MMLLC Electing S Status

[jeanniee]

New client has set up multi-member LLC and wants to elect S status. I have asked a lawyer to prepare an operating agreement. He did as requested except he prepared it with typical partnership language. I have read how you have to be careful that the operating agreement does not allow a second class of stock. Does anyone have a template or know of one that I can reference? My lawyer doesn't seem to be knowledgeable in this area and we're in small town USA where I don't have a lot of options. Thanks!

[Nashville]

I dream of Jeanniee

Remember that the lawyer is not setting up a corporation, but instead an LLC. Although the LLC may elect to be taxes as a corporation, the typical corporate structure involving capital stock, paid-in capital, etc. does not apply. There should not be "classes" of stock in an LLC to begin with. In most states there won't be any "stock" at all, just percentages of ownership.

I do believe all the LLC members should be individuals and percentages of ownership and income be preserved, or the reporting structure under an S corp may become violated. Although you may not have paid-in-capital, you WILL have other resultant accounts such as Retained Earnings.

[ATSMAN]

New client has set up multi-member LLC and wants to elect S status. I have asked a lawyer to prepare an operating agreement. He did as requested except he prepared it with typical partnership language. I have read how you have to be careful that the operating agreement does not allow a second class of stock. Does anyone have a template or know of one that I can reference? My lawyer doesn't seem to be knowledgeable in this area and we're in small town USA where I don't have a lot of options. Thanks!

Jeanniee why are you asking your lawyer to prepare the documents for your client's LLC? You could refer them to a competent lawyer and let them deal with the lawyer directly. You could even refer them to legalzoom?

This is for your information:

http://www.nolo.com/legal-encyclopedia/llc-operating-agreement-30232.html

[DaveinTexas]

My 2 cents

I will just add the verbiage from IRS LTR 200548021:
This letter responds to the letter dated January 18, 2005, and related correspondence, written on behalf of X, requesting a ruling that a draft limited liability company (LLC) agreement of X, once executed in a substantially identical form, will be a “governing provision” within the the meaning of § 1.1361-1(l)(2)(i) of the Income Tax Regulations, and the agreement will not cause X to have more than one class of stock within the meaning of § 1361(b)(1)(D) of the Internal Revenue Code (“Code”). This ruling supplements the private letter ruling issued to X on April 8, 2005 (“April 8, 2005 letter ruling”).

This tells me that even though the underlying entity is an LLC, the operating agreement language won't violate the 2nd class of stock S Corp rule. Here is a link to the PLR: http://www.irs.gov/pub/irs-wd/0548021.pdf

This PLR is an answer to the question of when an S Corp converts to an LLC, it will not lose its S Status, nor will the operating agreement (as the new LLC) will not affect the 2nd class of stock rule for S Corps. The verbiage I think is important to note is the following:
"once executed in a substantially identical form". Your client just may have to hire a competent attorney to explain that comment in the PLR.

[Roland Slugg]

Jeanniee why are you asking your lawyer to prepare the documents for your client's LLC?

I wondered the same thing.

I don't believe the wording in the underlying agreement is especially important. If the agreement the lawyer drew up is a basic, vanilla p'ship agreement, it probably refers to all the partners having equal rights, differing only by the percentages of ownership. Even if the agreement allows for two or more tiers of partners, each with different voting privileges, it shouldn't matter as long as all the partners are in the same tier ... presumably general partners.

I trust you understand, and that your client's underlying owners understand, that once the election to be taxed as a corporation (by filing IRS F-8832) or as an S corporation (by filing IRS F-2553) is made, that the entity will be treated as a corporation from then on, and that the underlying owners will be deemed to be shareholders of that corporation. Once made that election converts the entity to a corporation in all tax respects, not just for figuring the tax on each year's taxable income.

[jeanniee]

"My client" is actually my daughter and her husband. The lawyer I referred this work to is the only lawyer in town. So I used the term "my lawyer" but it is actually just "a lawyer". And since I'm doing the work pro bono it's all starting to feel like a big mistake. Perhaps I'm making too big of a deal out of the operating agreement. I have always used the PPC Deskbooks and according to the Guide to Limited Liability Companies, page 6-34 and 6-35 the operating agreement should comply with subchapter S rules.

[jeanniee]

And as an afterthought I'm wondering why it's an issue that I'm referring work to a lawyer. I know my boundaries as a CPA. I am not to perform legal work. I am always looking for ways to help my clients save taxes, that is my job, and I frequently refer work to a lawyer, and before my clients sign anything I recommend that they have me review it to see if it accomplishes their goal. As a CPA my goal is to be a trusted business advisor.

[buzzardbreath]

Doesn't have to be an issue

if this is a lawyer with whom you work well together.

Many of us who work with fledgling entities do a great deal of "damage control" where attorneys advise under the discipline of law, but leave the client terribly exposed with lack of tax planning. Usually the client believes everything is OK when he comes into our office to get his taxes filed, but then learns the truth.

That being said, there are a couple of lawyers who I work with very well, and some that I have to go behind and pick up the pieces.

[jsamans]

I don't believe the wording in the underlying agreement is especially important. If the agreement the lawyer drew up is a basic, vanilla p'ship agreement, it probably refers to all the partners having equal rights, differing only by the percentages of ownership. Even if the agreement allows for two or more tiers of partners, each with different voting privileges, it shouldn't matter as long as all the partners are in the same tier ... presumably general partners.

Partnerships make distributions in liquidation on the basis of capital accounts that are tallied differently than those used for recording basis in S-Corps, which has the effect of conveying more than one class of stock as it relates to equity ownership and is incompatible with an S-Corp election. If a standard partnership operating agreement is used -- specifically, language regarding qualified income offsets, minimum gain chargebacks, and the maintenance of capital accounts -- the S-Corp election is invalid.

This reference can help you rework the operating agreement so it passes muster: http://www.taxwarriors.com/Portals/1...3_28_2013_.pdf