Some of you may recall an old Seinfeld episode where Elaine acquired three new friends who in some respects were very similar to Jerry, George and Kramer, but in other respects were total opposites. She found it difficult to reconcile the differences between the two groups and whom to pick as her real friends. She declared at one point in that episode that she found herself in the “Bizzaro World.”
That’s how I feel sometimes when I’m dealing with a limited liability company (“LLC”) that has made the S election for income tax purposes, but has the usual operating agreement in place that presumes it is being taxed as a partnership for federal and state income tax purposes. On the one hand, I find myself dealing with LLC statutes and terminology and on the other hand dealing with corporation terms and corporation tax issues. Sometimes it really seems like being in the “Bizzaro World.”
The purpose of this blog is to point out that when the S election has been made or will be made for a LLC, the operating agreement should not contain any offending provisions that might cause an inadvertent termination of the S election, resulting in detrimental income tax consequences. Two very dangerous areas are where the operating agreement provides for disproportionate distributions to the members, which could lead to the IRS determining that a second class of stock exists or that an impermissible entity under the S rules is admitted as a member, thereby causing a termination of the terminating the election.
So if a S election is in place or you are contemplating making the S election to have your LLC be taxed as a S corporation, you should consult with your accountant and/or lawyer to make sure that there is no offending language in your company’s operating agreement that could trigger a termination of the S election. It is far better to replace or amend your company’s operating agreement to avoid the risk of terminating the S election than to assume the risk of terminating that election.
Michael W. Margrave
Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.