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New IRS Ruling Shows the Dangers of Standard LLC Agreement Provisions When an S Election is Made

By Anthony P. Daddino, P.C. on September 3, 2019

Most LLC agreements provide that distributions will be made to members in accordance with their positive capital accounts. In fact it is virtually boilerplate.  So what happens when an LLC makes a Subchapter S election with this provision in its LLC agreement?   You guessed it -- a second stock of class, and the need for IRS relief in resurrecting the S election, as a new IRS private letter ruling reveals. 

The facts in Private Letter Ruling 201930023 (released July 26, 2019) are straightforward.   A limited liability company was formed under state law, and elections were made for it to be treated as an association taxable as an S corporation.   The original LLC agreement provided that distributions would be made to members in proportion to their respective membership interests.  The LLC agreement was later amended, however, to state that distributions would be made to members in accordance with positive capital account balances.   [It is not clear in the ruling what prompted the amendment, and in most instances, you would expect the initial LLC agreement to have such a provision.]   The LLC eventually discovered the problem, i.e., that liquidation based on positive capital account balances did not provide identical rights to distribution and liquidation proceeds , as required for S corporation eligibility under Section 1361 and interpreting regulations.  The LLC promptly amended its LLC agreement, reverting back to the original language which provided for distributions based on pro rata ownership percentages.  The LLC proceeded to file a private letter ruling request, asking the IRS to “forgive” its inadvertent S election termination.

Fortunately for the LLC, the IRS is very forgiving when to comes to providing S election relief.   The LLC was granted relief, but not after paying the IRS a hefty user fee (upwards of $30,0000) on top of professional fees in preparing the PLR request.  Of course the alternative was likely far more expensive:  without IRS relief, the LLC would have defaulted to C corporation status of federal income tax purposes.  Although the LLC terminated its S election by amending LLC agreement, such amendment did not otherwise affect its election to be treated as a corporation for federal income purposes which remained in effect.  The LLC did not default to a partnership status for tax purposes.    

The lesson learned?  For LLCs, S corporation status is not simply an “election” away.  Due diligence must be conducted to confirm that the LLC agreement is otherwise S corporation ready and does not contain provisions that run afoul of the S corporation eligibility requirements. 

For a copy of the above PLR, follow this link:  https://www.irs.gov/pub/irs-wd/201930023.pdf.

For more information on the private letter ruling process, see my prior blog post linked here.

If you have any other questions about this blog post, please do not hesitate to contact me at (214) 749-2464 or adaddino@meadowscollier.com.