Page 511 - TaxAdviser_2022

ince 2004, the IRS has admin-
Many tax advisers find Subchapter K of the
Sistratively made S elections for
limited liability companies (LLCs) Internal Revenue Code too complex and
very easy. An LLC that is otherwise
eligible to be an S corporation that prefer to deal with Subchapter S.
is classified as a partnership or a
disregarded entity can simultane-
attorneys find that organizing an entity election. Even if the LLC operating
ously elect to be classified as both as an LLC under state law is much agreement does not terminate the S
a corporation and an S corporation simpler and less expensive, requiring election, many of its provisions are
by timely filing Form 2553, Election only a state organizational certificate inapposite to a corporation, as ex-
and a simple operating agreement, than plained below.
by a Small Business Corporation,
an actual incorporation that requires An LLC operating agreement is
without the need to also file Form
bylaws, corporate resolutions, and the foundational governing docu-
8832, Entity Classification Election.
stock certificates. The corporate at- ment for LLCs, similar to the articles
The Treasury regulations treat the torneys then leave the tax classification of incorporation and the bylaws for
“one-stop-shop” rule as a “deemed to the tax advisers. For these reasons corporations. In many cases, the tax
election” under the entity classifica- and possibly additional ones, many adviser is not the first professional
LLCs have elected to be classified as who is consulted for the choice of
tion regulations.1
S corporations. business entity. Business clients con-
The authors find that tax advisers This article discusses some of the cerned with personal liability seek the
frequently recommend an S election negative aspects of electing S corpora- advice of an attorney who invariably
due to the uncertainty under the tion tax classification for LLCs and recommends and organizes an LLC
law regarding what portion of LLC the practical problems the election can for the client and prepares the operat-
earnings (i.e., LLCs that are treated present. This article is not intended to ing agreement. In the authors’ experi-
as partnerships or disregarded enti- be a comprehensive and thorough dis- ence, it seems in recent years, for
ties for tax purposes) are subject to cussion of the proper choice of business small to medium-size business, LLCs
self-employment tax to its member(s). entity. It is limited to those situations are the chosen legal vehicle rather
Provided that the salary of a share- where the accountant or attorney is than corporations.
holder in an S corporation is not making a choice whether to elect Sub- The default tax classification for
unreasonably low and is considered chapter S status for an LLC. For pur- a domestic multimember LLC is a
“reasonable,” payroll taxes, including poses of this article, LLCs with more partnership.2 The default classifica-
Federal Insurance Contributions Act than one member will be emphasized. tion for a domestic single-member
and Medicare taxes are imposed on The following are 10 good reasons LLC is a disregarded entity.3 LLC
the amount of salary only rather than why LLCs should think twice before operating agreements are written
the entire amount of the trade or electing S corporation tax classification. under the applicable state statute
business income that would otherwise and tend to conform to partnership
be subject to self-employment tax. Reason 1: Operating tax law in the case of a multimember
Further, many tax advisers find agreements can invalidate LLC. Operating agreements for
Subchapter K of the Internal Revenue the S election single-member LLCs are typically
Code too complex and prefer to deal Many LLC operating agreements much shorter without much of the
with Subchapter S. Many corporate can result in the termination of the S partnership tax language but can still

1. “An eligible entity that timely elects to be an S corporation under section remain in effect until the entity makes a valid election, under
1362(a)(1) is treated as having made an election under this section to be §301.7701-3(c)(1)(i), to be classified as other than an association” (Regs.
classified as an association, provided that (as of the effective date of the Sec. 301.7701-3(c)(1)(v)(C)). See also the instructions to Form 8832, Entity
election under section 1362(a)(1)) the entity meets all other requirements to Classification Election, and the instructions to Form 2553, Election by a
qualify as a small business corporation under section 1361(b). Subject to Small Business Corporation.
§ 301.7701-3(c)(1)(iv), the deemed election to be classified as an associa- 2. Regs. Sec. 301.7701-3(b)(1)(i).
tion will apply as of the effective date of the S corporation election and will 3. Regs. Sec. 301.7701-3(b)(1)(ii).

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