S Corporation Or LLC ? A Misleading Question That Can Lead To Expensive Mistakes

Failure to understand the subtle differences in different sorts of tax entities can lead to disastrous results. Sometimes you can plead with the IRS and they will provide a deus ex machina that will avert the disaster. PLR 202142003 is an example of that sort of IRS dispensation.

It is worth looking at this ruling to reflect on the blunder that created the need for a plea for mercy and a little bit of a discussion on what is involved in the quest for indulgence. We’ll call the entity involved Oopsies Inc., which became Oopsies LLC.

What Happened ?

Oopsies Inc was an S Corporation. For some reason the owners wanted it to become a limited liability company (LLC). LLC is not really a category when you are talking about business taxation. An LLC can be taxed as a corporation, which may or may not have S status. It can be a partnership or a disregarded entity if it only has one owner.

There are defaults that differ depending on whether the entity is foreign or domestic. If you don’t like the default or you want to be extra thorough, you can specify using Form 8332. It appears that is what Oopsies LLC must have done electing to be a corporation that was the successor to Oopsies Inc, which would keep the S election in effect.

Being something of a pure tax guy, I have to wonder what the point of the exercise was, because there would be no difference in the federal income tax treatment of the entities. There are nontax reasons to prefer LLC to Corporation when it comes to governance. Conceivably there might be SALT (State and Local Tax) differences. There must have been a reason.

We should note that if they converted to an LLC that was not treated as a corporation, there could be gain, if there were appreciated assets.

Oopsie’s Oops

It is common for LLCs to have operating agreements that will spell out the rights and duties of the members including the managing members. There will be something about how they split up the money. When the LLC has the tax status of partnership, those provisions can be quite complex. And that was the case with the agreement that the former shareholders of Oopsie Inc, now members of Ooopsie LLC entered into. 

The ruling gives some excerpts from the agreement. Here is an example:

Allocations in Respect of Contributed Non-Cash Property. If a Member makes a contribution of non-cash property to the LLC, the LLC shall allocate its income, gains, deductions, losses and other tax items to the Member in respect of this contribution in accordance with Internal Revenue Code Section 704(c)(1)(A) and regulations thereunder.

That “704” there. Code Section 704 is titled “Partner’s distributive share“. That operating agreement was one that was meant for an LLC that is a partnership for tax purposes. And the problem is that the sorts of income allocation provisions common in partnership agreements violate the one class of stock requirement of a “small business corporation” eligible to make an S election. When the members of Oopsies LLC entered into that agreement, the in effect violated that requirement because:

Section 1.1361-1(l)(1) provides, in part, that a corporation is generally treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.

Whoever put that agreement together did not get that Oopsies LLC was not a partnership for income tax purpose. Or maybe they did not get that a typical partnership agreement does not treat each share the same as every other share, which will make a corporation (for tax purposes) ineligible for an S election.

The Fix

Applying for a ruling that the termination was inadvertent is the fix for this sort of problem.  Miri Adams Forster, Partner and Tax Controversy Co-Leader of Eisner Advisory Group LLC explained it this way:

In PLR 202142003, the Service provided relief to an entity that terminated its S corporation status when it entered into an agreement, creating a second class of stock. While the timing is unclear, within a reasonable period following discovery, the Company entered into a second agreement to correct its error. The Service concluded that the termination was inadvertent pursuant to IRC Sec. 1362(f) and that the entity would continue to be treated as a S corporation.

She pointed out a couple of relatively recent rulings (PLR 202005004 and PLR 202001001) where the IRS had granted relief for inadvertence. The only thing is this sort of mercy does not come cheap. Ms. Forster parsed Rev Proc 2021-1 for me and determined that the Oopsie LLC request need to go in with a $30,000 user fee. Good thing they did not dawdle. Requests received after February 3, 2021 will require a user fee of $38,000.

Ask The Right Question

You can find quite a few articles floating around in which the question under discussion is whether you should use an S Corporation or an LLC for your business. It would be two harsh to say that it is a stupid question. Let’s rather say that it is the wrong question. And the right question is actually two questions. Those two questions are:

1.  What sort of a state law entity do you want to have ?
2. What sort of a characterization do you want for federal income tax purposes ?

LLC is a possible answer to the first question. It is not a meaningful answer to the second question. An LLC can be taxed as a C corporation, an S corporation, a partnership or, with a single owner, a disregarded entity.

And be sure to tell whoever is doing the operating agreement which way you are going. It turns out that Reilly’s Ninth Law of Tax Planning – Tell the preparer want the plan is – has application beyond tax returns.