Some taxpayers may prefer to use a limited liability company (LLC) as the underlying legal entity in which to form what is intended to be, for tax purposes, an S corporation. It may be due to quirks in state law (as is true in my home state of Arizona) or some other reason. But what is too often overlooked is that the LLC’s operating agreement must not create a situation where there is deemed to be multiple classes of “stock” outstanding, or the LLC will not qualify as an S corporation.

This very issue forced taxpayers to pay for and seek an IRS ruling that the termination of their S corporation status was inadvertent in the ruling found at PLR 202247004.[1]

IRC §1361(b)(1) provides the following requirements for a corporation to be able to elect S status:

(b) Small business corporation.

(1) In general. For purposes of this subchapter, the term "small business corporation" means a domestic corporation which is not an ineligible corporation and which does not--

(A) have more than 100 shareholders,

(B) have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual,

(C) have a nonresident alien as a shareholder, and

(D) have more than 1 class of stock.

Treasury Reg. §1.1361-1(l)(1) provides the following description of what constitutes one class of stock, looking to rights to distribution and liquidation proceeds:

(l) Classes of stock.

(1) General rule. A corporation that has more than one class of stock does not qualify as a small business corporation. Except as provided in paragraph (l)(4) of this section (relating to instruments, obligations, or arrangements treated as a second class of stock), a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.

However, such ownership classes can have different voting rights, as the regulation goes on to note:

Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock. Thus, if all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.[2]

Treasury Reg. §1.1361-1(l)(2)(i) makes it clear that the rights provided in the governing documents are the items to consider in making this determination.

(i) In general. The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).

Advisers must realize that since it is rights that are considered, the question is not if a differing distribution for different ownership classes has been or is likely ever to be made. Rather, the question is whether the governing documents allow for such a distribution to take place, even if it is only true if certain conditions are met.

The problem we encounter with limited liability companies is that they don’t issue corporate stock, so we must treat the membership interests as if they are stock. That’s not an insurmountable problem—it is possible to draft an operating agreement that provides for “units” for ownership interests and provide the necessary identical rights for each unit.

But here we run into another problem. LLCs with more than one owner are most often treated by the owners as partnerships under tax law and, in such cases, the operating agreements are drafted most often to comply with the regulations under IRC §704(b) so that allocations under the agreement can be treated as having economic effect and thus respected by the courts when the LLC is taxed as a partnership. Quite often the §704(b) regulations are incorporated by reference into the operating agreement.

However, those §704(b) regulations require that distributions in liquidation of an interest must be governed by the capital accounts determined under these regulations. That liquidation can very easily lead to differing amounts per unit, thus creating differing classes of “stock” being held by each equity holder under the S corporation regulations.

The §704(b) language will be found quite often in standard LLC operating agreement boilerplate text, which leads to it often being found in the operating agreements for LLCs that wish to be treated as S corporations unless the party drafting the agreement is both aware the entity plans to elect S status and is aware of the need to modify their standard agreement to contain the proper S corporation distribution language.

If the LLC has only one member the §704(b) language really isn’t a problem—that owner’s “units” all have identical rights in liquidation.

But once a second member is admitted to the LLC the second class of stock is now treated as issued—and the S status is terminated, with the entity reverting to being taxed as a C corporation. While the status of the LLC as a corporation isn’t impacted by having more than one class of stock, it simply can no longer be an S corporation.

One unusual aspect of this letter ruling request is that it appears the entity did not have this problem initially. The ruling notes:

The information submitted states that X was formed on Date 1 under the laws of State and elected to be treated as an S corporation effective Date 2. A and B were the sole shareholders of X as of Date 3.[3]

We can’t tell from these facts if the entity was originally formed as a state law corporation, or if it was an LLC that had an agreement that properly took care of the one class of stock issue. But we do know that when the entity adopted a new operating agreement, the problematical §704(b) language made its first appearance:

On Date 3, A and B entered into an Amended and Restated Operating Agreement that included provisions regarding partnerships. Section 5.1 of this agreement provides, in part, that X would maintain capital accounts for each member. Section 10.4 of this agreement provides, in part, that upon liquidation of X, members would distributions to the extent of their capital account balances followed by their interests in X.[4]

The LLC later adopted a second revision to the operating agreement that also contained the problem text. However, eventually the issue was discovered, and the LLC adopted a third revised operating agreement that removed the §704(b) text and now complied with the one class of stock requirement:

Upon discover [sic] of the effect of the partnership provisions, A and B entered into a Third Amended and Restated Operating Agreement on Date 5 to remove the requirement for the members to maintain capital accounts and to provide identical distribution and liquidation rights to the members.[5]

The problem at this point is that while the entity now qualifies to be an S corporation, its S status terminated when the first revised operating agreement was adopted. Good news is that the IRS can grant relief from inadvertent terminations under IRC §1362(f), but bad news is that obtaining that relief requires requesting and paying for a private letter ruling.

The LLC went ahead and asked for the private letter ruling. In doing so, the LLC made the following representations:

X represents that the termination of X’s S corporation election was inadvertent and not motivated by tax avoidance. X further represents that since Date 3, X and its members have filed all returns consistent with X’s status as an S corporation. X also represents that since Date 3, all distributions were made to the members based on their pro rata shares of ownership of X. X and its members have agreed to make such adjustments consistent with the treatment of X as an S corporation as may be required by the Secretary.[6]

The requested relief was obtained, as the IRS ruled:

Based solely on the facts submitted and representations made, we conclude that X’s S corporation election terminated on Date 3 due to the provisions in the Amended and Restated Operating Agreement. We further conclude this termination was inadvertent under the provisions of § 1362(f). We also conclude that if X’s status had not terminated on Date 3 it would have terminated on Date 4 due to the provisions in the Second Amended and Restated Operating Agreement. We conclude that X’s termination on Date 4 would also have been inadvertent under the provisions of § 1362(f). Therefore, pursuant to § 1362(f), X will be treated as an S corporation effective Date 3, and thereafter, provided that X is otherwise eligible to be an S corporation and provided that the election was not otherwise terminated.[7]

[1] PLR 202247004, 11/25/22, https://www.irs.gov/pub/irs-wd/202247004.pdf (retrieved November 26, 2022)

[2] Treasury Reg. §1.1361-1(l)(1)

[3] PLR 202247004, 11/25/22

[4] PLR 202247004, 11/25/22

[5] PLR 202247004, 11/25/22

[6] PLR 202247004, 11/25/22

[7] PLR 202247004, 11/25/22