Ineffective S Corp Elections

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Limited Liability Companies (LLCs) are amazingly flexible in structuring a deal. As mentioned elsewhere, you can build an LLC with all kinds of deal structures such as-

• Special allocation of income and losses (including qualified income offsets to maintain compliance),

• Liquidating distributions made in accordance with positive capital account balances,

• Employment agreements,

• Buy-sell and redemption agreements, and

• Options and warrants, including convertible debt.

This list isn’t exhaustive, but what this is telling us is that certain agreements inside and outside the Operating Agreement might make the S Corp election ineffective. Why? Special allocations are simply not allowed in a S Corp. That’s easy. However, the outside agreements such as employment, buy-sell, redemption, options, warrants, debt instruments, etc., can create a second class of stock. As you might recall, an S corporation can only have one class of stock (voting and non-voting is allowed, however) according to IRC Section 1.1361-1.

Let’s use buy-sell or redemption agreements as an example. It is common for business owners to enter into agreements where shares or interest may be redeemed upon a certain event such as a change in ownership or change in control. This in itself does not create a second class of stock. However, if the purchase price is significantly above or below the fair market value of the shares or interest, it might invalidate the S Corp election.

In continuing with our example, there is a safe harbor where book value may be used. In other words, if the purchase price is somewhere between fair market value and book value, this would be a strong argument that the buy-sell or redemption agreement does not create a second class of stock.

The big lesson is that having an entity taxed as an S Corp suddenly truncates some of the flexibility offered by various deal structures and Operating Agreements (and the like). The determination of a second class of stock is largely based on the governing documents. However, whether all shares have equal rights to distribution and liquidation proceeds is ultimately the deciding factor.

Please don’t get too hung up on this. It doesn’t affect 99% of the businesses out there who are exploring an S Corp election.

What happens if you made an S Corp election but perhaps shouldn’t have? There are several Private Letter Rulings from the IRS that are littered with all kinds of examples. Here are some recent ones-

PLR 202053005 (Oct 6, 2020)
PLR 202110002 (Nov 2, 2020)
PLR 202111011 (Dec 22, 2020)
PLR 202124002 (Mar 19, 2021)

A lot of these are after-the-fact “oopsies” where the entity is now asking for relief from the IRS for electing S Corp status when in fact their Operating Agreement or other agreements made the S election ineffective. As a side note, the user fee charged by the IRS can range from $3,000 to $12,600 (and sometimes as high as $38,000). This does not include your attorney’s fee. So, Yes, these PLRs had some big reasons to ask for forgiveness.

What can be done if your entity has “some hair” on its agreements and overall governance? First, you can amend or re-state your agreements to become compliant prior to electing S corporation tax status. But more importantly, the question should be asked, “Why do you need an S corporation election here?”

We don’t want to get too far into the weeds with discussions of Q Sub elections where two S corporations are combined (parent is an S corporation and an eligible subsidiary wants to be taxed as an S corporation as well). That’s another book, or at least a thick pamphlet for sure, discussing all the reasons why.

Small Spoiler: Most small business acquisitions are an asset sale versus a stock sale, but if the entity you are acquiring cannot transfer its assets easily, then you might have to purchase the stock and file a Qualified Subchapter S Subsidiary election for the combination. An example would be an entity who has a lucrative long-term government contract that cannot be re-assigned. In this case you would buy the entity as a whole, warts and all, versus just the assets (e.g., government contract).

However, if the objective is pass-through taxation and the avoidance of self-employment taxes associated with the entity’s income, a multi-entity arrangement as discussed in Chapter 2 might be your best bet.