An LLC electing to be treated as an S corporation first needs to amend its LLC Agreement. Failing to amend the LLC Agreement may cause an otherwise good S election to be invalid.

A partner in a tax partnership can be subject to self-employment tax on that partner’s distributive share of partnership income. Limited partners, however, are not subject to self-employment tax on their distributive shares. Further, some, but not necessarily all, of a partner’s distributive share of income is subject to self-employment tax. At some point, I’ll post some thoughts on the scope of the issue raised by self-employment taxes on distributive shares of partnership income, and some ways to deal with them. This post is about a common response to self-employment taxes on partnership income:  making an election to treat the partnership as an S corporation.

An LLC may elect to be treated as an S corporation, if it is a small business corporation. An LLC is treated as a small business corporation if it meets the requirements of Code Section 1361(b):

• Has 100 of fewer “shareholders”
• Generally, only individual “shareholders” (though an estate and some trusts can be shareholders)
• No nonresident alien shareholders
• Only one class of stock.

The last criterion (single class of stock) is something the LLC interest holders and their advisors must address, ideally before the election is made. The LLC will meet the single class of stock requirement only if it’s governing documents provide that all shares confer identical interests in distributions and liquidation proceeds.

The LLC Agreement is generally the governing document for this purpose. In most cases, the LLC Agreement as drafted for the LLC as a partnership will fail to provide that all “shares” will confer identical rights to distributions and liquidation proceeds. That’s because the typical LLC Agreement for an entity making this election says that the LLC interest holders will share in liquidation proceeds according to their capital account balances. In many cases, the capital account balances will not be according to “shareholdings”.

In addition, distribution provisions in the LLC Agreement may provide that interim distributions are not shared exactly according to “shareholdings”.

Except in the rare instance that all distributions are shared in proportion to capital contributions, and all interest holders contributed cash, and each acquired his/her interest at the same time as all other interest holders acquired theirs, the LLC Agreement will be at odds with Section 1361(b)’s single-class of stock condition.

This post is intended to highlight that it’s important to amend the LLC Agreement before making an S election. It’s also important to consider capital account balances in issuing shares of “stock” and the tax consequences of the deemed section 351 transaction that happens on the election. Finally, it’s important to remove all of the partnership tax provisions of the agreement and insert in their place language that agrees with the single class of stock condition and reflects the fact that the unitholders will receive a pro rata share of S corporation income, as opposed to a distributive share of partnership income.

If you fail to clean up the LLC Agreement before making the election, all may not be lost. Code Section 1362(f) allows the LLC to correct S elections that are invalid because the makers inadvertently failed to correct an LLC agreement comply with Code Section 1361(b) conditions. However, the relief available under Code Section 1362(f) is limited. Nobody will want to rely on this.

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