S-Corps and Operating Agreements

The most flexible type of entity, from a federal tax angle, is the LLC. 🧘‍♂️ The LLC is a shape-shifter of business types, which is great for a lot of different reasons. But it's not so great when it's not respected. ✊

When an LLC is going to be used as an S-Corp with multiple owners, there is an extra layer 🍰 of attention that must be paid to the LLC Operating Agreement (OA). Disregarding the OA language can result in a busted S-election and a C-Corp with years of back taxes. 🤕

When this happens to the S-Corp, all bets are off. 🎰 Unfortunately, this is often discovered in tax due diligence and can blow up deals faster than actual fraud being discovered.

Let's dive into why it matters, what to look for and some possible solutions from the IRS.

Why It Matters

For an S-Corp to be an S-Corp, it must follow several rules to qualify and keep that status:

1. No more than 100 shareholders 🗞️

2. Natural persons (and some trusts) only as shareholders 🙋‍♂️

3. Must have a single class of stock for distribution and liquidation purposes ☝️

   
   

The problem is normally the last item. Many shareholders and business owners usually take this to mean that all distributions are pro-rata (e.g. a $100 distribution is paid out $70 to a 70% shareholder, and $30 to a 30% shareholder). While that's not wrong, it's not the full picture.

The IRS weighs both (1) did you pay out non-equal distributions, and (2) what does the OA say. ✌️

That means even if you kept distributions fully in compliance, if the OA makes reference to more than one class of stock you're in a bad S-Corp position.

The opposite is also true. You can have good S-Corp language in the OA but are making non-pro rata distributions and still be in violation. You need to be a good S-Corp in appearance and in fact. 😦

What to Look For

Attorneys are not always up on this nuance. 👩‍💼 They'll advise that this is why your CPA needs to review the OA and weigh in on any tax concerns. But this is more than tax concern, this is a foundational issue with S-Corp OAs. Getting this wrong means the entity is set-up incorrectly from the start. 🙅‍♂️

So what exactly should you look for when the attorney sends you the OA draft to review? 🔍

1. Any reference to capital accounts - this implies that shareholders capital accounts can vary and also usually alludes to a code section in the §700s which is where partnerships live.

2. Any reference to Classes of Units - you don't want separate classes of units. Single class of stock.

3. Preferred return - Nope. No good. This means disproportionate distributions.

4. Promote or carried interest - same as preferred return. This implies disproportionate distributions.

5. Distribution priority or waterfall - same as "classes of units" - a set up for a busted S-election.

   
   

It's worth nothing that different voting rights don't necessarily mean separate classes of stock for the S-Corp. But still something to keep an eye out for as voting and distribution often are planned together. 😿

How to Fix It

If you have either disproportionate distributions OR bad OA language, Rev. Proc. 2022-19 will be your go-to guide and friend. 🫂

In this guidance, the IRS gives some direction on how to remedy these kinds of busts - which in itself is signal that this is happening A LOT.

In short:

1. If the OA has good language and only distributions are incorrect, you need to fix the distributions but your S-Corp is fine.

2. If the OA has bad language, the S-Corp can only be salvaged if: (a) no disproportionate distributions have been made, (b) all S-Corp filings have been made annually, (c) the IRS has not already identified this issue.

   
   

The tl;dr of #2 is that if you have bad OA language AND made disproportionate distributions then you're S.O.L. 🤷‍♂️ and have a C-Corp with back taxes. If this is you, I suggest you work with a tax specialist at a large firm and your attorney. There are people who do this all day every day because it's such an issue.

The maxim that an ounce of prevention is worth a pound of cure definitely applies here. ⚖️ Get the wording right from the start and keep distributions proportionate to avoid all this drama on the back end.