Many people are aware that virtually anyone can form a South Carolina limited liability company (“LLC”) online without the assistance of an attorney. This is not true of corporations, because an attorney must sign a certification contained in the Articles of Incorporation. Many people are also aware that an LLC may elect to be treated as a corporation for tax purposes. The default entity classifications for an LLC are: (I) a single member LLC is treated as a sole proprietorship, but the election may be made to treat the LLC as a corporation for tax purposes; (ii) a multi-member LLC is treated as a partnership unless the election is made to treat the LLC as a corporation for tax purposes.
Any LLC that elects to be treated as a corporation for tax purposes will be taxed as a “C” corporation unless the members elect “S” corporation status by filing Form 2553 within the applicable time period for making that election. The election to be taxed as a corporation is generally made when apply for the entity’s EIN using Form SS-4 or online at www.irs.gov, but the zebra may be able to change its stripes by subsequently filing Form 8832.
Some people believe that when an LLC elects to be treated as a corporation for tax purposes it magically converts to a corporation under state law. This is not the case. In South Carolina, LLCs are subject to the provisions of and governed by the Uniform Limited Liability Company Act of 1996 (the “Act”). Electing to be treated as a corporation for tax purposes is nothing more than a tax election. All of the provisions of the Act governing LLCs continue to apply. The Act permits, but does not require that, the LLC to adopt an operating agreement. If the LLC does not adopt an operating agreement, then the Act steps in and specifies how the LLC will be operated. Leaving operational provisions to be handled under the Act can provide unintended results. For example, SC Code §33-44-405 provides:
SECTION 33-44-405. Sharing of and right to distributions.
(a) Any distributions made by a limited liability company before its dissolution and winding up must be in equal shares.
(b) A member has no right to receive, and may not be required to accept, a distribution in kind.
(c) If a member becomes entitled to receive a distribution, the member has the status of, and is entitled to all remedies available to, a creditor of the limited liability company with respect to the distribution.
One of the very real problems encountered when anyone other than a tax professional forms an LLC and prepares an operating agreement for the LLC to adopt (e.g., using a form found on the internet), is that the operating agreement may contain language that will run afoul of the single class of stock requirement that an S corporation must satisfy. While LLCs do not issue stock, the single class of stock requirement applies to equity interests in the LLC (i.e., membership interests). Using an operating agreement designed for a partnership, the default entity type for multi-member LLCs, can unintentionally create a second class of equity interest. If this comes to light at a later time, during an audit, for example, the S election may be retroactively revoked. The revocation may be prevented by IRS procedures for inadvertent S election terminations, but why take that chance? Before adopting an operating agreement, consult a qualified tax professional.