Introduction
An oft-touted feature of the limited liability company as a preferred choice of entity is the extraordinary flexibility it accords to equity owners for structuring their legal and economic relationships. Seasoned practitioners in the field of entity planning and governance have found that the LLC permits the largely unhindered private ordering of relationships among business owners, investors, and other relevant stakeholders, especially in jurisdictions such as Delaware and others whose LLC statutes endorse a broad, “contractarian” approach. Corporations, by contrast, often operate under more rigid and well-established legal principles that often are difficult, and sometimes impossible, to circumvent.
Prior to the adoption of the so-called check-the-box regulations in 1996, the choice of a particular form of business entity (i.e., corporation or partnership) usually dictated the tax regime to which it was subject. The check-the-box regulations largely decoupled the choice of tax regime from the choice of entity. They allow limited liability companies and other entities not organized as a business corporation under state law to “elect” to be classified for federal tax purposes as a corporation or, if the entity satisfies the applicable criteria, to further elect to be taxed as an S corporation under the Internal Revenue Code (the Code).
For a variety of reasons, several of which are discussed below, it has become increasingly common for LLCs to choose to be taxed as subchapter S corporations. This article will explore some of the possible rationales for choosing the S corporation tax regime. Following that discussion is a brief recap of the rules applicable to subchapter S corporations and the mechanics of the subchapter S election. After contrasting some of the relative advantages and disadvantages of being taxed as an S corporation, the article concludes with practice points and drafting guidance for the organization, governance, and operation of a limited liability company that has elected to be taxed as an S corporation.
Why Choose Subchapter S?
When considering the relative costs and benefits of electing subchapter S taxation, it is important to first ask the question: “relative to what?” Generally, it is relative to the federal income tax regimes applicable to a regular C corporation, a disregarded entity, or a partnership. Although LLCs can (and for a variety of reasons often do) elect to be taxed as a C corporation, the C corporation lacks the benefit of “pass-through” taxation afforded to S corporations. The C corporation remains a viable, and indeed preferential, option in several settings. Although a full exposition of those circumstances is beyond the scope of this article, in many cases pass-through taxation may not be desirable to certain investors (such as 501(c)(3) qualified entities). In addition, the potential for gain exclusion afforded to qualified small business stock under section 1202 of the Code is only available to C corporation shareholders. The choice between subchapter S and disregarded entity status is relevant only for entities with a single equity owner. In the case of the solo business owner, the perceived potential for payroll tax savings, as discussed in greater detail below, is an oft-cited reason for making an S election. That benefit must be contrasted with the necessity of filing a separate tax return for the entity, and more importantly, the limitations of subchapter S. Finally, there is the choice between federal income taxation of S corporations and partnerships. The tax accounting required for partnerships generally is more complex and compliance more expensive—a situation often compounded by unique and complex economic arrangements among the parties. The trade off, of course, is the planning limitations associated with the S corporation regime.
There are perceived payroll tax advantages under subchapter S. It is important to note that there is no real distinction between subchapter S and subchapter C in this regard—subchapter C offers the same payroll tax advantage as subchapter S, but only subchapter S offers pass-through taxation. Generally, corporations are allowed a deduction for “reasonable compensation” paid to employees, even if the party receiving the compensation is also a shareholder of the corporation. In contrast, allocated profits from a partnership potentially are treated as earnings from a trade or business and therefore taxed as self-employment income. As a general rule, in an S corporation, a shareholder’s pro-rata share of net income is not considered earnings from self-employment either when earned or when distributed as dividends unless, and to the extent that, the dividends are paid in lieu of reasonable compensation for services rendered to the corporation by the shareholder. In that case, the income may be recharacterized as wages subject to employment taxes. Using a simple example, if an S corporation shareholder is paid an annual salary of $120,000, and his or her distributable share of net income is $380,000 (assuming that the $120,000 payment represents “reasonable compensation” to the shareholder for services rendered to the corporation), the $380,000 distributive share of net income is not subject to employment taxes. Under the partnership tax rules, that same $380,000 distributive share of net income (irrespective of whether it is characterized as a guaranteed payment in exchange for services rendered by the partner or as the partner’s allocable share of net income) could result in imposition of an additional employment tax liability of nearly $15,000. Given that there is no cap on the Medicare tax or the additional employment tax imposed under the Affordable Care Act, the higher the distributive share of net income, the greater the potential employment tax savings (as a subchapter S corporation) or employment tax liability (as an LLC taxed as a partnership under subchapter K).
There is a tension between the self-employment tax (which generally is imposed on a partner’s active trade or business income) and the net investment income tax (which generally is imposed on passive income). With proper planning, including the use of “guaranteed payments” made to a member as reasonable compensation for services, it is possible to limit the amount of partnership income subject to self-employment taxes, but also maintain a sufficient level of activity in the business to avoid imposition of the net investment income tax. Service partnerships (i.e., those in which all of the members provide professional or other consulting services) and member-managed LLCs present special planning challenges and more limited planning opportunities around these issues. If care is taken in the proper characterization of income and preparation of the underlying documents, however, in many cases the perceived payroll tax benefit thought to be available to S corporations can be achieved in the partnership context.
Several other planning considerations may drive a decision in favor of subchapter S taxation. Although a detailed review of these situations is beyond the scope of this article, they include utilization of an employee stock ownership plan, partial shifting of the tax burden on built-in gains, and effecting gain deferral through the use of a tax-free reorganization with another S corporation or a C corporation.
The Choice of Entity
As noted above, decoupling the decision on the form of entity from the applicable mode of taxation allows the planner to independently consider the relative nontax advantages of one form of entity over another. Most state law corporate enabling statutes impose certain rules relating to the formation and operation of those entities. In some cases, the rules are mandatory (i.e., they may not be modified in the corporation’s organizational documents or in a separate shareholders’ agreement). In others, the rules are normative (i.e., they will apply in the absence of a contrary provision in the certificate or articles of incorporation or the bylaws). In all cases, however, one must first look to the statute as the primary “roadmap” for permissible “alternative routes.” In contrast, enabling legislation for LLCs (especially more modern iterations) generally ensconce the characteristic of “freedom of contract” and impose few mandatory requirements. Although most of these LLC statutes also contain many normative provisions, these usually can be modified (to a greater or lesser extent) by the agreement of the members. The adage that with great power comes great responsibility applies with particular force in this context, as this freedom of contract imposes an enhanced obligation of care and precision on the draftsperson.
Among the areas of entity governance and operation for which LLCs offer great flexibility are enforceability of restrictions on transfer, including the ability to relegate a nonpermitted transferee to the status of an “economic interest holder.” Additional benefits include the elimination of formalities associated with the roles traditionally ascribed to shareholders, directors, and officers; the ease with which alternate classes and series of equity may be established; the creation of individualized governance, management, and voting structures; the modification or elimination of rights and duties, including fiduciary duties; and the ability to restrict access to information and, in some states, access to judicial remedies such as derivative claims, oppression claims, and judicial dissolution. In view of the expansive capacity for creativity and innovation, it is little wonder that LLCs are preferred by many practitioners.
Although many of the benefits of the LLC form are preserved following an S election, there are several important areas in which it is curtailed, particularly those involving economic rights. However, with careful consideration of the subchapter S restrictions and equally careful drafting, much flexibility, especially in the area of control and governance, can be retained. There is practically nothing that can be done by or with a corporation that cannot also be done equally well or better with an LLC. As one practitioner stated: “I have formed my last corporation.” Although the corporate form is not yet fully obsolete, given the choice (at least in the realm of privately held companies), the LLC has undeniable advantages.
Subchapter S Basics and How to Get There
Many mistakenly believe that a subchapter S corporation is a corporation that is taxed like a partnership. Subchapter S modifies the rules applicable to the taxation of corporations that elect subchapter S status. It is a series of modifications to the rules that otherwise apply to all corporations. Although the tax results under subchapter S and subchapter K may be similar in some circumstances, in many others they are significantly different.
The eligibility requirements for subchapter S status apply at both the entity and shareholder levels. At the entity level, the entity must be one that: (i) is formed within the United States; and (ii) does not have more than a single class of stock. At the shareholder level, the entity may have no more than 100 shareholders (a husband and wife are treated as a single shareholder), all of whom (with limited exception) must: (i) be individuals; and (ii) not be a nonresident alien. Certain estates and trusts, employee stock ownership plans, and other tax-exempt entities may also be eligible shareholders of an S corporation.
In order for an LLC to elect to be taxed as an S corporation, it must make certain filings with the Internal Revenue Service. The regulations allow an LLC that otherwise would be classified as a partnership or a disregarded entity to elect to be taxed as a corporation. There are two, primary means to accomplish the election. The first is for the LLC to initially elect to be treated as an “association taxed as a corporation” by filing Form 8832, Entity Classification Election. Once the LLC elects association status, its owners may further elect S corporation status by filing Form 2553, Election by a Small Business Corporation. It often is not necessary to first file Form 8832 to elect association status and Form 2553 to elect S corporation status. The regulations allow a single election to be made solely via the filing of Form 2553. A timely filed Form 2553 is a deemed filing of Form 8832. The “deemed association” election accomplished in this manner is effective only if the electing entity meets all of the qualifications of an S corporation as of the time of filing, and is not effective if the entity does not meet those qualifications. An LLC that first files Form 8832, but does not qualify to be taxed as a subchapter S corporation upon its subsequent filing of Form 2553, will revert to the status of a regular C corporation. By contract, an LLC that files only Form 2553 (which is effective only if all qualifications for subchapter S are satisfied as of the date of the election) will result in the entity reverting to its default tax classification (usually a partnership or disregarded entity). However, if the entity initially qualifies as a subchapter S corporation by timely filing of Form 2553 and subsequently becomes disqualified, it will revert to the status of a C corporation as well.
Subchapter S or Subchapter K
From a planning perspective, the clearest disadvantages of subchapter S taxation are the so-called single-class-of-stock rule and shareholder eligibility requirements. The single-class-of-stock rule applies solely to economic rights and requires that all equity owners receive allocations of income and loss as well as distributions of cash or property in strict proportion to their ownership percentages. Although voting and management need not be proportional to share ownership, economic rights must be. Similarly, the inability to issue or transfer shares to nonnatural entities can severely restrict the pool of available equity capital. Finally, the consequence of a “blown” subchapter S election, which will trigger a reversion to regular C corporation status and its attendant second layer of taxation, could be catastrophic. Imposing an absolute restriction on transferability of LLC interests may provide an extra layer of protection against this possible consequence. However, it may not be possible under certain state’s LLC statutes to restrict the transferability of economic interests, which presumably would have the same negative consequences.
A nonexclusive list of potential additional advantages of subchapter K over subchapter S include the ability to:
- include entity-level debt in partner basis;
- step up the basis of the partnership’s assets upon the death of, or other transfer of interests by, an equity owner;
- make disproportionate or special allocations, including in the year in which an interest is sold or redeemed;
- allocate built-in gain or loss to the contributing owner; and
- maintain consistency between inside and outside basis.
Additionally, if an entity plans to expand through acquisition in exchange for equity, the constraints of section 351 of the Code (subchapter S) may not permit the transaction to be a nonrecognition event for the contributing owner, whereas section 721(subchapter K) is much more flexible and often can accommodate a more favorable result.
There are many other differences between the two tax regimes, a thorough discussion of which is beyond the scope of this article. Suffice it to say that it is never safe to assume that the tax consequences of any transaction under subchapter S are identical to those under subchapter K.
Practice Points and Drafting
All too often, operating agreements for an LLC that has elected to be taxed as an S corporation contain the full complement of provisions that address capital account maintenance, which are designed to satisfy the “substantial economic effect” requirements of section 704 of the Code. Among the provisions typically found in these agreements are requirements that liquidating distributions be made “in proportion to the members’ positive capital account balances.” Given that it is quite possible (and perhaps likely) that those balances do not and will not be strictly proportionate to the party’s ownership percentages, the effect of that provision is an immediately “blown” subchapter S election. The only potential silver lining in this situation is that S elections are more commonly made only by filing Form 2553 (rather than filing Form 8832 ahead of Form 2553), so the S election was defective from the start. As noted above, this results in “no change” to the entity’s default classification. This is but one example of the importance of proper drafting of operating agreements to account for the special qualifications of an S corporation. It is not enough to simply cut and paste into the document the subchapter S maintenance provisions from your favorite form of shareholder agreement. The drafter must also take care to excise the subchapter K provisions from the agreement. In certain states, the LLC statute itself may provide for a “default” liquidating distribution scheme that, if applicable, would be a prima facie violation of the single-class-of-stock rule. In that case, the operating agreement must contain language that specifically overrides any offending statutory scheme.
Examples of the kinds of provisions that must be considered in operating agreements of an LLC that has elected to be taxed as an S corporation include the following:
Heading. Indicate in the agreement’s heading (cover page, first page, signature page, and unit/share tabulation page) that the LLC is an S corporation.
Recitals. Recite the filing of Form 2553 to be classified as a corporation electing to be taxed as an S corporation, and any wholly owned corporate subsidiaries thereof electing to be taxed as qualified subchapter S subsidiaries.
Company-Purpose Provision. Consider: “Company’s Purpose. The purpose of the Company is to engage in any lawful business or other activities for which a limited liability company may be organized under the Act other than engaging in any activities that may cause it to become an “ineligible corporation” within the meaning of Code § 1361(b)(2) or that may otherwise cause the Company’s status as an S corporation to terminate (the “Company’s Business”).” When including provisions that require vigilance such as this, consider the exposure to the manager/management and whether there should be personal liability for noncompliance or absolution/exculpation.
S-Election Provision. Consider: “Election and Preservation of Company’s Status as an S Corporation. The Company and the Interest Owners shall take all necessary and appropriate actions to elect, preserve, and if need be restore the Company’s status as an S corporation (including taking such action as may be necessary under Code § 1361(f) to remedy an inadvertent termination of the Company’s election to be an S corporation). Each Interest Owner shall execute, acknowledge, and cause to be filed with the appropriate taxing authorities (including the Internal Revenue Service) any certificates, statements, forms, schedules, reports, or other documents as may be required, or that the Manager determines to be necessary or appropriate for the Company to be, and otherwise be treated as, an S corporation (including signing Internal Revenue Service Form 2553 acknowledging Interest Owner’s consent and agreement to the Company’s election to be an S corporation, and taking such actions as may be necessary or appropriate to maintain or reinstate or otherwise restore that election or status as an S corporation). In furtherance of the foregoing, the Company shall not issue any Shares or other ownership interests to any corporation, partnership, limited liability company, trust, or any other Person who is not eligible to be a shareholder of an S corporation as contemplated by Code §§ 1361(b)(1)(B) and (C) or issue any Shares or other ownership interests that may be considered to be a second class of stock as prohibited by Code § 1361(b)(1)(D).”
Capital Contributions and Ownership Interests. Consider: “Special Vote to Issue Additional Shares. Without the consent of at least [____%] of the Voting Shareholders, the Company may issue only Shares, and each Share must be deemed to be of the same, single class of Shares (within the meaning of, and as necessary to satisfy the “one class of stock” requirement of, Code § 1361(b)(1)(D)), and those Shares may only be issued to individuals (i.e., natural persons) other than nonresident aliens and to certain estates and trusts that are eligible to be shareholders of S corporations; that is, a Person’s ownership of Shares in the Company must not result in the Company ceasing to be an SBC, or that Person’s ownership of Shares or other membership or economic interests in the Company must not otherwise cause the termination of the Company’s election to be an S corporation.”
Change S Status. Consider: “Special Vote to Change the Entity Character of the Company. Without the consent of at least [____%] of the Voting Shareholders, the Company shall not convert or reorganize the Company into another Entity form (including a corporation) or cause the Company to be taxed as a “C” corporation (as defined by Code § 1361(a)(2)) or a partnership (as defined by Code §§ 761(a) or 7701(a)(2)) for federal income tax purposes or otherwise cause the Company to be deemed to have sold all of its assets or dissolved or liquidated for federal income tax purposes except in accordance with Section 10.1 hereof.”
Allocation of Profits and Losses. Consider: “Allocations. The Company’s income or loss, as determined in accordance with applicable federal income tax accounting principles, including all items of income, gain or loss (whether taxable or tax-exempt), deduction and expense, and all credits, are to be allocated among the Interest Owners in the manner provided and otherwise contemplated by Code § 1366 and, more generally, Subchapter S of the Code, the Code itself, and other applicable federal and state income tax Law.”
Nonliquidating Distributions. Consider: “Distributions. Each Share (whether a Voting Share, Nonvoting Share, Economic Interest Share, or any other Share that may be outstanding) shall confer identical economic rights (i.e., identical rights to distribution and liquidation proceeds as contemplated in Treas. Reg. § 1.1361-1(1) for the Company to be deemed to have only one class of stock outstanding as, and to the extent required by, Code § 1361(b)(1)(D)) as any of the Company’s other outstanding Shares.” This provision is in addition to the general requirement that distributions (including tax distributions) are to be made in accordance with percentage interests (i.e., in proportion to outstanding shares/units).
Restrictions on Transfers and Encumbrances. Consider: “General Prohibition without Authorization by the Manager. An Interest Owner may not Transfer or Encumber all or any portion of the Interest Owner’s Interest: (i) in a way that may cause the Company to be deemed to have more than one class of stock outstanding as contemplated by Code § 1361(b)(1)(D); (ii) to a corporation, partnership, limited liability company, trust, or other Person described in Code §§ 1361(b)(1)(B) or (C) whose ownership of such interest will cause the Company to fail to be an SBC; (iii) to any Person or Persons if by doing so may cause the Company to have more than one-hundred (100) “shareholders” as prohibited by Code § 1361(b)(1)(A) for the Company to be an SBC; or (iv) in any other way or to any other Person or Persons that would cause the termination of the Company’s election as an S corporation; and any purported Transfer or other Encumbrance or other action by an Interest Owner in violation of the foregoing or that would otherwise cause the termination of the Company’s election as an S corporation shall be void ab initio and will have force and effect whatsoever and shall otherwise be treated as if that transaction or other action had never taken place or occurred.” The above restriction is in addition to the more general restriction requiring board, member, or other approval to any transfer or encumbrance of ownership interests, which approval may be denied, or otherwise withheld, in the decision makers “sole discretion,” which (as that term may be defined) need not be objectively reasonable or disinterested.
Certifications of Shareholder Eligibility. Consider: “Written Attestations, Eligibility of Transferee to Be an S Corporation Shareholder. In the case of the Transfer of Shares, the proposed transferee’s delivery of a written certification or other statement to the Company that the prospective transferee is a “United States person” within the meaning of Code § 7701(a)(30) and is not a person described in Code §§ 1361(b)(1)(B) and (C) whose ownership of Shares other than ownership interest in the Company will cause the Company to cease to be an SBC.” Ineligible members/shareholders include corporations, limited liability companies, partnerships, nonresident aliens, and most trusts. If the proposed transferee is a trust, consider giving the board, members, or other decision makers the right to require an opinion of counsel that the trust is eligible to be a shareholder of an S corporation.
Liquidating Distributions. Consider: “Liquidating Distributions. The balance [after payment of liabilities], if any, to be distributed to the Interest Owners in accordance with their Percentage Interests at the time those distributions are to be made. Each Share (whether a Voting Share, Nonvoting Share, Economic Interest Share, or any other Share that may be outstanding) shall confer identical economic rights (i.e., identical rights to distribution and liquidation proceeds as contemplated in Treas. Reg. § 1.1361-1(l) for the Company to be deemed to have only one class of stock of outstanding as, and to the extent required by, Code § 1361(b)(1)(D)) as any of the Company’s other outstanding Shares.”
Vote to Terminate S Election. Consider: “Revocation of S Election. Consent of at least [____%] of the Voting Shareholders is required to cause the Company to revoke its S election under Code § 1362(d)(1), or take any other action with the expressed written intent to cause the Company to cease to be an S corporation. In connection with, or following, the amendment to this Agreement to cause the revocation or other termination of the Company’s S election, the Company and all of the Interest Owners shall take such action as may be necessary or appropriate to effect such revocation or other termination of the Company’s S election, including executing and filing with the Internal Revenue Service or other Governmental Authority all consents and other certificates and documents that may be necessary or appropriate to cause that revocation or other termination to occur as directed by the [Voting Majority].”
Certain Definitions
“‘Economic Interest’ of an Interest Owner means only the Interest Owner’s right under this Agreement and applicable Law to: (i) share in the profits and losses of the Company; and (ii) receive distributions from the Company and therefore does not include any right to participate in, vote on, or authorize or approve any decision concerning the management or affairs of the Company or any other matter subject to the vote or approval of members of a limited liability company under the Act or of the Members under this Agreement.”
“‘Economic Interest Owner’ means a Person who holds an Economic Interest but has not been admitted as, and otherwise is not, a Member. The limited rights of an Economic Interest Owner are described in Section [____].”
“‘Economic Interest Share’ means the Shares that comprise an Economic Interest. Each Economic Interest Share confers identical rights as any other of the Company’s outstanding Shares to “distribution and liquidation proceeds” as contemplated by Treas. Reg. § 1.1361-1(l) and therefore are not to constitute a separate class of stock or otherwise cause the Company to have more than “one class of stock” within the meaning of Code § 1361(b)(1)(D).”
“‘Interest Owner’ means an Economic Interest Owner or a Member.”
“‘QSSSs’ means each of those Entities, if any, that would otherwise be classified as a corporation (as defined by Code § 7701(a)(3)) in which the Company is the sole shareholder or member and that is a “qualified subchapter S subsidiary” under Code § 1361(d).”
“‘S Corporation’ means an SBC that has an election under Code §§ 1362(a)–(c) in effect to be an S corporation (within the meaning of Code § 1361(a)(1)).”
“‘SBC’ means an Entity that meets the requirements for being, or otherwise is treated as, or is deemed to be, a “small business corporation” within the meaning of Code § 1361(b)(f).”
“‘Shares’ means the shares or units of ownership into which an Interest Owner’s Interest is divided and includes Voting Shares and Nonvoting Shares as well as Economic Shares. Except with respect to voting and approval rights or as otherwise provided in this Agreement, the relative rights, privileges, benefits, preferences, and limitations attributable to Voting Shares and Nonvoting Shares are identical, and the Economic Interest Shares, Voting Shares, and Nonvoting Shares confer identical rights “to distribution and liquidation proceeds” as required by Treas. Reg. § 1.1361-1(1) for the Company to be recognized as having only one class of stock under Code § 1361(b)(1)(D). Unless otherwise provided herein, references made to an Interest Owner’s Shares include all of that portion of the Interest Owner’s Interest that relates, or is attributable to, those Shares. Notwithstanding anything in this Agreement or any other agreement to which the Company may be a party or deemed to be a party or otherwise subject to, the outstanding Shares are to be treated as a single class of common stock for purposes of Code § 1361(b)(1)(D), for which Code § 1361(c)(4) recognizes and otherwise allows “differences in voting rights among the shares of common stock” to not cause the corporation or association taxable as a corporation to be deemed to have more than one class of stock.”
Conclusion
As hopefully is evident from the preceding discussion, the decision of an LLC to elect subchapter S status must be based on thoughtful consideration of all potential benefits and pitfalls, not solely as a gambit on potential employment tax savings. The cost of an ill- considered or improperly executed subchapter S election often will far outweigh the potential short-term benefits.
If subchapter S is the best alternative, care in drafting and, equally important, care in execution by the entity will help ensure realization of the tax benefits that were sought at the planning stage.
This article is based upon a presentation by the author, together with Warren Kean, Esq. of Schumaker, Loop & Kendrick of Charlotte, North Carolina, and Professor Martin J. McMahon, James J. Freeland Eminent Scholar and director of The Graduate Tax Program at the University of Florida Law School, that was made at the ABA Business Law Section LLC Institute in November 2015. The sample contract provisions included under “Practice Points and Drafting” were part of Warren Kean’s program materials and are used with his permission. The author would like to thank both Warren and Marty for their contributions to the program, their dedication to legal education and scholarship, and most importantly, for their patience with my (nontax practitioner’s) vain attempt to address these concepts from the perspective of the uninitiated.