“S” Corporation Election Inadvertently Terminated by Operating Agreement Amendment

August 13, 2019

In a private letter ruling, the Internal Revenue Service has concluded that a limited liability company (LLC)’s “S” corporation election was inadvertently terminated after its members adopted an amendment to the distribution provisions in the LLC’s operating agreement.  [PLR 201930023 / issued July 26, 2019]

Background

Internal Revenue Code (“Code”) section 1361 defines a small business corporation (“S” corporation) as an eligible domestic corporation, which does not have:

  1. More than 100 shareholders;
  2. A shareholder who is not a U.S. resident individual (subject to certain exceptions); and
  3. More than one class of stock.

A corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.  Whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is determined by looking at the corporation’s governing provisions, including any binding agreements relating to distributions and liquidation proceeds.

An entity’s election to be taxed as an S corporation may be terminated if the entity ceases to qualify as an S corporation.  A corporation ceases to qualify as an S corporation if it has more than one class of stock.

If the IRS determines that:

  1. The termination of the corporation’s S election was inadvertent,
  2. The corporation promptly took reasonable steps to correct the problem, and
  3. The shareholders agreed to make any adjustments required by the IRS, then the corporation will continue to be treated as an S corporation during the period specified by the IRS.

Facts

The taxpayer, an LLC, elected to be treated as an S corporation effective on January 1 of a given calendar year.  The LLCs members agreed to amend the LLC’s operating agreement to provide that all distributions from the LLC would be made to the members in proportion to their respective membership percentage interests, including upon liquidation.

The amendment also stated that, upon liquidation of the LLC, distributions would be paid to members with positive capital accounts in accordance with their respective positive capital account balances. Thus, annual distributions and liquidating distributions might be made on differing theories.

Shortly thereafter, the initial amendment was amended to correct the liquidating distribution language and provide for distributions on a pro-rata basis in accordance with each member’s ownership percentage interest.

The LLC represented that it, and its members, filed all returns consistent with the LLC’s status as an S corporation and that all distributions made to the LLC’s members were based on their respective pro-rata shares of ownership of the LLC.  The LLC and its members also agreed to any adjustments consistent with the treatment of the LLC as an S corporation required by IRS during an audit of the LLC.

S Election Termination Inadvertent 

IRS concluded that the LLC’s S election terminated on the date of the initial amendment stating that distributions would be made based on positive capital accounts, as opposed to a pro-rata basis in accordance with each member’s ownership percentage.

This conclusion, by IRS, was based on the fact that the first amendment did not provide the members with identical rights as to distribution and liquidation proceeds, as required by the income regulations promulgated under Section 1361 of the Code.

However, the termination of the S election was “inadvertent”, within the meaning of the applicable Code section dealing with S corporation dealing with terminations, and was promptly corrected.

Therefore, the termination of the LLC’s S election was disregarded and, provided the LLC was otherwise still eligible to be an S corporation, the correction resulted in the LLC’s status as an S corporation remaining despite the inadvertent termination.

Note

An LLC, although usually a pass-thru type of partnership entity, can elect corporation status for federal tax purposes, and, additionally, elect S corporation tax status, as a part of the overall election.

The quick correction, by the taxpayer – members, of the LLC’s operating agreement distribution provisions, resulted in a no harm – no foul finding by IRS as to continuing S corporation status.