For those organizing a limited liability company (“LLC”) that intends to “check the box” to be taxed as a corporation and then subsequently make an additional election to be treated as an S corporation, careful attention should be given to the content of any operating agreement which will control the governance of the entity.
From a tax perspective, the potential benefits of electing S corporation status are widely known; as long as a reasonable salary—reported annually on a Form W-2—is paid to the shareholders, neither company profits nor any further cash distributions to shareholders are subject to self-employment or payroll taxes. Structuring the operating agreement with S corporation-specific language is vital to not only take advantage of these tax benefits but also to ensure there is firm ground to stand on in the event of a government examination.
The good news is that an operating agreement can be streamlined as a result of the elimination of all references, provisions, and definitions relating to the partnership special allocation rules, tax matters representative, and perhaps even capital calls. The definition of “capital account” may also be simplified by referencing rules relating to S corporations. Any definition of “dissolution” should be reviewed carefully and limited as well.
The bad news is that there are plenty of traps in typical forms of LLC operating agreements that lie in wait for the unwary. Chief among them are any provisions that might run afoul of the S corporation ownership rules, for example, that only “eligible shareholders” may be members and no more than 100 members are permitted.
Recurrent references to applicable sections of the Internal Revenue Code (“IRC” or the “Code”) may be appropriate to demonstrate the members’ intention to maintain the LLC’s S corporation election. For example, repeated reference to IRC section 1363 may be a best practice when referring to profit and loss. Adding express language setting forth the members’ intention to adhere to all S corporation rules and regulations is advantageous. For example, include language that clearly states that the LLC and its members intend that allocations to members are to be consistent with the provisions of IRC section 1366 (and any other relevant sections of the Code) that address allocations to S corporation shareholders.
While most LLC operating agreements contain restrictions on the transfer of membership interests, sections related to these restrictions should include language specifically clarifying that no person may acquire a membership interest in the LLC, and no transfers may be made to any person, if in either case, such transfer would cause the LLC’s S corporation election to terminate.
The inclusion of a distinct section that memorializes the members’ acknowledgment that the LLC has elected, or shortly will elect, to be taxed generally as a corporation, and specifically as an S corporation is important. Such section should further enumerate the various rules associated with S corporations and caution the members that any actions that contravene such rules could be disadvantageous to the LLC and the other members (such actions covering not only any personal filings with the IRS and transfers of membership interests but also issues that might arise regarding a member’s estate planning). Consider also providing a specific, single member—also known as a “manager”—with the authority to amend the operating agreement without the need to seek member approval where such amendment is deemed necessary to preserve the LLC’s S corporation election. Contact us at 410-497-5947 or schedule a consultation with our brief contact form.