Why “standard” agreements never really work

One of the first issues a business owner must solve is what type of company, if any, will be used to operate a business.

Two of the more common types today are the S Corporation and the Limited Liability Company.

Treasury Department regulations classify “eligible business entities” as LLCs for federal income tax purposes.

If an LLC has two or more owners, it is classified as a partnership for tax purposes, and if it has only one owner, it is disregarded for tax purposes.

The regulations also allow an LLC to elect to be taxed like a corporation. Company status is chosen by filing Form 8832.

Once the LLC has elected corporate status, its owners can also elect to have it taxed as an S corporation. To simplify the voting process, the “normal” voting form 2553 can be submitted in such cases.

A timely filed Form 2553 constitutes a fictitious filing of Form 8832. This fictitious corporate election is effective only if the voting entity meets all of the requirements to be an S corporation.

However, some consultants recommend making both choices. A consultant told me this was “doubly sure”.

Although not required for the LLC form, most LLC corporations begin life with an operating agreement prepared by an attorney. This operating agreement will contain language that addresses federal income tax issues typically seen in a partnership.

For example, partnerships can allocate income and losses by agreement. If one or more partners contribute property with built-in gain or loss, that built-in gain or loss must be attributed to the contributing partner.

The operating contract drawn up by the lawyer regulates the distribution of profits and losses. It is also common for standard language to be used that addresses a “qualified income equalization” or a “minimum profit chargeback” to override the agreed allocations.

Sometimes members donate money to the company, but the agreement provides for a refund to the contributor to compensate them for the use of their money. Such returns may be “guaranteed,” meaning they are paid regardless of the existence of profits, or a “preference” return, usually meaning the contributor gets priority on distributions, but one consistent with the income matches.

Unfortunately, a typical LLC operating agreement creates problems when the taxpayer or an advisor suggests that a choice would be advisable. S corporations are subject to certain listing rules under the tax laws, including the requirement that the corporation may have only one class of shares.

Generally, a second class of shares will exist where shareholders’ share rights differ in terms of distribution rights and liquidation rights. Profit and loss allocations must follow share ownership.

The regulations state that we must refer to the company’s “Governing Rules” to determine if there are differences in liquidation or distribution rights. One of these provisions is the operating agreement, as it is binding on the parties.

Unless the operating agreement was designed for a company taxed as an S corporation, it will likely contain provisions that violate the requirements of being an S corporation.

An S election for an LLC incorporated company typically requires amendments to the operating agreement to remove any provisions inconsistent with Subchapter S. If the Form 2553 is submitted without such changes, we need to address the status of the company.

Preferred status is partnership (two or more owners) or disregarded entity (one owner). This avoids the two levels of taxation possible with a C corporation.

The preamble to the regulations states that if the selection of the eligible company is not timely and valid, the standard classification rules of the regulations apply.

The default status would be partnership or disregarded entity. This is a better result than a C corporation, but still not our desired S corporation status.

The obvious approach to choosing S corporation status for an LLC is to review the operating agreement and make changes to any provisions that are not consistent with Subchapter S.

Better yet, the attorney drafting the contract should be made aware of the intended taxation. Accountants should assume that this never happened.

Jim Hamill is the head of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected]

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