Ward on Iowa Limited Liability Company Law

Interesting PLR Involving LLCs and S Corps

IRS Private Letter Ruling 200927014 (March 20,2009), presents an interesting fact pattern.   The two individuals who own all of the shares of X, an S corporation, will each transfer their shares to two LLCs. They will manage their LLCs and retain all rights to profits, losses and distributions.  But each of them will also transfer certain management rights to Y.  It is not clear whether Y is an individual or an entity.  These rights include the right to participate in management of the LLCs, the right to vote on their business activities, merger or sale of substantially all of their assets, borrow money, make distributions, liquidate the LLCs, amend their operating agreements, and transfer their interests to others.  Y would also appoint new managers if the shareholders die while acting as managers. All of these actions would indirectly affect the S corporation.  Y is not a member of either LLC.

The IRS held that the transfer of the S corporation's shares to the LLCs and the role of Y in the management of the LLCs would not cause the corporation to lose its S corporation status. For tax purposes Y is not considered a member of either LLC and each LLC will be treated as owned, respectively, by the two former shareholders of X.  The shares of X are treated as owned directly by the two individuals.  The LLCs will be disregarded entities for tax purposes.

It appears from the ruling that Y will participate in management but not have sole responsibility for management.  It is not clear if Y has control, but the tenor of the ruling suggests that the outcome was not be dependent on control, but on the determination that for tax purposes membership status is based solely on the right to the economic interest in the LLC.

-Marc Ward

Converting an S Corporation to an LLC - The IRS Lays Out the Rules

In Private Letter Ruling 200839017 (Released Sept. 26, 2008) the IRS recognizes as an "F" reorganization the conversion an S corporation incorporated as a corporation under state law to a limited liability company organized under state law, so long as the entity remains an S corporation for tax purposes.

The taxpayer (corporation) made 16 representations in connection with the ruling.  You can read all 16 here, but in sum it was a plain vanilla transaction.  The units received were equal in value to the shares converted, no other consideration was paid, there were no plans by the shareholders to dispose of the units or by the company to sell any assets, no plans to redeem. 

Interestingly, the company represented there would be no dissenting shareholders.  If that continues to be a key to a conversion it might prove problematic and limit conversions to transactions in which all of the shareholders agree to the conversion in advance.  This does not appear to be a requirement in the more traditional F reorganization.

Finally, the taxpayer represented that under state law Newco would be considered the same entity after the conversion as before.  Under current Iowa law, a corporation could not make that representation.  Under the new Iowa LLC Act Section 489.1009(1) does provide that an organization converted to an LLC is the same entity as before.

Based on these representations, the Service ruled that the conversion would be an F reorganization, no gain or loss would be recognized by any of the participants, the tax basis would be unchanged and the holding periods would tack.  Also, the S election would not terminate and the taxpayer would keep its EIN.  The Service also noted that the operating agreement would not create different classes of stock because "it does not create different rights to current distributions or liquidation proceeds."  There is no way to know if these means that distributions were mandated to be pro rata, like a corporate dividend, or the IRS was recognizing the discretion inherent in LLC distributions.  Be cautious here.

-Marc Ward

Second Class of Stock Rules Can Cause Trouble for LLCs Seeking S Corp Treatment

There are situations when it is advantageous to elect S corporation status for a limited liability company.  In a future post I will address the pros and cons of partnership taxation versus S corporation taxation. 

For those LLCs that elect S corporation status it is of critical importance that the operating agreement not create a second class of stock.  More than one class of stock will destroy an entity's S corporation status.

An LLC will be treated as having only one class of "stock" so long as the governing provisions of the LLC (primarily the articles of organization/certificate of organization and the operating agreement) provide that all of the outstanding membership interests/transferable interests "confer identical rights to distribution and liquidation proceeds."  Lackadaisical drafting of the operating agreement or over reliance on forms can lead to unfortunate results in this regard.

At least one respected commentator believes he has yet to see an operating agreement that does not violate the second class of stock rule.  However, there is at least one IRS Private Letter Ruling that did find the operating agreement satisfied the requirement. See PLR 200548021 (August 23, 2005).  The drafting was no doubt precise and the provisions related to distributions and liquidations tied closely to S corporation requirements.

-Marc Ward