S corporation election or termination. Revenue Procedure 2022-19 can allow this relief without the need to request a private letter ruling. Although this article focuses on provisions that exist when the election is originally made, it should be noted making changes to the operating agreement for an existing LLC/S corporation that results in a prohibited second class of stock will terminate the S corporation election.

The Single Class of Stock Requirement
Internal Revenue Code §1361(1)(D) is the source of the single class of stock requirement.^v Treasury Regulation §1.1361-1(l)(1) states a corporation will be treated as having a single class of stock so long as all outstanding shares have identical rights to distributions and liquidation proceeds. Differences in voting rights are allowed. The determination of whether all shares have identical rights to distributions
and liquidation proceeds is based on the entity’s governing provisions, which include the corporate charter, articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds.^vi The regulations address state law requirements for the payment and withholding of income tax, permitting differences in timing between the constructive distributions for the
shareholders where withholding was required and the actual distributions to those owners who were not subject to withholding. ^vii The regulations also address buy-sell agreements, allowing agreements that restrict share transferability or call for purchase or redemption of shares at book value or an amount between book value and fair market value. The regulations include safe harbors for determining book value.^viii Additionally, bona fide agreements for the redemption or purchase of stock due to death, divorce, disability, or termination of employment (including forfeitures of nonvested shares for which an election was made under IRC §83(b)) are permitted.^ix The regulations allow governing provisions for distributions that take into account the shareholders’ varying interests in the S corporation’s income for the current or immediately preceding tax year that result from changes in stock ownership.^x Finally, a special rule addresses IRC §338(h)(10)
elections that allows the receipt of varying amounts per share where the varying amounts are determined through arm’s length negotiations with the purchaser.^xi Illustrating the application of the rules, the regulations include examples addressing the impact of state laws that result in nonidentical distribution and liquidation rights, differences in the timing of distributions, the payment of excessive compensation, and below market loans. Of particular interest, differences in health insurance premiums paid for employee-shareholders are permitted.^xii

The regulations also address purported debt that is properly treated as equity under general tax principles, adopting a principal purpose test of circumventing the rights to distributions and liquidation proceeds or the limitation on eligible shareholders in determining whether the obligations will result in a prohibited second class of stock.^xiii Safe harbors are provided for short-term unwritten advances and debt obligations that are held by the S corporation shareholders in proportion to their ownership interests. ^xiv There is also a “straight debt” safe harbor for nonconvertible obligations held by individuals, estates, or eligible trusts, where the interest rate or payment dates are not contingent on profits, borrower discretion, the payment of dividends, or other similar facts.^xv Specific rules govern when shares awarded as deferred compensation are taken into account, ^xvi and address call options, warrants, and similar instruments that include a safe harbor.^xvii Rules are also provided for convertible debt. ^xviii

These regulations have been applied to LLCs that have made elections under Subchapter S in several private letter rulings (PLRs) requesting relief under IRC §1362(f) from inadvertently invalid and terminated elections:

Private letter rulings 201930023 and 202315005 involved LLCs with governing provisions that were amended to provide liquidating distributions would be made to their members based on the members’ positive capital account balances as adjusted under IRC §704, resulting in the termination of the LLC’s election under Subchapter S due to nonidentical distribution rights.

Private Letter Ruling 201949009 involved an LLC that had made an election under Subchapter S that had an operating agreement that included several partnership provisions, including a provision that stated it was intended the LLC would be treated as a partnership for federal income tax purposes and each member would be treated as a partner of the partnership. The operating agreement also provided the LLC would have two classes of ownership units, one of which, the “profits units” would only share in liquidation proceeds attributable to profits earned after the issuance of the “profit unit.” The issuance of “profits units” resulted in the termination of the LLC’s election under Subchapter S due to nonidentical distribution rights.

Private Letter Ruling 202110010 involved an LLC that elected under Subchapter S when it had a single member. The LLC subsequently issued restricted membership units to employees. The employees did not make elections under IRC §83(b). At the time the restricted membership units first began to vest, the LLC operating agreement included partnership provisions that applied without regard to whether the LLC was recognized as a partnership for federal income tax purposes, including the provision distributions in liquidation would be made to the members with positive capital account balances in accordance with Treas. Reg. §1.704-1(b)(2)(ii)(b)(2). As a result, when the restricted membership units first vested, the LLC membership units no longer had identical distribution rights resulting in the termination of the LLC’s election under Subchapter S.

Private Letter Ruling 202111011 involved an LLC that made its election under Subchapter S when its operating agreement included partnership provisions including a provision that distributions in liquidation would be made based on the members’ positive capital account balances. The existence of the governing provision providing for nonidentical distribution rights resulted in the invalidity of the LLC’s election under Subchapter S.

Private Letter Ruling 202310001 involved an LLC that made its election under Subchapter S when it had a single member. At the time the LLC admitted two additional members, the LLC members entered into an agreement that provided for different allocation percentages based on the sources of the LLC’s profits and losses, including allocations based upon existence of negative capital account balances. The agreement also provided that for defined transactions, distributions would be paid to members based on their positive capital account balances as adjusted in accordance with the provisions of IRC §704, and then paid pursuant to differing percentages. The S corporation election was terminated as a result of the existence of nonidentical distribution rights.

Conforming the LLC’s governing agreements to the single class of stock requirement is a matter where the client should engage the services of an attorney that has experience with the applicable state LLC act. Under the Uniform Limited Liability Company Act (ULLCA) §105(b), matters not provided for in the operating agreement are governed by the act’s provisions. Thus, it is not simply a matter of eliminating operating agreement provisions that apply partnership tax rules, but also ensuring the agreement has positive provisions where state law would otherwise result in the LLC ownership interests having nonidentical distribution rights.

Relief Available Under Rev. Proc. 2022-19
Prior to Rev. Proc. 2022-19, relief from an invalid or terminated election under IRC §1362(f) was only available through a request for a private letter ruling.^xix The revenue procedure addresses six areas where election issues are resolvable without obtaining a private letter ruling, including allowing retroactive correction of governing provisions that violate the requirement the S corporation’s shares have identical rights to distributions and liquidation proceeds (“nonidentical governing provisions”).^xx Under §3.06 of the revenue procedure, relief is available to S corporations with nonidentical governing provisions where:

• The corporation has not made actual or deemed disproportionate distributions to a current or former shareholder during the period it had nonidentical governing provisions.
• The corporation filed its Form 1120-S returns for each year it had nonidentical governing provisions for which a return was due by the due date, including extensions, or if no extension was received, no later than six months after the original due date.
• The corporation has secured corrective relief statements prior to discovery of the nonidentical governing provisions by the Internal Revenue Service.

Corrective relief statements, which must be signed under penalties perjury, are required for the S corporation and each of its shareholders who held shares during the period the entity had nonidentical governing provisions. The revenue procedure includes a sample Corporate Governing Provision Statement in Appendix A and a sample Shareholder Statement in Appendix B. The corporation’s statement must include a description of the relevant facts regarding the adoption of the nonidentical governing provision(s), how the impermissible provision(s) were discovered, and the actions taken to remove the offending provision(s) prior to discovery by the IRS. The description of the actions taken by the S corporation and each of its shareholders need to establish they acted reasonably and in good faith in correcting the governing provision(s) to demonstrate reasonable cause for relief. The shareholder statements must include a consent to be bound by the entity’s election under Subchapter S and the representation the shareholder reported the income from the entity for each affected year consistent with the entity having a valid election. Under §3.06(d), the original signed copies of the Corporate Governing Provision Statement, the required Shareholder Statement(s), and the revised governing provisions must be maintained by the corporation for inspection by the IRS. A corporation that does not qualify for relief under the automatic procedure may still seek corrective relief through submission of a private letter ruling request.^xxi

Conclusion
Review of the LLC operating agreement, including any binding agreements between the LLC members, should be undertaken prior to filing an election under Subchapter S to ensure the LLC is not in violation of the single class of stock requirement. This is particularly a concern for LLCs that were either formed without the assistance of an attorney, or where legal assistance was obtained, where the attorney was not told the LLC would be electing under Subchapter S. In these instances, there is an elevated risk the operating agreement adopted will either include distribution and liquidation provisions necessary to conform with the substantial economic effect rules in Treas. Reg. §1.704-1(b)(2) that will result in an impermissible second class of stock, or will default to state law that has the same result. For clients with existing S corporation elections for LLCs where this review has not taken place and nonidentical governing provisions are discovered, Rev. Proc. 2022-19 provides a welcome alternative for eligible clients to the expensive private letter ruling process for obtaining retroactive corrective relief. As always, clients should be encouraged to have changes in LLC operating agreements reviewed prior to adoption to ensure the agreements do not have unforeseen tax consequences.