Page 512 - TaxAdviser_2022

LLCs & LLPs

contain language that is not appropri- a comprehensive list of provisions in The determination of whether all
ate for corporations. an operating agreement that would re- outstanding shares of stock confer
The important issue here is that quire review and revision; it highlights identical rights to distribution and
operating agreements written with some of the more common provisions. liquidation proceeds is made based
partnership tax law in mind have pro- First, a corporation that has more on the corporate charter, articles of
visions that can invalidate an S election than one class of stock is ineligible incorporation, bylaws, applicable
due to the Subchapter S prohibition of to become an S corporation.5 The state law, and binding agreements
having more than one class of stock.4 Treasury regulations provide that “a relating to distribution and liqui-
It is critical that before making the S corporation is treated as having only dation proceeds (collectively, the
election for an LLC, the tax adviser one class of stock if all outstanding governing provisions).7
read and provide recommendations for shares of stock of the corporation
revisions to the operating agreement confer identical rights to distribution Therefore, the operating agree-
to conform to the S corporation rules. and liquidation proceeds.”6 Further, the ment is the governing instrument of
This article is not intended to create Treasury regulations provide that: the LLC for purposes of establishing

4. Sec. 1361(b)(1)(D). However, voting and nonvoting common stock are per- 6. Id.
mitted (Sec. 1361(c)(4)). 7. Regs. Sec. 1.1361-1(l)(2)(i).
5. Id.; Regs. Sec. 1.1361-1(l)(1).

EXECUTIVE SUMMARY the property were sold to the • Reason 7: Unlike the rules
LLC. for partnerships, there is no
• Although an LLC’s election to be provision in Subchapter S that
classified as an S corporation • Reason 4: S corporations have permits the inside tax basis
for tax purposes can have no flexibility with respect to of the corporation’s assets to
certain advantages, such as allocating items of income and achieve a step-up in tax basis
payroll tax savings, there are deduction not in proportion to when a shareholder dies, when
often significant downsides. the shareholders’ ownership a person acquires the stock of a
The following are 10 reasons for interests. shareholder, or when there is a
not electing S corporation tax distribution of property or cash to
classification. • Reason 5: While a significant a shareholder.
advantage of partnership
• Reason 1: Many LLC operating taxation is the ability to include • Reason 8: S corporations
agreements contain language entity-level indebtedness have other restrictions, such
that can inadvertently result in the partner’s tax basis as a 100-shareholder limit
in the termination of the S of his or her interest in the and a rule that corporations
election. If the operating partnership, a shareholder of an and partnerships cannot be
agreement’s language is not S corporation cannot include shareholders.
revised beforehand, the LLC’s entity-level indebtedness in the
Subchapter S election may end shareholder’s tax basis of his or • Reason 9: The one-class-of-
up being involuntarily terminated. her stock. stock rule can make it difficult for
an S corporation to attract new
• Reason 2: An S election can • Reason 6: While a partnership rounds of investment funds.
result in gain recognition at the that distributes appreciated
time of the election. property to a partner generally • Reason 10: Tax issues can arise
does not recognize gain, an for S corporations in the context
• Reason 3: A new member that S corporation’s distributions of a merger or acquisition,
contributes property to an LLC of appreciated property to a although a possible workaround
that has made an S election may shareholder can result in gain exists that relies on an F
recognize taxable gain as though recognition. reorganization.

26 October 2022 The Tax Adviser