IRS, in three Private Letter Rulings, has taken the position that a single-member LLC that is completely owned by an eligible S corporation shareholder (e.g., an individual), can itself be an eligible shareholder of an S corporation. The Internal Revenue Code provides that only an individual, estate (including a bankruptcy estate), charity, qualified retirement plan and certain types of trusts (grantor trust, qualified subchapter S trust or electing small business trust) are eligible to be S-corporation shareholders. An S corporation can also be a shareholder, but only when that S corporation is a 100 percent shareholder. A partnership can’t own stock of an S corporation. On the day that an S corporation has an ineligible shareholder, the S corporation loses its S corporation tax status and is treated as a C corporation (with an entity-level tax).
In the Private Letter Rulings, IRS allowed a single-member LLC to be an S corporation shareholder on the basis that the LLC is disregarded for federal tax purposes (indeed, the tax information of the LLC is reported on the sole owner’s personal income tax return, just as was the case when the individual personally owned the stock. Under the facts presented to the IRS, an individual transferred S corporate stock and other property to his solely-owned single-member LLC.
The IRS position raises a couple of questions. First, if another person ever becomes a member of the LLC, the question is whether the corporation would lose its S status on the basis that the LLC would be deemed to be a partnership for tax purposes. The Tax Court, in Kates, et al. v. Comr., T.C. Memo. 1968-264, said that a corporation did not qualify to be an S corporation where one partner in a business venture arranged for the purchase of all of a corporation’s stock and then elected S status. The court held that the stock issued in the name of one of the partners was beneficially owned by the partnership. Likewise, in Priv. Ltr. Rul. 8536017 (Jun. 6, 1985), the proposed formation of a limited partnership which would own and operate certain equipment, would not cause the proposed partners to be considered shareholders of an S corporation – it was the partnership that was the shareholder. So, an LLC as an owner of an S corporation poses a greater risk of inadvertent termination when an additional person is added to the entity.
A second question relates to overall business planning. When would it be prudent to place S corporation stock in a single-member LLC? One reason may be so that the charging order concept of LLCs can be utilized. In many states, an LLC’s creditors are entitled only to a charging order on the interest of the LLC members. In other words, creditors can only get their hands on the actual distributions that are made to the LLC member – if the member doesn’t receive any distributions, the creditor gains nothing. However, several recent bankruptcy cases involving single-member LLCs have allowed the bankruptcy trustee to get past the protection of the charging order. See In re Modanlo, No. 05-26549-NVA, 2006 Bankr. LEXIS 4524 (Bankr. D. Md. May 18, 2006); In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003). Granted, these opinions are based on bankruptcy, but the charging order protection for a single-member LLC may not amount to much. But, a multiple-shareholder S corporation organized as an LLC that checks the box on Form 8832 could benefit from charging order protection.
Another advantage of having a single-member LLC treated as an S corporation is the associated employment tax benefit if the company has employees in addition to the owner.
The recent rulings are Priv. Ltr. Ruls. 200816002, 200816003 and 200816004 (Jan. 14, 2008).
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