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Price: $69.95
Revised: December 2012- 31 pages
Description:
Form 3.4 is an operating agreement for an LLC with two or more members that intends to make an S corporation election and is managed by its members. Management rights and responsibilities in a member-managed LLC are similar to those in a general partnership, with each member having a voice in the operation of the LLC and the authority to act as its agent in the ordinary course of its business.
Tax law permits an LLC to elect to be taxed as a corporation and make an S corporation election. This arrangement combines the best of both types of entity—the flexibility in structuring the management of an LLC and the employment tax advantages of an S corporation.
But a typical operating agreement doesn’t work for an LLC taxed as an S corporation. Such an agreement is designed for an entity that will be taxed as a partnership and fails to address critical issues affecting entities taxed as S corporations. Provisions need to be both added to and deleted from a standard LLC operating agreement to make it suitable for an LLC taxed as an S corporation. These changes are sufficiently important and numerous that it’s best to start with a form of operating agreement specifically designed for an LLC taxed as an S corporation when drafting an agreement for such an entity.
IRC §1361 limits both the number and type of equity owners that an S corporation may have. Equity owners must generally be individuals rather than entities, but may be estates and certain types of trust. There may be no more than 100 holders of equity interests. It’s obvious that compliance with these restrictions must be verified at the time an LLC is created if it wants to make an S corporation election. It’s also important for the LLC’s operating agreement to prohibit the LLC and its members from taking actions that would result in the LLC’s being out of compliance. These include transferring a member’s interest to a person who does not qualify as a S corporation shareholder or admitting such a person as a new member of the LLC.
An S corporation may have only one class of stock. This means that it may not issue stock with preferences as to either current or liquidating distributions. In the context of an LLC, this has two ramifications. First, special allocations can’t be made. A member can be given an interest in the LLC in exchange for services, but it must represent an interest in both profits and capital and must have the same rights as the interests of members of equal size. Second, members’ rights to liquidating distributions can’t be based on capital accounts but must be made in proportion to the members’ equity interests. This is contrary to the rules of partnership accounting on which most LLC operating agreements are based. In fact, all provisions for capital accounts can be left out of an operating agreement for an LLC taxed as an S corporation: they are only relevant in partnership accounting.
By law, the owners of a majority of the equity interests in an LLC taxed as an S corporation can revoke the election. It is often desirable to change the required consent to a supermajority of members or all members in order to protect the expectations of holders of minority interests.
If an S corporation’s election is terminated inadvertently, the members can take steps to have it reinstated. An operating agreement for an LLC taxed as an S corporation should require all members, including past members, to participate in taking these steps, so long as it does not result in the member’s incurring unreimbursed losses.
The stakes involved in having an S corporation election terminate involuntarily or revoking it with the consent of an LLC’s members are high. If an LLC ceases to be taxed as an S corporation, it becomes taxable as a C corporation, and its income will be subject to a double tax—one imposed when the LLC earns income and again when the income is distributed to its members.
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