S corporations (S corps) serve a purpose that is very attractive to clients, especially in Wisconsin where there are so many closely held family businesses.

But what many clients fail to realize is just how delicate S corps can be. The rules and requirements for S corps are incredibly rigid, and they are extremely easy to run afoul of them. Oftentimes, I find that the client is so focused on the benefits that they do not internalize the restrictions and the consequences of not strictly complying with the S corp rules and regulations.

This is further complicated because frequently a tax advisor or financial advisor will be the person to make the recommendation to make the election. While these advisors are incredibly skilled and knowledgeable, they may not realize the vast legal implications that need to be considered and addressed when making this type of election and do not involve the company’s legal counsel.

Some Pitfalls

There is a vast array of ways an entity can jeopardize their S election through non-compliance.

There are the usual suspects, having an obvious second class of stock or disproportionate distributions.

But others are a bit more nuanced, such as errors or omissions on Form 2553, like a mistyped name or Social Security number, or only having one spouse sign the election in a community property state.

An Issue: Non-identical Governing Provisions

This article focuses on one of the more common, but less discussed issues: having “non-identical governing provisions.”

Non-identical governing provisions typically arise within a multimember limited liability company’s operating agreement. Most form operating agreements contain partnership tax provisions that discuss different rights for distribution.

More often than not, those provisions describe a distribution strategy which is not strictly in accordance with a member’s percentage of ownership in the entity but rather are in accordance with capital accounts or a waterfall outlined in the agreement. Those distribution schemes do not align with the rules for S corp distributions, which dictate that all distributions are to be made proportionally based on ownership percentage.

If the tax distributions provisions in a company’s operating agreement do not comply with the S corp requirements, they are considered to be “non-identical governing provisions” and inclusion of such provisions in an operating agreement will either invalidate or terminate the Selection.

So, what we see happen is that an attorney starts with their form, and either does not appreciate that the entity has made an S election or does not realize that it is the intention of the client to make an S election. They retain the standard provisions for a multi-member limited liability company – and thereby terminate or invalidate the S election.

Or the client does not realize these provisions have this power, for example, when their tax advisor suggests they consider making the election, and the election is made without an update to the operating agreement rendering the S election invalid.

The Consequences

What does this mean practically for the client, and what happens to the election?

• If the operating agreement was entered into before the election was made, then the election was invalid and the entity has remained a partnership for tax purposes.
• If the operating agreement was entered into after the election was made, then the election is terminated and the entity becomes a C corp.

In both cases, it is likely that the tax returns filed have been incorrect and there may be additional tax obligations.

Some Remedies

The IRS has released Rev. Proc. 2022-19, which allows a company to fix a “non-identical governing provision” among other foot-fault-type violations. However, the non-identical governing provisions must be the sole cause of the S corp election being invalid or terminated.

If the invalidity or termination of the S election is attributable to additional compliance failures, then the company will either need to seek a private letter ruling from the IRS to fix all of the issues and remain an S corp or, as noted above, the entity will need to file amended returns.

An Ongoing Issue

In recent years, I have come across this problem more and more, generally when performing due diligence on a target company during a transaction.

Often, the issue is a result of an election made years or decades after the company was originally formed, and such election was made without consulting their attorney. At other times, there may have been a communication breakdown between client and counsel, and counsel was unaware that an S election was made when they are assisting in drafting the initial operating agreement or during the amendment or restatement process.

Helping Your Clients Avoid the Issue

One strategy to avoid non-identical governing provisions is to advocate for any entity that will make an S election to be formed as a corporation rather than as a limited liability company. Since most form or template bylaws do not discuss distribution or tax elections, you do not have to worry as much about them being inadvertently included.

I have found it helpful when counseling clients during the formation of a business to ask, “will you be making or do you think you will ever make an S election?”

If the answer is yes, then I recommend forming the entity as a corporation from the start, and explain the issues that can arise.

If the answer is no, I still flag the issue, explain the consequences, and make it clear if they are ever considering making an S election, to make sure they involve counsel so that some of these simple errors are not made.

This article was originally published on the State Bar of Wisconsin’s Business Law Blog. Visit the State Bar sections or the Business Law Section webpages to learn more about the benefits of section membership.