Why “Standard” Agreements Never Really Work

One of the first issues a business owner must resolve is what type of entity, if any, will be used to operate a business.

Two of the most common types used today are the S corporation and the limited liability company.

Treasury regulations classify “qualifying business entities,” such as LLCs, for federal income tax purposes.

If an LLC has two or more owners, it will be classified as a partnership for tax purposes and if it has only one owner, it will be disregarded for tax purposes.

The regulations also allow an LLC to elect to be taxed like a corporation. Corporate status is chosen by filing Form 8832.

Once the LLC has elected corporate status, its owner(s) may also elect to have it taxed as an S corporation. To simplify the election process in such cases, the “normal” Form S election 2553 can be filed.

A timely filed Form 2553 will constitute a deemed filing of Form 8832. This deemed corporate election is only effective if the electing entity meets all of the requirements to be an S corporation.

However, some advisers recommend doing both elections. An adviser told me that it was a “double security”.

Although not required in the LLC form, most LLC entities begin life with an operating agreement prepared by an attorney. This operating agreement will contain language dealing with federal income tax issues typically encountered with a partnership.

For example, partnerships can allocate items of income and loss by mutual agreement. If one or more associates contribute property with an intrinsic profit or loss, such embedded gain or loss shall be attributed to the contributing associate.

The operating agreement drafted by the attorney will address profit and loss allocations. It is also common to see boilerplate language dealing with “allowable income offset” or “minimum earning chargeback” as nullifying agreed allowances.

Sometimes members contribute money to the entity, but the agreement provides for a return to the contributor to compensate him for the use of his money. These returns can be “guaranteed”, i.e. paid without regard to the existence of profits, or a “preference” return, which generally means that the contributor gets first priority on distributions, but which corresponds to income.

Unfortunately, a typical LLC operating agreement creates problems when the taxpayer, or an advisor, suggests that an S election would be desirable. S corporations are subject to specific eligibility rules under tax laws, including the requirement that the corporation have only one class of shares.

Generally, a second class of shares will exist if the rights of shareholders differ with respect to distribution rights and liquidation rights. Profit and loss allocations should follow ownership.

The regulations explain that we must consult the “governing provisions” of the entity to determine if there are any differences in liquidation or distribution rights. These provisions include the operating agreement as it binds the parties.

Where the operating agreement was not designed for an entity taxed as an S corporation, it will likely include provisions that violate the requirements to be an S corporation.

An S election for an entity incorporated as an LLC will generally require amendments to the operating agreement to remove any provisions inconsistent with subchapter S. If Form 2553 is filed without those amendments, then we must determine what is the status of the entity.

The preferred status is a partnership (two or more owners) or an ignored entity (one owner). This avoids the two levels of taxation possible with a C corporation.

The preamble to the rule states that if the eligible entity’s choice S is not timely and valid, the rule’s default classification rules will apply.

The default status would be partnership or ignored entity. This is a better result than a C corporation but still not our desired S corporation status.

The obvious approach to use when electing S corporation status for an LLC is to review the operating agreement and make changes to any provisions inconsistent with subchapter S.

Even better, the lawyer who drafts the agreement should be informed of the expected tax status. Tax advisers should assume that this never happened.

Jim Hamill is the Tax Practice Manager at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected]

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