29 Apr S-Corp Status, What’s in an Election?

After spending the last several weeks discussing litigation-related issues, we are switching gears today to discuss another service that Edwards Law provides – business formation.  Edwards Law has had several inquiries lately regarding corporate formation, so this is as good a time as ever to address those questions. Today’s blog will discuss the pros and cons of forming as an LLC, and electing S-corp tax status.  However, as with all of our blogs, this discussion is not legal advice and cannot be relied on as such.

LLC v. Corporation?

Before electing S-corp tax status, one must first weigh the pros and cons of forming as an LLC vs. corporation formation.  While there are cons to electing the LLC formation, the LLC provides the most benefit for the small business owner.  It’s just plain easier for a small business owner to incorporate as an LLC.

When you utilize the typical corporate status, you must follow certain state statutes relating to formation and operation.  Many of these statutes cannot be modified, and many will apply if you fail to include a contrary provision in a certificate or in the articles of incorporation or bylaws.  For a corporation, the statute controls and must serve as the roadmap for your company’s formation.

LLCs on the other hand provide for a much more lax formation.  LLCs impose few mandatory requirements.  The notion of “freedom of contract” controls the process.  Most all of the normative provisions of the LLC statutes can be modified by the LLC member’s agreement.  For example, LCCs allow for greater flexibility in enforcing restrictions on transfer, and altogether eliminate the formalities associated with the roles of shareholder, director and officer.  LLCs also make it easier to make alternate series of equity and to create individualized governance, management, and voting structures, including the elimination of rights, fiduciary duties and the ability to restrict access to information.

Electing “S-Corp.” Status

Once an entity has elected to form as an LLC, it must then decide whether to be taxed as a C-corporation or an S corporation.  “S-corp” status provides many benefits to the small business owner, but if not used correctly could result in what is called a “blown” subchapter S election.

One of the biggest benefits to S-corp status is the “pass-through” taxation it allows small business, which provides a payroll tax savings.  Generally, in an S-corporation, a shareholder’s pro-rata share of net income is not considered earnings from self-employment when earned or distributed as dividends unless dividends are paid in lieu of reasonable compensation for services rendered to the corporation by the shareholder.  In the latter case, the income can be re-characterized as wages, and subject to employment taxes.  The higher the distributive share of net income, the greater the employment tax savings.  While similar savings may be achieved for a partnership with the proper planning, it is easier to maximize the tax benefits with an S-corporation.

Other benefits include tax accounting (which can be much simpler for S-corp status than the tax accounting often required for corporations and partnerships); utilization of an employee stock ownership plan; and tax burden shifting on built-in gains.

Are There Any Downsides to Electing “S-Corp.” Status?

While the downsides are few, there could be big negative consequences to blindly electing S-corp status without understanding your business’s needs first.  For example, subchapter S taxation only allows for a single class of stock and has shareholder eligibility requirements.  The “single-class-of-stock” rule applies to economic rights of the S-corp shareholder and requires that all equity owners receive allocations of income and loss (as well as distributions of cash or property) in strict proportion to their ownership percentages.  S-corp shareholders are also restricted in their ability to issue or transfer shares to non-natural entities.  For the single-member managed LLC not looking to grow exponentially, this is a non-issue; but to an LLC owned by more than one person, this could result in what’s called a “blown” subchapter S election.  Blowing an S-corp election will trigger a reversion to a regular C corporation status and its second layer of taxation, which could have a financially-catastrophic effect on a small business owner.

How Do You Make an S-corp Election?

In order for your LLC to be taxed as an S corporation, it must make certain filings with the IRS.  There are two primary ways to do this:

(1) the LLC can first elect to be treated as an “association taxed as a corporation” by filing Form 8832, “Entity Classification Election,” and then the owners would further elect S-corporation status by filing Form 2553, “Election by a Small Business Corporation;” or

(2) the LLC can opt to skip the first step outlined in (1) above, and instead simply file form 2553.  The regulations allow for a single election to be made by fling the Form 2553 only, which is deemed a filing of Form 8832, so long as the LLC meets all of the qualifications of an S corporation at the time of filing.

The only difference between opting for (1) instead of (2) is that the entity will revert to the status of a regular C corporation if it does not qualify to be taxed as a subchapter S corporation upon filing of the Form 2553.  Opting for option (2) will result in the entity reverting to its default tax classification (such as partnership or disregarded entity).

A few Drafting Tip for the S-Corp Operating Agreement

Drafting the operating agreement for LLCs that elect S-corp status can be the trickiest part of the process.  Often operating agreements will include form provisions found in a standard LLC agreement, which could serve to blow up S-corp status if care is not taken to refine the agreement.   For example, the typical operating agreement may include a provision that requires liquidating distributions to be made in proportion to the members’ “positive capital account balances.”  However, if these balances are not strictly proportionate to the party’s ownership percentages, this would result in blowing the S-corp status.  The following drafting options could help avoid a blow-up, especially where the LLC statute itself provides for a default liquidating distribution scheme (which if applicable would result in a de-facto S-corp blow up because of violation of the single-class-of-stock rule):

          Recitals

The recitals that begin an operating agreement should spell out the entity’s S-corp election and how it was achieved.

          Company-Purpose Provision

This provision should expressly state that the company’s goal is to engage in all lawful activity other than engaging in activity that may cause it to lose S-corp status.

          S-Election Provision

This provision should lay out all steps the company will take to elect and preserve S-corp status.

          Capital Contributions and Ownership Interests

This provision should be used to set forth how the company would maintain shares of owners under the one-class-of-stock requirement of Code § 1361(b)(1)(D).

          Change S Status

This provision could be used to limit the circumstances under which a company could change S-corp status.

These are only a handful of ways to ensure your company preserves its precious S-corp status.  If you are interested in forming an LLC and need help navigating the preferable tax status for your LLC, call Edwards Law PLLC today for an initial consultation.  Edwards Law can not only assist with drafting your operating agreement, it can also offer you the benefit of its strategic alliances with business organization consulting experts, who can provide you with the formation expertise you need, without the attorney price-tag.