Can an LLC be an S Corporation for Tax Purposes?

If you are starting a new business using a limited liability company (LLC) and wondering whether it can be taxed as an S corporation, the answer is yes, it can. However, there are a number of requirements that must be satisfied to be a validly electing S corporation, and without proper planning and review, you could have an LLC operating agreement that can result in the inadvertent termination (or invalidation) of your S election. In our experience, this is more common than you would expect as many corporate lawyers or online document preparation companies prepare LLC operating agreements assuming the entity will be taxed as a partnership for US federal income tax purposes (the default tax classification for a multi-member LLC).

Operating agreements drafted using partnership provisions can violate the single class of stock requirement for S corporations resulting in an inadvertent termination. For instance, many operating agreements provide that, upon liquidation, distributions will be made to the members in accordance with positive capital account balances. Positive capital account balances do not necessarily align with each members' proportionate ownership interest in the LLC. So, even if you have not made a liquidating distribution, this provision would likely invalidate or terminate your entity's S corporation status.

To avoid this issue, it is important to involve your tax advisor in the review of these type of documents when starting your business or looking to change your classification to an S corporation, so that references to capital accounts and other partnership-tax boilerplate language can be removed from the LLC operating agreement.