Page 518 - TaxAdviser_2022

LLCs & LLPs

etc., that contain legal characteristics
that offer the members priorities as to An S corporation is not an attractive
distributions and/or a rate of return
on their investment would run afoul investment vehicle if the corporation is
of the one-class-of-stock rule if the seeking new rounds of investment funds from
LLC were to elect S status. Therefore,
an S corporation is not an attractive individual investors that require an investment
other than plain-vanilla common stock.
investment vehicle if the corporation
is seeking new rounds of investment
funds from individual investors that
require an investment other than plain-
vanilla common stock. 4. Newco meets the requirements for Newco and the acquirer as members/
qualification as an S corporation. partners. The acquirer could also
Reason 10: Maintaining 5. Newco timely elects to treat Y as a purchase 100% of Newco’s member-
passthrough treatment in an qualified Subchapter S subsidiary ship interest in Y. This would be
M&A transaction (QSub).47 Y then becomes a disre- treated as a deemed asset purchase,
Maintaining passthrough treatment garded entity.48 and Y would become a disregarded
and single-level taxation can be chal- 6. In year 2, Newco sells a 1% inter- entity to the acquirer. In either
lenging for an acquirer that is not est in Y to D. case, the acquirer has preserved the
an eligible shareholder of S corpora- The IRS ruled that Y’s original passthrough treatment without caus-
tion stock. A corporate acquirer or S election does not terminate but ing Y to convert to a C corporation.
a multimember LLC acquirer of S continues for Newco. Y retains its
corporation stock would terminate the employer identification number Often overlooked
S election because they are ineligible (EIN). Newco must obtain a new considerations
S shareholders. There are no member EIN. Upon the sale of 1% of Y, Y’s The discussion above offers at least
eligibility rules for LLCs classified as QSub election terminates (because it 10 reasons why LLCs should not
partnerships for tax purposes. is not 100% owned after the sale of elect S status. There may be more.
There is, however, a possible 1% to D). An LLC’s election to be classified as
workaround to this problem that has Tax advisers have added another an S corporation results in a hybrid
become popular in recent years due step to this transaction. Immediately entity with state law characteristics
to the IRS’s issuance of Rev. Rul. after the QSub election for Y, Y is that align in many respects with a
2008-18. The workaround involves a converted to an LLC under a state partnership while being treated for
pre-acquisition restructuring using an law conversion statute. Y will then tax purposes as a corporation. This
F reorganization.46 The downside is become a single-member LLC and a can create traps and can result in
that with any legal restructuring, there disregarded entity. This step should adverse tax consequences, including
are several steps along with associated be nontaxable because a disregarded the disqualification of the S corpora-
fees and costs. In Rev. Rul. 2008-18, entity (the QSub) is converting tion election. In our view, in many
the IRS ruled that the following facts to another disregarded entity (the cases, the payroll tax savings are
meet the requirements of a nontaxable single-member LLC). After the outweighed by the disadvantages of
F reorganization: conversion to an LLC, an investor Subchapter S. The failure to review
1. B, an individual, owns all of the purchases a membership in the LLC the operating agreement for provi-
stock in Y, an S corporation. either from Newco or directly from sions incompatible with Subchapter
2. In year 1, B forms Newco. the LLC under Sec. 721. Y would S can result in the termination of the
3. B contributes all of the Y stock to then transform into a multimember S election. When making the choice
Newco. LLC treated as a partnership with whether to elect S status for an LLC,

46. An F reorganization is a nontaxable reorganization and is defined as “a mere 47. See line 14 of Form 8869, Qualified Subchapter S Subsidiary Election, which
change in identity, form, or place of organization of one corporation, how- includes a question whether the QSub election is being made in combination
ever effected” (Sec. 368(a)(1)(F)). with an F reorganization described in Rev. Rul. 2008-18.
48. Sec. 1361(b)(3)(A).

32 October 2022 The Tax Adviser