In some situations, business owners have state-law reasons for wanting their business to be formed as a limited liability company (LLC), but for tax purposes they would prefer S corporation (rather than partnership) tax treatment. For example, S corporation status may be desired because a partner in a partnership is subject to self-employment tax on his or her distributive share of the partnership’s trade or business income, while an S corporation owner is not subject to self-employment tax on his or her passthrough income or distributions from the S corporation.
Electing S Status for a Corporate Entity Under the Check-the-Box Rules
An LLC can elect under the check-the-box rules to be classified as a corporation. If the LLC makes the election it is deemed to (1) transfer all of its assets and liabilities to the corporation in exchange for the corporation’s stock and then (2) distribute the stock to its owners in complete liquidation (Regs. Sec. 301.7701-3(g)(1)). The deemed transfer to the corporation is tax free, assuming Sec. 351(a) applies and the LLC’s liabilities do not exceed the basis of its assets. The LLC can then elect S status, assuming that its members are eligible to hold S corporation stock (Regs. Secs. 1.1361-1(c) and 301.7701-3).
The entity normally files the election to be taxed as a corporation on Form 8832, Entity Classification Election , in accordance with Regs. Sec. 301.7701-3(c). However, if an LLC that is eligible to elect S status timely files an S election (Form 2553), the entity is considered to have elected to be taxed as a corporation (Regs. Sec. 301.7701-3(c)(1)(v)(C)). This means that the entity does not have to file the Form 8832 if it timely and properly elects S status.
Under Regs. Sec. 301.7701-3(c), the effective date of the classification election specified on Form 8832 cannot be more than 75 days before the date on which the election is filed and cannot be more than 12 months after the date on which the election is filed. This means that the classification change can be retroactive for up to 75 days before the entity files Form 8832. Under S corporation rules, however, a newly formed corporation must file the S election on or before the 15th day of the third month following the corporation’s activation date, which is the earliest date that the corporation has shareholders, acquires assets, or begins conducting business.
If the entity plans to elect to be treated as a corporation and become an S corporation on the same date, only Form 2553 is filed, and it should conform to S corporation rules. The authors recommend that the entity file the Form 2553 by the earlier of 75 days or two months and 15 days after the date the S election is to become effective. In this way, the entity will have filed Form 2553 within both the Form 8832 and Form 2553 filing limits.
Planning tip: An LLC that elects to be treated as a corporation and become an S corporation on the same date is not required to do so on the first day of the calendar year. Rather, the election can be retroactive or prospective within the time limits surrounding the date the LLC files Form 2553, as outlined above. Allowing an LLC to make a midyear S election makes sense because a newly electing S corporation can begin its first S year at any allowable date. To conform to S corporation rules, however, the authors recommend that the effective date of the S election should not occur before the earliest date that the LLC has members, acquires assets, or begins conducting business.
An entity that makes the deemed election to be taxed as a corporation by filing the S election, Form 2553, will be classfied as a corporation on the date the S election is effective and will continue to be treated as a corporation until it makes an other entity classification (Regs. Sec. 301.7701-3(c)(1)(v)(C)). If an entity elects to change its classification, it cannot do so again during the 60 months after the effective date of the election without the IRS’s permission (Regs. Sec. 301.7701-3(c)(1)(iv)).
Since no actual incorporation takes place and no shares are issued, how does an LLC complete the S election Form 2553? While the instructions offer some guidance, they do not divulge how an LLC shows the effective date or state of incorporation. It would seem, the authors recommend that a copy of the Form 8832 be attached to the Form 2553, along with a statement that the entity has made the check-the-box election and is now making the S election. If the LLC has not filed Form 8832, the effective date of the S election could be entered. The instructions say that the number-of-shares and date-acquired sections of Form 2553 should show each individual’s percentage of ownership and the date(s) acquired.
If the LLC does not file Form 8832, the authors recommend that a statement be attached to the Form 2553 that the entity is electing to be classified as an association taxable as a corporation under Regs. Sec. 301.7701-3(c)(1)(v)(C).
Relief for Missed S Corporation Elections
In Rev. Proc. 2013-30, the IRS updated and consolidated the procedures for requesting relief when taxpayers miss the deadline for making a number of S corporation-related elections, including the election to be treated as an S corporation under Sec. 1362(a) and the election to treat an eligible entity as a corporation under Regs. Sec. 301.7701-3(c)(1)(v)(C) so that it can elect to be treated as an S corporation. The relief available under Rev. Proc. 2013-30 is in lieu of requesting relief via the letter ruling process, and user fees are not charged.
Electing S Status by LLC Treated as Partnership
When an eligible entity classified as a partnership elects to be treated as a corporation (or converts into a corporation under a state-law conversion statute), the partnership is treated as contributing all of its assets and liabilities to the corporation in exchange for stock. It is also considered to have liquidated by distributing the corporation’s stock to its partners immediately before the close of the day before the election is effective. Thus, if the conversion takes place at the beginning of the year, the deemed contribution and liquidation are treated as if they occurred immediately before the close of the previous tax year. If the corporation makes a timely S corporation election for its first year, the corporation will be an S corporation for that year, and there will be no intervening period during which the entity was a C corporation (Rev. Rul. 2009-15).
Planning tip: Partners may want to incorporate their partnership to obtain personal liability protection and ensure the business’s continuity. If S corporation status is elected, the business can continue to pass through its gains and losses to the owners. Because of the S corporation passthrough rules, however, special allocations will not be allowed.
Potential One-Class-of-Stock Issues
When an LLC elects S status, it is imperative that its operating agreement and other documents conform to the S corporation eligibility requirements. Any prior documents based on the LLC’s treatment as a partnership must be amended or replaced. If, for example, the LLC’s operating agreement allows special allocations of income or loss to be passed through to members, the LLC is not eligible to be treated as an S corporation because it would be considered to have more than one class of stock. (An S corporation has one class of stock only if all outstanding shares (which, in the case of an LLC, would be membership interests) confer identical rights to distribution and liquidation proceeds. Differences in voting rights are ignored.) Allocations based on anything other than percentage of ownership breach the one-class-of-stock rule and are not allowable in an S corporation.
S corporation shareholders must be of the same class, except for the ability to hold voting and nonvoting shares. The operating agreement of an LLC operating as a partnership, on the other hand, might specify that certain members are general partners and that others are limited partners. The IRS has ruled that the general and limited partnership interests that confer identical rights to distribution and liquidation proceeds satisfy the one-class-of-stock requirement (see IRS Letter Rulings 9739014 and 199942009). However, the IRS announced that it will not issue advance letter rulings on whether state-law limited partnerships that check the box to be taxed as corporations have more than one class of stock (Rev. Proc. 2013-3, §5.01(18)). This revenue procedure and its predecessors cause uncertainty as to whether such interests will presently conform to the one-class-of-stock rules.
This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 27th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller, Kimberly Drechsel, and Cynthia Zatopek, published by Practitioners Publishing Co., Fort Worth, Texas, 2013 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.