Limited liability companies (LLCs) offer significant tax flexibility – for one thing they can elect to be treated as disregarded entities, partnerships, C corporations, or S corporations, and can even shift between those tax classifications. Some advisors will suggest changing an LLC’s tax treatment from a partnership to an S corporation (the “Conversion”) for employment tax benefits and to avoid the extremely complicated partnership tax rules,[1] but the Conversion contains significant traps that can make it a mistake waiting to happen. It is not as simple as merely filing an IRS form to make the S corporation election.
This article will discuss traps in the Conversion arising both from the Conversion itself and the ongoing requirements for an S corporation. At the time of the Conversion, the LLC’s members may be forced to realize income if they have negative tax capital account balances. For the S corporation election to be valid, the LLC’s members must qualify as eligible shareholders and the S corporation must have only one class of stock. The single class of stock requirement is potentially complicated both by the LLC’s existing partnership operating agreement and requirements of the state LLC laws.
Conversion: Negative Tax Capital Account Balances
The first trap occurs if any of the LLC’s members have negative tax capital account balances (i.e., the LLC’s liabilities are greater than the tax basis of the LLC’s assets) at the time of the Conversion, in which case such members will recognize taxable income equal to the negative tax capital account balance (i.e., an LLC member with a negative tax capital account balance of $100,000 at the time of the Conversion would be deemed to have $100,000 of taxable income). This potential tax cost should be considered as a threshold question in determining whether a Conversion is prudent – in fact, it should be one of the first questions asked. If there are significant negative tax capital account balances, it is unlikely a Conversion will be worthwhile due to the significant resulting tax liabilities of the members.
Requirement: S Corporation Eligible Shareholders
The second trap is that an S corporation’s shareholders must be eligible shareholders, which includes individuals, estates, certain specified trusts, or certain tax-exempt organizations. Accordingly, none of the LLC’s members at and after the time of the Conversion can be entities taxed as partnerships or corporations, certain trusts, or non-resident aliens. An ineligible shareholder at the time of the Conversion invalidates the Conversion so that the LLC will not be treated as an S corporation. This is also a threshold question as any ineligible shareholders means that the Conversion is not possible, although restructuring may be able to accommodate this requirement.
Requirement: Single Class of Stock
The final and most-overlooked trap is that an S corporation’s ownership must consist of a single class of stock, meaning that all allocations of taxable items (e.g., income, deductions, credits) and distributions (both liquidating and non-liquidating) by the S corporation must be made pro rata among all shareholders in accordance with their percentage ownership of the S corporation. Many partnership operating agreements include preferred returns, liquidation preferences, or even return of capital among partners which in themselves violate this requirement. Even if the operating agreement is explicitly pro rata in all of its operational provisions, the customary regulatory tax provisions for an LLC taxed as a partnership (e.g., qualified income offsets, minimum gain chargebacks, and revaluations of capital accounts to fair market value) may also keep the LLC from meeting this requirement. To ensure that it meets the single class of stock requirement, the LLC’s operating agreement must be amended to ensure that all distributions and allocations among its members are made pro rata, including the removal of the aforementioned customary regulatory tax provisions. It is critical that the operating agreement be amended effective as of the time of the Conversion.
If either of the eligible shareholder or single class of stock requirements is not met at any point in time, including the moment the LLC converts from a partnership to an S corporation, the LLC’s S corporation status is invalid and, as of that time, the LLC will revert to either a partnership or C corporation for tax purposes. To hedge against the more costly repercussions of reverting to a C corporation (i.e., a second level of tax liability), the LLC should, when electing S corporation treatment, only file IRS Form 2553 (Election by a Small Business Corporation) and not an IRS Form 8832 (Entity Classification Election). Form 8832 makes the LLC “an association taxable as a corporation,” which in turn makes a blown S corporation election revert to a C corporation, whereas a blown S corporation election for an LLC which only filed Form 2553 reverts the LLC to either a partnership or a disregarded entity, either of which avoids the double taxation of a C corporation.
Final Remarks
LLCs wishing to be characterized as S corporations do have a safer option: reorganizing as a corporation rather than an LLC, and then electing S corporation treatment for the new corporation. The safer option still faces the threshold questions of whether negative tax capital accounts make a conversion impractical and whether all members are eligible shareholders, but the rules governing corporations as opposed to LLCs are generally more conducive to meeting the S corporation’s single class of stock requirement.
Due to the above traps and the complicated tax requirements, an LLC treated as an S corporation will also likely be subject to greater due diligence upon any potential exit events.
This article is not meant to be an exhaustive description of all of the tax requirements and consequences for Conversions.
[1] A member incurs self-employment taxes on the total amount of Schedule K-1 Self-Employment Earnings passed through to it from the partnership, but (i) a member who is also an employee of an S corporation will only incur employment taxes on the amount of such income that is treated as compensation to the member (e.g., W-2 income) and (ii) non-employee members do not incur any self-employment tax on income from the S corporation. However, the tax savings arising from the Conversion could be minimal and potentially offset by state taxes specific to S corporations (e.g., Massachusetts’s “sting tax”).
