Probably dumb LLC/Corp question

Technical topics regarding tax preparation.
#1
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So people create LLC's, and then elect to be taxed as either S or C corporations. Can someone explain to me why these people don't become corporations to begin with? This has always baffled me. And when it is done, what then? They are an LLC being taxed as a corporation but they are still an LLC? Or are they now a corporation? Sorry to be so dumb.
 

#2
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There is a legal aspect as well as a tax aspect to every entity.

Legal business entities include LLCs and corporations.

Tax entities include disregarded entities, partnerships, S Corps, and C Corps.

Making an S or C election for an LLC doesn't change the legal side. It's still an LLC for legal purposes and that's how it should carry itself in the world. In the eyes of the IRS however, it is taxed as a S Corp or C Corp.

People often choose LLCs over corporations as the legal entity because there is generally less maintenance involved in running an LLC for legal purposes vs a corporation.
 

#3
EADave  
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Two words, charging order. But, in most cases, it is best to have a MMLLC rather than a SMLLC; from what attorneys have told me in the last, to gain the best liability protection.

Here you go, I used the Google and found this; https://www.legalzoom.com/knowledge/llc ... s-and-llcs
 

#4
jon  
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I think if you talk to attorneys who know if you have a LLC electing to be a "S" you better have LLC articles changed. They seem to think there are several things to get changed if you want to be safe in the "S" operation.
 

#5
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Like taxable income and distribution allocations. Everything needs to be pro-rata for an S Corp based on ownership.
 

#6
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jon says "...if you want to be safe in the "S" operation."

And I ask, "safe" from what? ;)
 

#7
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In my state (Oklahoma), an LLC taxed as an S corporation is still an LLC (i.e., noncorporate entity) legally and avoids corporate franchise tax.
 

#8
JR1  
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The ones I have that have done that started out as an LLC. Profits were not high enough to justify an S corp with the added costs. So now that you have an LLC and it IS generating a profit where it makes sense, why spend $1000 to inc:? We send in the 2553 and it's done. Tough to beat.
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#9
EADave  
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Good point JR. LLCs are flexible in that you can start simple (DRE) and move into another tax structure suited best for the client’s situation.
 

#10
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About forty years ago, some whiners out in Wyoming wanted to have simple taxation *and* limited liability for some oil or gas or other natural resource extraction business, and the State of Wyoming "invented" the Limited Liability Company for them. Since then, the IRS, regulation writers, Congressional committees, state legislators, and tax professionals have struggled mightily to cope with the chaos and contradictory confusion that ensued. There must have been some alternative that wouldn't have generated so much confusion, maybe like a *federal* version of the LLC?

Yeah, maybe there were some careers that were successful cuz of all the LLC variations and uncertainty....
 

#11
jon  
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"safe" from distributions and ownership %s varying by organization type. One said in LLC articles does not say distributions must be in any ratio. LLC articles do have differences to S/C Corps unless you get them changed taxing authorities will inform you if audited. You may be in a state that has one set of articles for LLC and/or S Corp and/or C corp, but I have never been informed of one. May never have an audit or any partner stockholder problems you will be safe. I always thought at first the attorneys were trying to come up with more business(which they did), but finally decided that some of what they said even seemed possible to me.
 

#12
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jon wrote:"safe" from distributions and ownership %s varying by organization type. One said in LLC articles does not say distributions must be in any ratio. LLC articles do have differences to S/C Corps....


If you're an LLC that has elected s-corp and your 'articles' (I think you actually mean Operating Agreement) state that disproportionate distributions are allowed, that doesn't mean you are in violation of the s-corp rules. If you actually DO make disproportionate distributions, NOW you have an issue with the taxing authorities.

That said, I usually suggest s-corps rewrite their operating agreement when there are multiple owners, but there is no value in doing so if there is only one owner.
~Captcook
 

#13
Pitch78  
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Good points.

Main advantages to LLC taxed as S corp.

Less formalities required. For example, no annual meetings required. Less formalities required makes it harder to pierce corporate veil.

Better flexibility on how the company is managed.

Charging Order as EA Dave mentioned. This limits a creditor of a member to receive only distributions to which the member is entitled. In contrast, corporate stock will be sold at auction.

The reason a SMLLC does not work well regarding a charging order is due to the fact that, if bankruptcy is filed, the court (bankruptcy trustee) basically becomes the manager/owner. Also, the reason for the charging order (to protect the other members from unwanted third parties) is no longer valid in the case of an SMLLC.

Yes, you need to have the operating agreement conform to the tax status of the LLC. While the IRS may not care what your operating agreement says as long as you make pro-rata distributions in the case of an S Corp/LLC, the member entitled to the disproportionate distribution might care. The Operating Agreement, as its name states, is an agreement among the members and enforceable as such.
 

#14
jon  
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Call an attorney - I think the answer is LLC articles do not apply to an S or C Corp. activity and some are in contradiction. If that is not true then you are completely correct and do not worry about it.
 

#15
Pitch78  
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jon wrote:Call an attorney - I think the answer is LLC articles do not apply to an S or C Corp. activity and some are in contradiction. If that is not true then you are completely correct and do not worry about it.


As CaptCook said, you are talking about the Operating Agreement. The articles are what are filed with the Secretary of State (or equivalent).

The Operating Agreement applies regardless of the tax status of the entity. It needs to be fixed.
 

#16
Noobie  
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The Tax Court has ruled before that the S Corp election is not violated/revoked by disproportionate distributions, unless the disproportionate distributions are written into the stock agreement(two classes of stock).
 

#17
Nilodop  
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They seem to think there are several things to get changed if you want to be safe in the "S" operation.


Like taxable income and distribution allocations. Everything needs to be pro-rata for an S Corp based on ownership.


"safe" from distributions and ownership %s varying by organization type. One said in LLC articles does not say distributions must be in any ratio.

If you're an LLC that has elected s-corp and your 'articles' (I think you actually mean Operating Agreement) state that disproportionate distributions are allowed, that doesn't mean you are in violation of the s-corp rules. If you actually DO make disproportionate distributions, NOW you have an issue with the taxing authorities.

While the IRS may not care what your operating agreement says as long as you make pro-rata distributions in the case of an S Corp/LLC, the member entitled to the disproportionate distribution might care.

Is it true that IRS doesn't care unless and until disproportionate distributions happen? The preamble to the final regs. adopted in 1992 says
The proposed and final regulations provide that a corporation is treated as having only one class of stock if all outstanding snares of stock of the corporation confer identical rights to distribution and liquidation proceeds and if the corporation has not issued any instrument or obligation, or entered into any arrangement, that is treated as a second class of stock. Under the proposed and final regulations, the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is based on the corporate charter, articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distribution or liquidation proceeds (collectively, the governing provisions). The proposed and final regulations also provide that although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.


The actual regs. are consistent with the excerpt from the preamble. Makes me at least raise the question of whether the TPT members' views would survive an IRS challenge in a case where the OA allows for disproportionate distributions but none are made.
Last edited by Nilodop on 18-Feb-2019 11:29am, edited 1 time in total.
 

#18
JR1  
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Huh? Noobie, is there some case on that? Sounds kinda weird...if you're suggesting that an electing LLC can have disproportionate distributions. Surely not.
Go Blackhawks! Go Pack Go!
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#19
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An operating agreement allowing (or, more likely, not prohibiting) disproportionate distributions is very different than an OA providing for a special allocation of some sort.
My statement above was referencing the former, not the latter.

I would agree that, if electing 'S', an OA would need to change, if it contained a special distribution/allocation.
In such a case, if one were to follow the 'S' rules, they would be violating their OA. Additionally, a change to 'S' would change the economics of the deal for the owners.

These are issues that are of far more significant weight to discuss with the client before advising a change to 'S'.
~Captcook
 

#20
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JR1 wrote:Huh? Noobie, is there some case on that? Sounds kinda weird...if you're suggesting that an electing LLC can have disproportionate distributions. Surely not.


I think Noobie may be thinking of the Tax Court case involving a family owned S corp with disproportionate distributions over a 3-5yr period, but who rectified the disproportion in that window. The court allowed that dynamic to not affect 'S' status.
~Captcook
 

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