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LLCs Taxed as S Corporations: Welcome Relief for Inadvertent “S” Failures

 

A Disaster Waiting to Happen 

Picture it: The year is 2003. You are an owner of a limited liability company that has elected to be taxed as an S corporation. When you formed your LLC, you worked with an attorney to draft the operating agreement, and your CPA filed the S election. You went about your business, growing the company and ensuring a nice standard of living for yourself, your co-owner, and your employees.  It is now the summer of 2022, and your co-owner has decided he wants to leave the business.  You pull the operating agreement out of the drawer and, because your original attorney has since retired, you take it to your new attorney to provide advice as to the buy-out procedure.  

Enter your attorney’s nightmare: The operating agreement that you and your co-owner signed in 2003 did not contemplate that the LLC would be taxed as an S corporation. Rather, it contains all of the income tax allocation and distribution provisions that are standard for LLCs taxed as partnerships!

What to do? Should you live with an invalid S election? Can you live with an invalid S election? What potential buyer of the company would want to take on that risk?  

Your new attorney would in all likelihood recommend that the company seek a Private Letter Ruling from the Internal Revenue Service to ensure that the company’s S corporation election was valid since inception. Unfortunately, that Private Letter Ruling request likely will require payment of a $38,000 filing fee, (Rev. Proc. 2022-1, Appendix A, § A(4), 2022-1 I.R.B. 1; ABA Tax Section Comments requesting reduced PLR User Fees) in addition to the legal fees necessary to file the request. 

Fortunately, however, it is 2023 (and not late summer 2022), which means that your attorney can deliver the great news that you may be eligible to take steps to ensure you have a valid S-election without needing a PLR! 

Revenue Procedure 2022-19 (Rev. Proc. 2022-19, 2022-41 I.R.B. 282.) 

In October of 2022, the Internal Revenue Service (the “IRS”) issued Revenue Procedure 2022-19, providing the means by which an S corporation may secure relief from an inadvertent election or termination without the necessity of obtaining a private letter ruling.   

Retroactively Correcting One or More Non-Identical Governing Provisions 

In the case of an LLC that has elected Subchapter-S Status, where the LLC’s operating agreement contains distribution and liquidation provisions that otherwise could give rise to a second class of stock (such as the provisions described in the “Disaster Waiting to Happen” above), as long as the LLC/S corporation and its shareholders meet certain specified requirements and are otherwise eligible, (Rev. Proc. 2022-19, 2022-41 I.R.B. 282, Section 3.06.), then the LLC/S corporation can essentially self-correct the error, and the IRS will treat the LLC/S corporation as having a valid S-election.   

Importantly, to secure retroactive correction, in addition to meeting the eligibility requirements, the S corporation must: (1) Correct the errors in the governing provisions (e.g., amend the operating agreement); (2) complete a Corporate Governing Provision Statement, which must be kept in the company’s file and must be signed under penalties of perjury by an authorized person; and (3) have each shareholder sign a statement attesting to various items, including that each shareholder reported income consistent with the S election.  

Time to Act 

Importantly, the corrective action must be taken before any non-identical governing provision is discovered by the IRS, which means that any LLC taxed as a Subchapter S corporation should review its operating agreement and consider taking corrective action (if necessary and if eligible) sooner rather than later.  

About the Tax Group

Business Tax Planning

Our Business & Corporate Transactions Team navigates and plans for the tax consequences of business transactions, including:

  • Choice of Entity and Tax Classification
  • Mergers and acquisitions
  • Executive Compensation
  • Tax Deferred Section 1031 Like-Kind Exchanges

 

Tax Controversy

We provide legal counsel to businesses and individuals in federal, state, and local income, employment, sales and use, and excise tax examinations and disputes and advocate for and defend clients in disputes with the Internal Revenue Service, the United States Department of Justice, and state taxing authorities

We provide guidance in a wide variety of tax controversy matters including:

  • Advance guidance via Private Letter Ruling requests
  • Dispute resolution via audits, administrative appeals, and litigation
  • Representation of clients under criminal investigation for, or charged with, tax and related financial crimes
  • International tax compliance
  • Resolving significant tax delinquencies

 

Private Client Services: Tax Advice and Consultation

Our Private Client Services Team counsels clients regarding income, estate, and gift tax planning in connection with overall estate planning.

 

Tax-Exempt Organizations

Capes Sokol has significant expertise in counseling and assisting clients with the formation of tax-exempt corporations and in securing and maintaining their tax-exempt status.

About Capes Sokol

At Capes Sokol, we strive to find the best solutions to our client's legal problems and to turn even complex challenges into opportunities. That’s why each member of our St. Louis-based team is committed to looking at every issue from multiple angles. We bring teamwork and collaboration across disciplines. We take the time to listen and understand our clients' industries, problems and challenges. And then we apply deep legal knowledge, experience and creativity all leading to strategies and execution that just make sense.

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