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whether the LLC has only one class order to satisfy the requirement to allocations of income and deduc-
of stock. “confer identical rights to distribution tions, references to Sec. 754 elections,
Most, if not all, operating agree- and liquidation proceeds.” If the oper- allocations of contributed built-in
ments that are not structured for the S ating agreement is silent with respect gains or losses under Sec. 704(c), the
election have many references to capi- to liquidating distributions, the state deficit restoration obligation and
tal accounts, which can be problem- LLC statute will be the default, which qualified income offset under the Sec.
atic. Equity interests in corporations may not always be proportional.10 704(b) substantial-economic-effect
are represented by capital stock and Accordingly, for LLCs treated as S regulations,11 and provisions deal-
paid-in capital; not capital accounts. corporations, all references to capital ing with allocations of nonrecourse
Partnerships are required to maintain accounts should be removed from the deductions.12
capital accounts for the partners in operating agreement, and liquidating Another issue that arises is wheth-
order to meet the safe-harbor provi- distributions should be proportionate er a multimember LLC that makes
sions of the substantial-economic- to the ownership percentages. an S election, but fails to qualify as
effect regulations under Sec. 704(b).8 Other provisions that will cause an S corporation because of a defec-
Capital accounts can be the measuring distributions, income, and deductions tive operating agreement, would be
device that determines which members to be made or allocated disproportion- classified as a partnership or a C cor-
receive distributions, the amount of the ately to the member’s ownership per- poration. The regulations under the
distributions, and when distributions centage should also be removed. Many one-stop-shop procedure of merely
are made. of these provisions are tax boilerplate filing a Form 2553 and the preamble
For example, many operating agree- and are critical for entities classified as to the temporary regulations issued
ments, for both business reasons and partnerships but, nevertheless, present in 2004 suggest that the LLC would
to meet the safe harbors under the serious problems for LLCs classified default to the partnership classifica-
substantial-economic-effect regula- as S corporations. For example, some tion rather than a C corporation.13
tions under Sec. 704(b), provide that of the more complex operating agree- Query whether the filing of Form
upon liquidation of an LLC, liquidat- ments have distribution “waterfalls” 8832 and then subsequently filing
ing distributions are to be made to that provide for priority of distribu- Form 2553 (two-step method) would
members according to the positive tions to certain members before other change that result to a C corpora-
balance in their capital accounts.9 Such members receive distributions or pro- tion.14 Nevertheless, although better
positive balances do not always cor- vide for a guaranteed rate of return on than a C corporation, defaulting to a
respond to the members’ proportionate capital. These provisions could result partnership presents procedural issues
membership interest in the LLC. Such in a second class of stock. Operating related to employment taxes and self-
a provision would violate the single- agreements that create more than one employment tax. Because partners of a
class-of-stock rule and would invali- class of membership interest are prob- partnership cannot also be employees,
date the S election. lematic (see reason No. 9, “Investor the tax adviser would need to wrestle
For an LLC electing S status, liq- Opportunity Is Limited,” for further with incorrect payroll tax returns and
uidating distributions are required to discussion). self-employment tax issues at the
be made in proportion to the owners’ Examples of other provisions that member level for prior tax years that
membership interests in the LLC in should be removed include any special have already been filed.

8. Regs. Sec. 1.704-1(b)(2)(ii)(b)(1); Regs. Sec. 1.704-1(b)(2)(iv). 13. See fn. 1; “However, if the eligible entity’s election is not timely and valid,
9. Regs. Sec. 1.704-1(b)(2)(ii)(b)(2). the default classification rules provided in §301.7701-3(b) will apply to the
10. For example, if the operating agreement is silent with respect to liquidating entity unless the Service provides late S corporation election relief or inad-
distributions, the Connecticut LLC statute requires distributions to be first vertent invalid election relief. If the late or invalid election is not perfected,
made to members in an amount equal to the respective values of the mem- the default rules will maintain the passthrough taxation treatment by clas-
ber’s unreturned contributions and then proportionate to their membership sifying the entity as a partnership or a disregarded entity” (T.D. 9139 (July
interests (Conn. Gen. Stat. §34-267f). Such a provision could confer differing 19, 2004)). See also Hamill, “Avoiding Traps When Electing S Corporation
distribution rights among members and, thus, invalidate the S election. Status for an LLC,” RIA Checkpoint (March 28, 2013).
11. Regs. Sec. 1.704-1(b)(2)(ii)(b)(3); Regs. Sec. 1.704-1(b)(2)(ii)(c); Regs. Sec. 14. For an excellent discussion see Hamill, “Avoiding Traps When Electing S
1.704-1(b)(2)(ii)(d). Corporation Status for an LLC,” RIA Checkpoint (March 28, 2013).
12. Regs. Sec. 1.704-2. See also Hamill, “Avoiding Traps When Electing S Cor-
poration Status for an LLC,” RIA Checkpoint (March 28, 2013).

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