Why ‘standard’ agreements never really work

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

Two of the more common types in use today are the S corporation and the limited liability company.

Treasury regulations classify “eligible 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 elected by filing Form 8832.

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

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

However, some advisers do recommend making both elections. One adviser told me this was being “double safe.”

While not required of the LLC form, most LLC entities begin their life with an operating agreement prepared by an attorney. This operating agreement will contain language addressing the federal income tax issues that one typically sees with a partnership.

As examples, partnerships may allocate items of income and loss by agreement. If one or more partners contributes property with a built-in profit or loss, that built-in gain or loss must be allocated to the contributing partner.

The operating agreement drafted by the attorney will address the allocations of profit and loss. It is also common to see boilerplate language addressing a “qualified income offset” or a “minimum gain chargeback” as overriding the agreed-to allocations.

Sometimes members contribute money to the entity but the agreement provides for a return to the contributor to compensate them for the use of their money. Such returns may be “guaranteed,” which means paid without regard to the existence of profits, or a “preference” return, which typically means that the contributor gets a first priority on distributions, but one matched with income.

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

Generally, a second class of stock will exist if shareholder equity rights differ with respect to distribution rights and liquidation rights. Allocations of profit and loss must follow share ownership.

Regulations explain that we must look to the “governing provisions” of the entity to determine if there are differences in liquidation or distribution rights. Such provisions include the operating agreement as it is binding on the parties.

When 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 formed as an LLC will typically require modifications to the operating agreement to remove all provisions inconsistent with subchapter S. If the Form 2553 is filed without such modifications, we must then address what is the status of the entity.

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

The preamble to the regulations notes that if the eligible entity’s S election is not timely and valid, the default classification rules of the regulations will apply.

The default status would be a partnership or a disregarded 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 attorney drafting the agreement should be made aware of the intended tax status. Tax advisers should assume this never happened.