S Corporation Election: New or Existing Entity — Be Very Careful

Many business owners who run their companies as partnerships (multi-member LLCs or statutory partnerships) or single-owner entities often make an election under subchapter S of the IRC using Form 2553 to be treated and tax as an S Corporation to mitigate self-employment tax (FICA/SSI and Medicare tax) and take advantage of employee fringe benefits that may have not been deductible before. However, this entity choice requires adherence to several strict criteria, including a maximum number of shareholders (limited to 100 shareholders), appropriate residency or citizenship of the shareholders (LLC members if the entity is an LLC), and a limitation on the number of classes of stock (limited to just one class of stock)—critical note: this does not mean a C Corporation, LLC, or partnership (before the Sub S election) cannot have different voting rights—the corporate bylaws, partnership agreement, or LLC operating agreement (as applicable) would need to avoid language and provisions that create multiple classes of ownership or varying types of income, loss, or capital (equity) allocation.

We get more into this below, but this is where a experienced attorney in corporate law with exposure to tax accounting working with a tax accountant with exposure to corporate law is invaluable. SPOILER ALERT: It is a rare combination. At Cruncher Accounting, PC we have the knowledge-sharing and experience from both sides of the isle to effortlessly and confidently navigate Subchapter S and corporate law matters. Consult us if you have any questions on this topic.

Many passthrough entities that are treated for tax purposes as partnerships or disregarded entities instead elect to use S corporation status to pass their income through to their owners. An entity can elect S corporation status only if it meets numerous requirements such as a limited number of shareholders, the proper residency or nationality of the owners, the type and location of the business entity, and the electing entity cannot have “more than one class of stock.”1 The one class of stock rule is often violated by entities that are not originally organized with the purpose of making an S election but subsequently elect to be taxed as S corporations.Taxable corporations allocate distributions based on stock ownership. S corporation status may be violated by a corporation if it issues multiple classes of stock. Unlike corporations, electing LLCs and partnerships allocate profits, losses, and distributions based  on the entity’s partnership agreement (aka membership agreement in the case of LLCs), which often have formulas or special allocations that are not based on pro rata ownership. The partnership agreements will often run afoul of the one class of stock rule.Example of special allocations: Bam, LLC has two equal owners, A owns 50% and B owns 50%, but B is entitled, under Bam’s membership agreement, to a preferred return of 5% on her $100,000 capital account (which is not a loan). When Bam LLC earns $10,000 for the year, A is allocated $2,500 and B $7,500 (5% of $100,000 + 50% of the remaining $5,000). Bam’s special allocation to B violates the one class of stock rule.One class of stockTo qualify as one class of stock, the agreement must provide for identical rights to distributions, liquidations, and the allocation of profits and losses. A corporation is not treated as having more than one class of stock solely because there are differences in voting rights among the shares of common stock. Buy–sell and redemption agreements are disregarded unless a principal purpose is to circumvent the one class of stock, and the agreement establishes a purchase price that at the time of the agreement is not at fair market value. With an entity originally organized as a C corporation, one class of stock is typically not an issue because each owner receives distributions based on their stock ownership percentage as long as all stock is common stock. One class of stock can become an issue when a second class of stock is outstanding, such as preferred stock or if debt is held disproportionately to the stock ownership if the debt is really disguised equity. Unlike a corporation, LLCs and partnerships don’t have stock. The distributions and allocations are based on the partnership or membership agreement. The agreement must be examined to determine if it creates a possible second class of stock. The one class of stock rule is not a problem if there is only one owner. A spouse and family members and their estates are not considered a second owner for this purpose. The one class of stock problem exists if the agreement contains provisions that allow for disproportionate rights to distributions, liquidations, or allocation of profits and losses other than strictly being pro rata based on each owner’s capital ownership percentage. This causes there to be a second class of stock, which terminates the S election or prevents an S election from being made. The reason this problem exists is because partnership and membership agreements are designed to operate in a partnership context and therefore often provide for variedinterest for profits, losses, liquidations, and capital accounts rather than require a pro rata allocation and distribution based on ownership percentages. Differences in the owner’s rights, such as preferred returns, special allocation, or distributions will cause a disqualifying second class of stock. A second class of stock can be caused by §704(b)language in the agreement that requires liquidating distributions to be based on capital accounts, as opposed to being based on ownership percentages.5 A similar problem exists if the agreement uses various partner ratios for calculating profits and losses based on the substantial economic effect rules of Treas. Regs. §1.704-1(b)(2)(iv).6A second class of stock can exist even if all actual distributions are equal. It is the possibility that the agreement allows for future unequal distributions that creates the problem. This means that an S election cannot be made unless the partnership or membership agreement is amended prior to the S election to provide for unit-based/pro rata allocations and distributions-based capital ownership percentages. With an existing S corporation, if the agreement violates the one class of stock rule, the S election is terminated retroactively to the occurrence of the event that caused the violation.Effect of terminationIf a second class of stock exits, the S corporation election is terminated. The partnership or LLC must file as a taxable C corporation.Relief if the agreement creates a second class of stock The IRS can grant retroactive relief if the entity amends the partnership ormembership agreement to prevent a second class of stock for an inadvertent termination.7 Unfortunately, this requires requesting relief from the IRS and paying a large fee for a private letter ruling. Revenue Procedure 2022-19, effective October 11, 2022, discusses violations of the one class of stock rule.ConclusionIn the case of an S election by an LLC or partnership, the governing agreement must be reviewed to determine if it allows for an allocation of profits, losses, or distributions that are not based on pro rata ownership percentages, which violate the S corporation one class of stock rule. If that is the case, the agreement should be amended prior to the S election to remove the improper provisions used to measure allocations. Allocations and distributions should be based solely on ownership percentages. If an S election was made and the current agreement has allocations that violate the one class of stock rule, the S election will be terminated unless Revenue Procedure 2022-19 relief is available or if a private letter ruling is requested.

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