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Say It Isn’t So

At different times over the course of the last thirty days or so, I have seen reports describing various plans to increase income taxes and/or wealth taxes on the “rich” that have either been endorsed or proposed by the likes of China’s President Xi Jinping, California’s Gov. Newsom, the Commonwealth of Massachusetts, Democratic Party leaders, and the European Central Bank, as a way to facilitate economic growth, redistribute wealth, and support vulnerable groups.[i]  

One of these things is not like the others,
One of these things just doesn’t belong,
Can you tell which thing is not like the others
By the time I finish my song?

Unable to answer this decades-old question posed by the characters of Sesame Street – mind you, it was not for want of trying – I decided to focus instead on another issue, one that came from a client who had organized their closely held, actively conducted business as a limited liability company (LLC) under state law.

As it turned out, this endeavor was almost as frustrating.

LLC Qua S Corp?

“We’d like to elect S corporation status for our LLC,” the client said.

My immediate reaction was to ask them, “Are you aware what becomes of a superhero who relinquishes their superpowers?” It doesn’t end well.

Judging from the client’s facial expression – I am not fond of Zoom – I realized this was no laughing matter.

It also made me realize that this is a topic worth discussing with a business owner who is considering the appropriate form of entity through which to operate their business, and who must determine how or whether the entity’s desirable features under state law may be reconciled with the owners’ economic arrangements and preferences as to taxes.

Setting taxes aside for the moment, what is so special about an LLC as compared to a state law corporation?

LLC vs Corp Under State Law[ii]

What follows immediately below is an admittedly cursory review of some key features of New York’s limited liability company law and a comparison thereof to their counterparts in the state’s business corporation law.


Both LLCs and corporations are creatures of state law: an LLC is created when its articles of organization are filed with the state’s department of state; a corporation when its certificate of incorporation is so filed.


An LLC’s articles are not required to but may set forth the business purpose for which the LLC is formed.

A corporation’s certificate must set forth the purpose for which it is formed, though it may simply state that its purpose is to engage in any lawful act or activity form which corporations may be formed under state law.


Significantly, if the LLC does not timely satisfy the publication requirement[iii] set forth in the LLCL, its authority to carry on business in the state will be suspended, though the validity of any prior act or contract of the LLC will not be limited. Likewise, the rights or remedies of any other party to such act or contract will not be impaired.[iv]

No such publication requirement applies to corporations.


The certificate of incorporation must also set forth the aggregate number of shares the corporation may issue and, if the shares are to be divided into different classes, the number of shares of each class together with a statement of the relative rights, preferences, and limitations of each class.

Notwithstanding that the certificate of incorporation may deny, limit, or otherwise define the voting, dividend, or liquidation rights of shares of any class, no such denial, limitation or definition shall be effective unless at least one class of outstanding shares is entitled to full voting rights and to unlimited dividend and liquidation rights.[v]

Similarly, an LLC’s articles may provide for classes of members having such relative rights, powers, preferences, and limitations as the LLC’s operating agreement may provide, or it may provide for the future creation of additional classes pursuant to the operating agreement.[vi]

If it becomes necessary to change any of the foregoing items as set forth in the articles or certificate, an amendment thereto must be filed with the department of state.


In the case of an LLC, unless its articles provide for management by a manager, the company will be managed by its members. That said, the LLC’s operating agreement may grant or withhold management powers or responsibilities from one or more members.[vii]

Except as otherwise provided in the operating agreement, each member of an LLC has the right to vote in proportion to their share of LLC profits in managing the affairs of the LLC.

However, the qualifier “except as otherwise provided in the operating agreement” allows the establishment of a board of managers and of officers for the LLC.

The business of a corporation is managed by its board of directors, the members of which are elected by the shareholders of the corporation.[viii] The shareholders, as such, are not authorized to manage the corporation, though they typically vote themselves in as directors – we’re considering a closely held business here, after all.

The board of directors may elect officers to perform such duties as the board may determine or as provided in the by-laws.[ix]

Operating Agreement

The members of an LLC are required to adopt a written operating agreement[x] that contains provisions relating to the LLC’s business, the conduct of its affairs (governance), and the rights, powers, preferences, limitations, or responsibilities (including without limitation voting and economic rights) of its members or managers, as the case may be.[xi]

The operating agreement may be amended by the members in accordance with its terms.

A corporation and its shareholders are not required to enter any sort of agreement with respect to governance; the statute and the corporation’s by-laws cover most issues. A shareholder’s economic rights are determined by their class of stock, though a shareholders’ agreement is often useful for addressing the disposition of one’s shares of stock.


The members of an LLC are required to meet at least annually unless otherwise provided by the operating agreement; thus, the requirement for such a meeting may be eliminated.

In the case of a corporation, an organizational meeting must be held for the purpose of adopting by-laws and electing directors.

Thereafter, the shareholders must meet annually for the election of directors, though they may participate remotely.[xii] Two or more shareholders may enter a written agreement with respect to the exercise of their voting rights.[xiii]

The shareholders must be given advance notice of any meeting.[xiv]

Profits and Distributions

The profits and losses of an LLC, and distributions of cash and other property by the LLC, are allocated among the members in the manner provided in the operating agreement.[xv]

In the case of a corporation, subject to the relative rights, preferences, and limitations of each class of shares outstanding, each share shall be equal to every other share of the same class in terms of both dividends and liquidating distributions.[xvi]

The board of directors may declare and pay dividends, the right to which is determined by a shareholder’s class of stock.[xvii]


Unless the operating agreement provides otherwise, the only effect of an assignment of a membership interest is to entitle the assignee to receive, to the extent assigned, the distributions and allocations of profits and losses to which the assignor would be entitled.[xviii]

In the case of a corporation, its shares are transferable by the shareholders in the manner provided by law and in its by-laws.[xix] What if a corporation recapitalized into voting and non-voting stock, with the voting stock representing a very small portion of the total equity – basically, economic rights only?

Limited Liability

Assuming the entities are properly organized, are respected by their owners as separate legal entities, and abide with the applicable statutes and their internal governing provisions, each will provide its owners with protection from the liabilities of the business.[xx]

Conclusions Drawn?

Based on the foregoing, can we say that the differences between the two statutes are significant enough to sway the owners of a business toward the LLCL and away from the BCS?

Without considering the income tax consequences arising from one form of entity as compared to another and focusing only on the “default” rules of the LLCL, I would say “no” though it must be conceded that a corporation’s certificate would need some careful tweaking to approximate the outcome under those rules.

However, if one introduces the ability afforded under the LLCL to draft around that statute’s default rules, then the LLC is the better choice.

But how does one explain an owner’s decision to use the LLC form of business entity but to reject the flexibility afforded under the LLC statute?

Stated differently, why would an LLC elect to be treated as an S corporation for tax purposes?

To better appreciate the inherent inconsistency of this decision, one needs to understand the requirements for qualification as an S corporation.

S Corporations

A domestic corporation is eligible to elect treatment as an S corporation for tax purposes if it does not:

  • have more than 100 shareholders;[xxi]
  • have as a shareholder a person other than an individual who is not a nonresident alien, the estate of such an individual, certain kinds of trusts,[xxii] or certain tax-exempt organizations; and
  • have more than one class of stock.[xxiii]

In other words, an S corporation cannot have a partnership, a corporation, or a foreign person as a shareholder.

A corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock.[xxiv]

The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds.[xxv]

Thus, for example, an S corporation cannot have special allocations of income or deductions, gains or losses, among its shareholders – all shareholders must include their pro rata share of such items in determining their taxable income; nor can any shareholder have a preferred return on (or a preferred distribution of) their investment.

LLCs – Default Tax Treatment

A business entity, such as an LLC, that is not classified as a corporation under the “check the box” rules (an “eligible entity”)[xxvi] can elect its classification for federal tax purposes.

An eligible entity with at least two members can elect to be classified as either an association (i.e., a corporation) or a partnership.[xxvii]

In the absence of such an election, an eligible entity will be treated as a partnership for tax purposes if it has at least two members.[xxviii]

In the case of an LLC that is treated as a partnership, a partner’s distributive share of income, gain, loss, deduction, or credit is generally determined by the partnership agreement.[xxix] Thus, its members may agree to a non-pro rata, or special, allocation of the LLC’s income, gain, deduction, loss, or credit among the members, provided the allocation has substantial economic effect.[xxx]

In addition, distributions may be made among the members on a non-pro rata basis – the key is that the LLC maintain capital accounts in accordance with the applicable regulations.[xxxi]

LLCs – Checking the Box

As indicated above, an eligible entity generally may elect its tax classification.

An LLC that is treated as a partnership may elect to be classified as a corporation by filing IRS Form 8832.[xxxii]

When such an election is made, the LLC-partnership is treated as having contributed all of its assets and liabilities to a corporation/association in exchange for stock in the corporation and, immediately thereafter, the LLC is treated as having liquidated by distributing such stock of the LLC’s members.[xxxiii]

The foregoing transaction should be treated as a tax-deferred exchange provided the former members of the LLC retain control of the “new” corporation.[xxxiv]

It is important to note that the LLC continues to exist as such as a matter of state law – only its classification and treatment for tax purposes has changed following the above election.

At that point, the LLC qua association would be treated as a “C” corporation for tax purposes.[xxxv]

However, the regulations provide that an LLC-partnership may forgo the filing of Form 8832 if it files IRS Form 2553 to elect treatment as an S corporation; I that case, the LLC will be treated as having also elected to be treated as a corporation, provided the LLC meets all other requirements (described earlier) to qualify as an S corporation.[xxxvi]

“Qualifying” the LLC Before Electing

Assuming the members of an existing LLC are eligible to own shares of S corporation stock, is there anything else the LLC needs to address before electing “S” status for tax purposes?

For starters, what is the economic arrangement among the members? How are the LLC’s items of income, gain, deduction, loss, and credit allocated among them? What about distributions?

Because the LLC is required to have an operating agreement as a matter of state law, the agreement will have to reviewed and amended where necessary to ensure that it does not confer different economic rights to different members.

The LLC and its members will also have to address any economic “entitlements” that may have accrued to certain members under the operating agreement before an S corporation election is made.[xxxvii]

Similarly, has the LLC issued any profits interests? Such an interest in an S corporation setting must be avoided. How will the interest be valued for purposes of issuing “S corporation stock” in exchange for the interest?

If the operating agreement provides for the purchase and sale of its members’ interests, consider the circumstances in which a redemption or purchase is required and also how the purchase price is determined. Under the S corporation regulations, bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation’s shares of stock confer identical rights.[xxxviii] In other buy-sell situations, does the agreement establish a purchase price that is significantly in excess of or below the fair market value of the stock?[xxxix]

There are other provisions of the operating agreement that will no longer be required once the LLC elects to be treated as an S corporation and which may, in fact, cause some confusion going forward; for example, those dealing with capital accounts.

Preserving the “S” Election

Although scrubbing the operating agreement may feel like a chore, the process is manageable and within the LLC’s and its advisers’ control, assuming a cooperative group of members.

The real challenge in preserving the LLC’s “S” election will arise later, when members often forget their entity is now treated as an S corporation for tax purposes notwithstanding they are organized as a state law LLC.

A sampling of the issues I’ve encountered: the admission of an ineligible shareholder, the issuance of a profits interest, and the determination of a redemption price based upon only one line of business.

Why the obvious confusion? The business is organized as an LLC – a form of business entity that has been rightly touted as providing the greatest flexibility, especially in the context of a closely held business.

While it may be possible to rectify missteps, like the ones described above, by applying to the IRS for relief from what may have been an inadvertent termination of an LLC’s “S” election,[xl] the process can be costly and is dependent upon the LLC and its members becoming aware of and taking steps to correct the disqualifying event before the IRS discovers that the election was terminated.

Why Do It?

Notwithstanding the foregoing, the fact remains that there are LLCs out there that have elected to be treated as S corporations.

The reason most commonly given for making the election: the ability to reduce its members’ employment tax liability. Specifically, a member of an LLC that is treated as a partnership for tax purposes is generally required to include their distributive share of LLC income (plus any guaranteed payments for services) in their self-employment income.[xli]

In contrast, neither an S corporation shareholder’s pro rata share of the S corporation’s income nor the corporation’s distribution thereof to the shareholder is subject to employment tax, provided a shareholder who renders services to the corporation is paid reasonable compensation in exchange for such services; of course, such compensation is subject to employment taxes. In the absence of such compensation, however, the IRS may reclassify distributions made to the shareholder as wages.[xlii]

Granted, this is a legitimate tax reason for “converting” to a corporation. However, given the issues described with maintaining an LLC’s “S” status, why should an LLC consider an S corporation election instead of actually incorporating under state law and then making the election? Wouldn’t the latter provide greater certainty and avoid subsequent confusion on the part of the members qua shareholders?

That said, one possible explanation may be the ability of the LLC to retain its EIN following the election, which is also treated as a change in its tax classification under the check the box regulations.[xliii]

Another explanation would be the state law governance rules that apply to an LLC (discussed earlier) versus those that apply to corporations. The LLC rules are generally less formal and more flexible. In the eyes of many business owners, these differences may suffice.

In the end, it is imperative that an LLC and its members understand and remember that the S corporation rules are not entirely compatible with most of the reasons for which business owners choose to operate through LLCs.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Have you read the 7-book “Kelly Turnbull Series” by Kurt Schlichter?

[ii] I’m referring to New York’s Business Corporation Law (“BSC”), as effective January 1, 2023, and to New York’s Limited Liability Company Law (“LLCL”). The analysis may be quite different when considering the laws of another state.

[iii] Not inexpensive.

[iv] LLCL Sec. 206.

[v] BSC Sec. 501(a).

[vi] LLCL Sec. 418(a).

[vii] LLCL Sec. 401.

[viii] BCS Sec. 701 and 703.

[ix] BSC Sec. 715(a).

[x] Within 90 days after the filing of the articles. LLCL Sec. 417(c).

[xi] LLCL Sec. 417.

[xii] BSC Sec. 602(c).

[xiii] BSC Sec. 620(a).

[xiv] BSC Sec. 605(a).

[xv] LLCL Sec. 503 and 504.

[xvi] BCS Sec. 501(c).

[xvii] BSC Sec. 510 and 701.

[xviii] LLCL Sec. 603.

[xix] BSC Sec. 508(d).

[xx] LLCL Sec. 609.

[xxi] There are special counting rules for members of a family. IRC Sec. 1361(c)(1).

[xxii] IRC Sec. 1361(c)(2) and Sec. 1361(d).

[xxiii] IRC Sec. 1361(b)(1).

[xxiv] Reg. Sec. 1.1361-1(l).

[xxv] Reg. Sec. 1.1361-1(l)(2). Most commercial contracts are not considered unless a principal purpose of the agreement is to circumvent the one class of stock requirement.

[xxvi] Reg. Sec. 301.7701-2(b).

[xxvii] Reg. Sec. 301.7701-3(a)

[xxviii] Reg. Sec. 301.7701-3(b)(1).

[xxix] IRC Sec. 704(a).

[xxx] Reg. Sec. 1.704-1(b)(1) and 1.704-1(b)(2). If the allocation does not have substantial economic effect, a partner’s distributive share will be determined in accordance with their interest in the partnership, taking into account all the facts and circumstances. Then, of course, there are a number of rules that cover specific situations; for example, IRC Sec. 704(c).

[xxxi] Reg. Sec. 1.704-1(b)(2)(iv).

[xxxii] Reg. Sec. 301.7701-3(c).

[xxxiii] Reg. Sec. 301.7701-3(g).

[xxxiv] IRC Sec. 351. The LLC’s distribution of the stock is not taken into account for purposes of determining control “immediately after” the exchange. IRC Sec. 351(c). See also Rev. Rul. 84-111, Situation 1; and Rev. Rul. 2004-59 (dealing with a “formless” conversion under state law).

Speaking of IRC Sec. 351, one must also consider whether IRC Sec. 357(c) presents an issue – if the sum of the amount of the liabilities assumed exceeds the total of the adjusted basis of the property transferred pursuant to the exchange, then the excess will be considered as a gain from the sale or exchange of property.

[xxxv] If the LLC does not elect S corporation treatment effective as of the date of its “incorporation,” it will be subject to the built-in gain rules of IRC Sec. 1374.

[xxxvi] Reg. Sec. 301.7701-3(c)(v)(C).

[xxxvii] Timing is important here. A timely election made by a corporation during the taxable year for which it is intended to be effective is nonetheless treated as made for the following taxable year if the corporation is not a small business corporation during the entire portion of the taxable year which occurs before the date the election is made. Reg. Sec. 1.1362-6(a)(2).

[xxxviii] Reg. Sec. 1.1361-1(l)(2)(iii)(B).

[xxxix] Reg. Sec. 1.1361-1(l)(2)(iii)(A). This regulation contemplates that “a” principal purpose of the agreement is to circumvent the one class of stock requirement. Why tempt fate? Consider using the safe harbor in Reg. Sec. 1.1361-1(l)(2)(iii)(C).

[xl] IRC Sec. 1362(f); Reg. Sec. 1.1362-4.

[xli] IRC Sec. 1402.

[xlii] Rev. Rul. 74-44.

[xliii] Reg. Sec. 301.6109-1(h)(1).