Written by Guy Schmitz J.D., LL.M.
When advising on choice of entity, practitioners will sometimes recommend that a client form a limited liability company, which then elects to be taxed as an S corporation. There are good reasons for this recommendation, all touching upon state taxation. Whether the federal election is automatic at the state level (in piggyback states) or whether an additional state filing is required, the election at the state level usually goes only to state income taxation. In a given state, there is often no corporate annual registration report (because the LLC is not a corporation for purposes of the report) nor is there any corporate franchise tax due (because the franchise tax is usually due by corporations formed under state corporate law, not LLC law). Although the described choice of entity is sound, great care must be taken with this hybrid if the newly minted LLC has more than one member. See PRL 201505008.
The Facts: X was formed as a state limited liability company under an operating agreement dated as of Date 1, and made an election to be treated as a S corporation effective Date 2. X’s operating agreement was amended and restated on Date 3 to authorize the issuance of new classes of membership interests in X: Preferred Units, Class B Common Units, and Class C Common Units. The units held by the original members were classified as Class A Common Units. There were various distribution rights and liquidation rights for each class of membership units.
Beginning on Date 3 through Date 4, X issued interests in some of the new classes of membership interests, including Preferred Units, to IRAs.
On Dates 5 and 6, X redeemed all outstanding Preferred Units. On Date 7, X redeemed all outstanding Class C Common Units; exchanged all Class B Common Units for Class A Common Units; and amended its operating agreement to eliminate all references to second classes of units. As of Date 7, X had only one class of units, all held by eligible shareholders.
X timely filed its tax returns as an S corporation for all years and reported all items of income, loss, deduction, and credit on a pro rata basis for Class A Common Units and Class B Common Units. No allocations or distributions were made to Preferred Units or Class C Common Units.
The Ruling: The IRS concluded that X’s S corporation election was terminated on Date 3 when X issued units in more than one class of stock between Dates 3 and 4, some of which were issued to ineligible shareholders. Despite these foot faults, the IRS determined that the termination of the S election was inadvertent under Code §1362(f) and ruled that X would still be treated as an S corporation from Date 3, when the unpleasantness began. The ruling of the IRS was contingent on the usual requirements — for example, that there be corrective distributions by X to shareholders, as more fully described in PLR 2015005008, and that shareholders file amended returns.
The problem, of course, was the failed attempt to engraft flexible partnership tax law, embodied in the operating agreement, on rigid S corporation tax law. The hybrid didn’t take and the entity went rogue, resulting in the Code §1362(f) ruling request. Questions of embarrassment aside, it costs money to draft a ruling request, amend an operating agreement, and file amended returns.
Practitioners know the S corporation rules. What happened here? A client attempting self-help? A lawyer who knew nothing of tax law? The hybrid choice of entity recommendation can be a good one, but clients who take the recommendation must provide you with a draft of the original operating agreement and all amendments thereto.