LLC members have the right to elect that their company be taxed as an S corporation, rather than as a partnership (if there are multiple members) or a “disregarded entity” (if there is only one member). If such an election is made, the LLC will continue to be recognized as an LLC under North Carolina law, but will receive S corporation tax treatment from the IRS. Electing to have an LLC taxed as an S corporation is a relatively straightforward process with the IRS with the members merely needing to execute and submit Form 2553 to the IRS.
Why would an LLC want to be taxed as an S corporation? One of the more common reasons for an LLC to make such an election is the payroll tax treatment of “shareholder-employees” in an S corporation versus the self-employment tax treatment of members in an LLC. For LLCs taxed as partnerships, if the members provide services to the company and have management control over the company, then the entire amount of income flowing through to the members is subject to self-employment tax in the eyes of the IRS. By contrast, for LLCs that have elected to receive S corporation tax treatment, if the members pay themselves a “reasonable” salary for the services they provide to the company, then only the salary portion of the income flowing through to the members is subject to payroll taxes.
However, there is more to the process of having an LLC taxed as an S corporation than submitting Form 2553, in particular, the members need to pull out their operating agreement and make some important modifications.
By electing S corporation tax treatment, the members are required to adhere to the eligibility rules applicable to S corporations, including the requirement that there be only “one class of stock”. If all members have identical rights to distribution and liquidation proceeds in proportion to their respective membership interest percentage, then the “one class of stock” requirement will be satisfied. On the other hand, if there are provisions in an operating agreement that call for distributions to be disproportionate to the membership interest percentages, then the rule is not satisfied and the company will be deemed to have more than one class of stock.
Many standard LLC operating agreements are drafted with the intent of the LLC being taxed as a partnership, and thus will fail to comply with the “one class of stock” requirement. The standard partnership tax law provisions in a standard operating agreement need to be properly modified or deleted in order to comply with this requirement. Any specified priorities on cash distributions or provisions that require distributions on liquidation of a member’s interest to follow capital accounts need to be deleted. Any preference or guaranteed returns for capital will also need to be eliminated. Even if an LLC has made every actual distribution strictly in proportion to the members’ interests, the fact that the operating agreement contains provisions that would allow for disproportionate distributions will violate the one class of stock requirement and create issues with the S corporation election.
The operating agreement needs to be reviewed and modified by an experienced business attorney to make certain the provisions are compliant with the S corporation requirements prior to any submission of Form 2553 to the IRS. If you are considering having your LLC elect S corporation tax treatment, please contact our firm, Connors Morgan, PLLC, and one of our business attorneys will be happy to assist in the review and modification of your operating agreement.