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A Better Partnership


Apr 2014
April 08, 2014

Common pitfalls to avoid when converting an LLC into an S Corporation

A growing number of LLCs are electing to be treated as S corporations for tax purposes, but that strategy could backfire if the original corporation’s operating agreement isn’t amended properly.

The result could be an entity with an invalid S corporation election or an election that is involuntarily terminated.  Either situation can have unexpected, dramatic and adverse impacts on the LLC, its owners and the dynamics of a merger or acquisition in which the LLC is involved. Other potential problems include: 
  • Preferential economic rights: LLCs can use preferential economic rights to give some members of the company larger distributions than others, but that arrangement violates the “one class of stock” rule applicable to S corporations. If the LLC operating agreement provides for preferential rights, it is believed that the S corporation election is invalid from the outset.  An LLC could file S corporation returns unaware of this flaw, and the problem could go undetected for years, but it could become an issue during an IRS audit or when a buyer reviews the operating agreement during due diligence. The fix is not entirely clear, but the uncertainty surrounding the issue could sink a transaction.
  • Operating agreements follow the company: LLC operating agreements apply to the subsequent S corporations and cannot be voided by an action of the managers or officers. The operating agreement is an executory contract that the IRS will use to hold the company and its members accountable. Some LLC operating agreements are meant to reallocate taxable items among the members. For instance, if a member contributes appreciated tangible property, the typical LLC operating agreement states that depreciation will be allocated in accordance with a particular method under the 704(c) income tax regulations. But this arrangement conflicts with the “per share per day” allocation rule applicable to S corporations.
  • Different rules for distributions: LLC operating agreements allow liquidating distributions to be made in accordance with positive capital accounts. This doesn’t work with S corporations because S corporation owners do not have capital accounts and if someone made distributions on an “as if” basis, the distributions may not comply with the “one class of stock” rule.
How to avoid potentially devastating traps

These problems can be avoided by amending the LLC operating agreement so it conforms to S corporation rules. If an S corporation election has already been made, the operating agreement needs to be reviewed to determine whether the election is valid. If the S corporation election is invalid at the outset or was subsequently the subject of an involuntary termination, remedial measures should be considered before the IRS or a would-be buyer discovers the problem.
For more information or review of your tax classification, please contact:

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