Most entities operating as ‘S’ corporations are corporations formed under state law. However, under the check-the-box rules, a limited liability company (LLC) can elect to be taxed for federal tax purposes as a corporation. With such an election, the LLC can then elect to be taxed as an ‘S’ corporation, if it otherwise meets Subchapter S requirements.
But why would anyone want to do this? How is it done? Are there any pitfalls? A recent article by James R. Hamill addresses some of these issues. A summary of the key points follows.
WHY BOTHER? Probably the main reason why someone would go the LLC route to ‘S’ status is creditor protection. Many states limit the rights of creditors of a member of an LLC to obtaining a charging order. Stock of corporations (‘S’ or not) does not receive similar protection. Therefore, an LLC electing ‘S’ status provides superior creditor protection to its owners. Since ‘S’ status does not impact state law rights as to an entity and its owners, making an election to be taxed as an ‘S’ corporation does not impact creditor rights issues.
HOW IS IT DONE? The LLC and its members could file a Form 8832 to be taxed as a corporation, and then a Form 2553 to be taxed as an ‘S’ corporation. However, Treas. Reg. Section 301.7701-3(c)(1)(v)(C) and the form instructions allow this to be done just by filing a Form 2553, without the need for a Form 8832. However, an unsigned “dummy” Form 8832 election will be needed to be filed with the initial income tax return filed for the corporation as an ‘S’ corporation.
PITFALLS? The major pitfall in this area is to make sure that the operating agreement for the LLC is modified to comply with Subchapter S requirements. The key requirement that a plain vanilla operating agreement will often violate is that prohibiting a second class of stock. Typical LLC operating agreement provisions such as special allocations of income, gain, loss, or expense (including substantial economic effect provisions under Section 704), Section 704(c) contributed property allocations, preferential returns or liquidation rights, and provisions regarding distributions in accordance with capital accounts, will typically violate the second class of stock rules and thus need to be modified out. The article also notes that while you are engaged in modifying the standard form operating agreement, provisions regarding ‘S’ corporations that are typically found in shareholders’ agreements, such as prohibitions on transferring ownership to nonqualified owners, should be included in the operating agreement.
AVOIDING TRAPS WHEN ELECTING S CORPORATION STATUS FOR AN LLC, by James R. Hamill, Practical Tax Strategies (WGL), Jan. 2013