Choosing S-Corp Status for an LLC: Why the Operating Agreement Matters

When business owners form a limited liability company (LLC), one of the early strategic decisions is how the entity should be taxed. By default, an LLC with one member is treated as a disregarded entity, and an LLC with multiple members is taxed as a partnership. But many entrepreneurs elect for their LLC to be taxed as an S-corporation (“S-corp”) to take advantage of potential self-employment tax savings and other benefits.

On its surface, the election seems straightforward: file Form 2553 with the IRS. But beneath that simplicity lies a set of rules and traps that must be carefully addressed in the LLC’s operating agreement to ensure the company remains compliant with S-corp requirements.

Why Choose S-Corp Status for an LLC?

For many small business owners, an S-corp election provides a middle ground between the flexibility of an LLC and the tax advantages of a corporation. Benefits often include:

• Self-Employment Tax Savings: Members can classify a portion of income as salary (subject to employment taxes) and the remainder as distributions (not subject to self-employment tax).

• Pass-Through Taxation: Income is taxed once at the shareholder level, avoiding double taxation.

• Flexibility in Structure: Unlike a corporation formed under state law, an LLC taxed as an S-corp can retain the contractual freedom of an operating agreement while enjoying S-corp treatment.

But with those benefits comes the need to strictly follow IRS rules that govern S-corporations.

Key S-Corp Requirements

The Internal Revenue Code imposes several requirements for S-corp eligibility:

1. Eligible Owners: Shareholders must be individuals (with limited exceptions), U.S. citizens or residents, and cannot be partnerships or corporations.

2. Single Class of Stock: S-corps can only have one class of stock. While voting rights may differ, economic rights (profits, losses, and distributions) must be equal across all owners.

3. Limited Number of Shareholders: Generally capped at 100.

4. Distributions and Allocations: Must be proportional to ownership interest; no “special allocations” permitted.

Violating any of these rules can result in termination of S-corp status, which could cause substantial tax consequences.

Why the Operating Agreement Matters

Here’s where many LLC owners run into trouble. LLC operating agreements are often drafted with broad flexibility, particularly when structured like a partnership. Common provisions often found in standard or boilerplate operating agreements can run afoul of S-corp rules:

• Special Allocations: LLCs often allow profits or losses to be allocated disproportionately among members. This violates the “single class of stock” rule.

• Discretionary Distributions: If the agreement allows distributions at the discretion of the manager without regard to ownership percentage, it risks creating multiple “classes” of equity.

• Buy-Sell and Redemption Provisions: Careless drafting could create differing economic rights between members.

• Voting and Control: While differences in voting rights are permissible, the agreement must be clear that economic rights remain equal.

A carefully drafted operating agreement must therefore mirror the uniformity required by the S-corp rules while still maintaining the operational flexibility LLC owners value.

Best Practices for Drafting an S-Corp LLC Operating Agreement

1. Equalize Economic Rights – Ensure ownership interests determine both distributions and allocations of income.

2. Avoid Partnership-Style Allocations – Do not include provisions for special allocations of tax items.

3. Align Distribution Provisions with Ownership – State clearly that distributions are made in proportion to ownership percentages.

4. Review Transfer Restrictions – Ensure transfers are limited to eligible shareholders to avoid disqualification.

5. Coordinate Compensation Arrangements – Remember that owner-employees must receive a “reasonable salary” to comply with IRS requirements.

Takeaway

Electing S-corp status can provide meaningful tax advantages for LLC owners, but only if the company’s governing documents are aligned with IRS requirements. An operating agreement drafted without attention to these nuances could inadvertently jeopardize the election and expose the business to unwanted tax consequences.

Business owners should consult legal and tax professionals when considering this election to ensure their operating agreement supports the benefits of S-corp status and does not unintentionally undermine it.