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Newly Uncovered LLC Pitfall

In the recent past, limited liability companies (LLCs) have been the default entity classification for organizations that wanted flexibility. You can seamlessly go from being taxed as a sole proprietorship, to a partnership, to an S Corporation, or even a C Corporation, with ease. However, one (up until now) unforeseen pitfall is lurking – the dreaded boilerplate LLC operating agreement.

On Friday, November 25th the IRS released a private letter ruling (PLR) that could strike fear into many business owners’ hearts. As PLRs go, it’s a fairly uncomplicated, easy read – and is very simple. The conclusion? If your LLC that is being taxed as an S Corporation is using an operating agreement that includes language around the maintenance of capital accounts, and/or liquidating distributions being in accordance with IRC Section 704, you may have a problem.

As we all know, S Corporations are only permitted to have one class of stock. One indicator of having more than one class of stock is different owners have differing rights to distributions. If you have an operating agreement that states that capital accounts shall be maintained, and that liquidating distributions must be in accordance with those capital accounts, you have a written document that states that different owners have different rights to distributions. As a result, you will be deemed to have a second class of stock, and thus are ineligible to be an S Corporation.

The ironic thing is, it doesn’t matter what did or didn’t happen. You could have never made disproportionate distributions – doesn’t matter. Even more ironic – you could have intentionally made disproportionate distributions – doesn’t matter. All that matters is that you have a written agreement documenting differing rights to distributions. In Mowry v. Commissioner, the tax court ruled that even though disproportionate distributions were made intentionally, there was no agreement conferring differing rights – and thus no second class of stock. In the PLR at issue here, the IRS references specifically that they had a written document in place. That is the issue.

So what? Now What?

Check your operating agreement and see if there are references to capital accounts or IRC Section 704. If there are (and maybe even if not), consult your tax advisor or legal counsel.

If you are (and always have been) a single-member LLC (one owner S Corp) – relax – you most likely have no issue. But you do still need to check your operating agreement in case you admit new owners in the future.

If you do have a problem, you have two choices (and here’s where it gets ugly) – you can either go back and file amended returns or request your own PLR. I guess you could always just ignore it and hope it goes away, but please don’t.

  • Amended returns – the tax impact may not be huge depending on your circumstances, but it will be a pain. You’ll have payroll issues to deal with as well (assuming the owners took salaries).
  • Private Letter Ruling – you have a pretty good chance of a positive outcome (assuming the issue was inadvertent), but it’s expensive. A PLR can cost as much as $38,000 (plus professional fees).

Bottom line – if you think you may have an issue, let us know, we can help. If you have any questions about the information outlined above, McKonly & Asbury’s experienced professionals are here to help. Please contact us or visit our website to find out more about our Tax Services.

About the Author

Mark Heath

Mark is a Partner with McKonly & Asbury. Serving as Director of Tax Services, he brings a wealth of experience in federal, state, and international income as well as franchise tax issues for both publicly and privately held corporatio… Read more

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