Limited Liability Companies (LLCs) emerged as the preferred form of doing business many years ago. In addition to state law advantages and liability protection, LLCs are flexible in their tax status for federal income tax purposes. When businesses that are organized as LLCs elect to be taxed as S corporations they follow a simple procedure that is based on eligibility criteria. However, an oft-overlooked foot fault may leave many LLCs surprised to find that they were not eligible to be S corporations. This would have disastrous tax consequences and a great number of unsuspecting LLCs may be in this predicament without knowing it.

New and existing C corporations elect to be taxed as S corporations by filing Form 2553 with the Internal Revenue Service. Form 2553 generally is required to be filed:

• No more than two months and fifteen days after the beginning of the tax year the election is to take effect, or
• At any time during the tax year preceding the tax year it is to take effect.

New and existing LLCs can elect to be taxed as corporations by filing Form 8832 (a so-called check-the-box election). LLCs desiring to simultaneously elect corporate tax status and S corporation tax treatment are permitted under regulations to simply file Form 2553. A minor incongruity in the timing requirement exists for LLCs desiring to make these simultaneous elections, where 75 days applies to such LLCs under the first condition instead of two months and fifteen days. In the case of late S corporation elections filed by any type of business, special procedures are available to request IRS relief.

Businesses electing to be taxed as S corporations must satisfy eligibility criteria. For example, eligible S corporations can have no more than 100 shareholders, and eligible shareholders can only be U.S. resident individuals, estates, or certain exempt organizations or trusts. S corporations also can have only one class of stock, which is determined with reference to identical rights to distribution and liquidation proceeds. This typically is not a problem for most business owners and tax planners. For instance, it may be clear that the owners desire distribution and liquidation parity, that they assent to these S corporation requirements by making the election, and that the business has only one labelled type of equity. For entities established as corporations, this is fairly straightforward as the existence of only one class of shares is generally sufficient to satisfy the one class of stock rule. For many LLCs however, the unsuspecting owners are mistaken.

Consider a typical LLC formed under state law for a business. For state law and governance purposes, the LLC must create an LLC operating agreement. Because LLC operating agreements often are drafted with little thought to the rules governing S corporations, "boiler plate" provisions frequently are included in these agreements that assume the default taxation treatment as a partnership. These LLCs can subsequently file S corporation elections without amending their LLC operating agreements. Lurking in the weeds of these boiler plate provisions (for LLCs particularly) are partnership capital account rules that are needed to comply with Section 704(b) of the Code. But a fundamental premise of Section 704(b) is to liquidate in accordance with the positive balance of each member's capital account, a stipulation that is incompatible with the S corporation requirement to confer identical rights to distribution and liquidation.

The Section 704(b) boiler plate language in LLC agreements govern the manner in which the LLC must liquidate as a contractual matter and under state law. These contractual and state law matters are enforceable regardless of the LLC's election to be an S corporation. Hence, S corporation elections do nothing to override these old partnership provisions. LLCs with agreements containing these boiler plate provisions are not eligible to be S corporations, because the Section 704(b) liquidation provisions create a de facto second class of stock. This serious problem often surfaces during sensitive due diligence proceedings.

LLCs that become aware of this problem can request relief from the IRS in a private letter ruling. In addition to an amendment to the LLC operating agreement to remove the Section 704(b) provisions, these LLCs demonstrate in their ruling requests that they otherwise maintained their businesses in accordance with the S corporation requirements at all times after the S election was made. The IRS routinely rules that this LLC operating agreement language creates an invalid S corporation, and grants relief to LLCs that request private letter rulings in the manner described (see PLR 201624003, PLR 201815003). However, the user fee to request this type of letter ruling from the IRS presently is $28,300 for most taxpayers. Professional fees to prepare the ruling request also add to the cost of a remedy for the LLC's failure to understand the problem initially.

Help may be on the way for the plethora of LLCs caught in this bind. On May 1 at a speaking event, Clifford Warren, special counsel to the IRS associate chief counsel, stated "[W]e get so many [private letter ruling] requests in connection with S corporation due diligence that we are developing a revenue procedure to address common S [corporation] foot faults that we have ruled favorably on in the past." The exact scope of this forthcoming revenue procedure is uncertain, but this statement suggests that it may cover the situation involving LLC operating agreement language that creates multiple classes of stock thereby invalidating an S election.

Standardized IRS relief for LLCs that unwittingly make invalid S corporation elections because of LLC operating agreement language would be a tremendous benefit for taxpayers. In addition to saving taxpayers from the costly user fee and professional fees involved with private letter rulings, taxpayers would be able to cure a defect in previous S corporation elections prior to sensitive due diligence negotiations or prior to an IRS examination. In the meantime, LLCs that are unsure about their S corporation elections should review their LLC operating agreements and contact their tax advisors to determine whether a problem potentially exists. For more information on these matters, please contact your local CBIZ MHM tax advisor.

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