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Overview
Scope of the chapter. An LLC that is classified as a corporation for federal tax purposes may elect to be taxed under subchapter S of the Internal Revenue Code. The election is common. It is made most often by an LLC with one owner who works in the business, or with a small number of individual owners, who want to keep the LLC's state-law form and its governance and creditor-protection features while paying federal income tax on the business's profits at the owner level and, within limits, taking part of those profits out of the business as distributions that are not wages. This chapter examines how an LLC becomes an S corporation, the eligibility rules as they apply to an LLC and its members, the one-class-of-stock requirement and the particular difficulty it presents for an operating agreement drafted on the partnership model, the taxation of an LLC that has elected S status and of its members, the treatment of members who work for the LLC, termination of the election and the relief available when it terminates by accident, and the means by which the owners leave the S regime or sell the business.
Why the subject belongs in an LLC treatise. Subchapter S was written for corporations, and the Code and regulations speak of shares, shareholders, charters and bylaws. An LLC that elects S status remains an LLC under state law. Its members hold membership interests, its governing document is an operating agreement, and its economic arrangements are often modeled on a partnership agreement. The federal tax law treats the LLC's membership interests as stock and its members as shareholders, and the result is a set of problems that do not arise for an ordinary business corporation. The operating agreement may provide for liquidating distributions in accordance with capital accounts, for allocations that vary by member, for preferred returns, for profits interests or for tax distributions that are not proportionate to units. Each of those provisions is familiar in a partnership-model LLC, and each may give the LLC a second class of stock and either prevent the election from taking effect or terminate it. The lawyer who drafts or reviews an operating agreement for an LLC taxed as an S corporation must therefore understand subchapter S well enough to recognize which ordinary LLC provisions cannot be used.
Relation to other chapters. The classification of an LLC as a partnership, a disregarded entity or a corporation, the default rules and the elections on Form 8832 are examined supra ch. 39. The partnership taxation rules with which the S corporation rules are compared in this chapter are examined supra chs. 40 and 41. The single-member LLC as a matter of business law is examined supra ch. 9, and the disregarded entity as a matter of tax law infra ch. 42. Self-employment tax, the deduction for qualified business income under section 199A and the net investment income tax, each of which bears heavily on the choice between partnership and S corporation status, are examined infra ch. 45, and this chapter refers to those rules without restating them. State taxation, including the states and cities that do not recognize the federal S election, is examined infra ch. 46.
Terminology. In this chapter, an LLC that has elected to be an S corporation is called an S corporation LLC, its members are called members or, where the Code's terms are being applied, shareholders, and its membership interests are treated as stock. The phrase "governing provisions" refers to the documents and laws that the regulations examine in deciding whether all outstanding shares confer identical rights to distribution and liquidation proceeds. Treas. Reg. § 1.1361-1(l)(2)(i). In the case of an LLC, those are the certificate of formation, the operating agreement, the LLC statute of the state of formation and any other binding agreement among the members that relates to distribution or liquidation proceeds.