Beware Cookie-cutter LLC Documents!

IRS audits are nerve wracking and typically very, very, very expensive!

Standard Scenario...

To save money, the entrepreneur forms their LLC online and elects to be taxed as an S-Corporation to save on taxes. All good so far... The formation documents are automatically generated from cookie-cutter templates or by an AI assistant. It's certainly inexpensive at the starting gate, right?

The problem is that electing and maintaining S-Corp status requires adherence to strict requirements. It all comes to a head when it's time to sell that wonderful company and walk away with your money...because that's when it's pretty common to discover the inadvertent creation of a prohibited “second class of stock” caused by provisions in the target LLC’s operating agreement.

This second class of stock invalidates the target’s S-Corp election from the date the offending provisions in its LLC operating agreement were adopted – in this case, from the date the LLC was formed...and that will be very, very, very expensive.

S-CORPS GENERALLY

A qualifying domestic corporation (or an eligible entity that elects to be treated as such) may elect to be treated as an S-Corp for federal income tax purposes. Like partnerships, an S-Corp’s items of income, gain, losses, deductions, and credits flow through to its owners. An S-Corp files an annual federal income tax return and issues a Schedule K-1 to each of its shareholders to report each shareholder’s proportionate share of the entity’s tax items.

To elect and maintain S-Corp status, an entity must (1) be a domestic corporation (or an eligible entity electing to be treated as such), (2) have only allowable shareholders, (3) have no more than 100 shareholders, (4) have only one class of stock, and (5) not be an “ineligible” corporation (i.e., certain financial institutions, insurance companies, etc.). Permitted shareholders include individuals, certain trusts, and estates while prohibited shareholders include partnerships, corporations, and nonresident aliens.

Generally, a corporation is treated as having one class of stock if all outstanding shares of the corporation’s stock grant identical rights to distribution and liquidation proceeds. A purported S Election filed by an entity when it has a “second class of stock” is invalid.

These sorts of mistakes can suck up much or all of the sale proceeds...

WHY DOES VALIDITY OF AN S ELECTION MATTER SO MUCH?

If a deal requires the target S-Corp to undergo a pre-closing reorganization, and it is later determined that its S Election was invalid, then the purchaser may bear the cost of the target’s historic unpaid corporate level tax. [Please note that currently, the corporate tax rate is 21% and it used to be 35%... per year... on the net profit of the entity going all the way back to its foundation?!] Similarly, if instead the transaction is structured as a purchase of the target LLC’s “stock” with the seller and purchaser agreeing to make a Section 336(e) election (to treat the purchase of “stock” as an asset sale resulting in a basis step-up in the LLC’s assets), such election will be invalid if the target LLC’s S Election is invalid...which means the value of the entity will drop considerably because it will still carry its old basis.

THE DANGER OF USING BOILERPLATE OPERATING AGREEMENTS

Many multi-member LLCs are treated as partnerships for federal income tax purposes and for that reason, their operating agreements often contain, among other provisions, a myriad of boilerplate citations to partnership tax provisions of the Internal Revenue Code and Treasury Regulations, priority operating distribution waterfalls, and provisions requiring liquidating distributions to be made based on capital accounts or on a priority liquidating distribution waterfall.

If such provisions are included (by mistake or as general language) and/or followed as set forth in the applicable operating agreement, disproportionate distributions may be made to the LLC’s members, thereby resulting in the LLC being deemed to have a second class of stock. The IRS takes the position that the mere existence of such provisions (i.e., “non-identical governing provisions”) has the effect of invalidating an S Election, even if such provisions are not followed and all distributions (if any) are or were made proportionally to the LLC’s members. [In Revenue Procedure 2022-19, the IRS sought to provide relief for situations, such as the latter scenario, so that an entity that otherwise made a valid S Election would not be required to pursue a PLR pursuant to Code Section 1362(f) for retroactive relief.]

Standard Scenario continued...

Now when it's time to sell the company and walk into a glorious sunset, the purchaser does its tax due diligence. The purchaser's lawyers note that the operating agreement that you printed off when you formed to company has provisions that would invalidate your S Election. The purchaser's accountants notice that you made unequal distributions over the last twenty years. Suddenly, your company's value drops by a massive amount because the purchaser potentially faces HUGE tax liability and the inability to claim a step up in tax basis on top of it. Whoops.

Curry Andrews, Attorney at Law