In a recent private letter ruling (PLR 201840004), the IRS ruled that an S corporation may continue to be treated as such, despite certain provisions in its operating agreement that rendered its initial S election ineffective.
Entities electing Subchapter S status are subject to numerous rules that may affect their ability to elect and maintain that status. For the unwary or inattentive, these requirements can be easy to violate – an act that can prove fatal to the entity’s S election. One well known requirement is that the entity can only have one class of stock, meaning that all shares must have equal rights to distribution and liquidation proceeds. This may seem straightforward, but taxpayers can unknowingly violate this requirement, particularly when the entity is legally organized as a limited liability company (LLC) and adopts a boilerplate operating agreement. This appears to be what happed in this case.
Specifically, according to the PLR, the entity in question was formed as a state law LLC. Following formation, the entity elected under the check-the-box rules to be treated as an association taxable as a corporation for federal income tax purposes, and then made a subchapter S election. At the time of these elections, the LLC’s activities were governed by a standard operating agreement, which employed much of the language one typically finds in these agreements. One such provision required that liquidating distributions be made in accordance with positive capital accounts. According representations made by the taxpayer, those distribution provisions created the possibility that distributions might not be made in accordance with each shareholder’s ownership percentage.
Upon becoming aware of the issue, the owners amended the operating agreement to provide for pro rata liquidation rights. Moreover, the shareholders represented that the liquidation preference language – and thus the ineffectiveness of the S election – was inadvertent, and not motivated by tax avoidance or retroactive tax planning. The IRS ruled that that entity’s subchapter S election was ineffective, but that its ineffectiveness was inadvertent. As such, the IRS ruled that the entity would be treated as an S corporation retroactive to the date of its initial election.
This ruling serves as a good reminder for any S corporation that is legally organized as a limited liability company. It is important to review the entity’s operating agreement to be sure there are no provisions that could create the possibility of disproportionate rights to distribution or liquidation proceeds. The mere presence of a requirement that liquidating distributions be made in accordance with positive capital accounts, a typical operating agreement provision, may be sufficient to create an issue. While taxpayers generally can receive a favorable ruling in these instances – as the taxpayer did here – that relief typically comes at a substantial cost. The IRS fees to consider a ruling are currently $28,300. That’s a heavy price to remedy what can best be described as a “foot fault.”