Key Takeaways

  • An LLC taxed as an S corporation needs a specially tailored operating agreement distinct from traditional LLCs or partnerships.
  • Essential provisions include designation of S corp status, stock ownership limits, income distribution protocols, and officer roles.
  • A sample operating agreement for LLC taxed as S corporation should also address S corp compliance, shareholder qualifications, and restrictions on transfer of interests.
  • Including IRS Form 2553 language and adapting capital account clauses for S corp requirements is crucial.
  • Templates help, but legal review ensures compliance and strategic alignment with business goals.
  • UpCounsel connects businesses with experienced attorneys for operating agreement drafting or review.

An operating agreement for LLC taxed as S corporation is the entity's main governing document. By default, an LLC is treated like a partnership for taxation purposes. So, most standard operating agreement forms are designed as modified agreements for partnerships. Standard operating agreement forms have provisions that are only there to cover tax issues for partnerships. However, when the LLC is going to be treated as an S corporation for tax purposes, many traditional partnership provisions aren't needed or even allowed.

Contractarian Approaches

One commonly cited benefit of limited liability companies that makes them a popular form of business entity is that it provides a very flexible way for owners of equity in the business to arrange legal and financial connections to companies. Professionals in the business entity planning and regulating field note that forming an LLC lets the relationships between owners, investors, stakeholders, and the businesses self-regulate without a lot of restrictions. Contractarian approaches that leave a wide variety of options regarding LLCs make this especially applicable in states like Delaware.

Check-the-Box Regulations

Check-the-box regulations were adopted in 1996, and they broke the connection between the choice of taxation format and business entity. Before the 1996 regulatory change, the type of business entity determined the taxation setup the business had to follow. These check-the-box regulations let LLCs and other business entities that aren't organized as corporations choose to be designated as a corporation, or when meeting the parameters, an S corporation. The subchapter S corporation format has emerged as a popular form of business entity.

Costs and Benefits of Subchapter S Taxation

To determine the disadvantages and advantages of choosing subchapter S taxation, you need to consider what you're comparing this type to, such as a regular C corporation. The three most common comparisons are to a traditional C corporation, a partnership, or a disregarded entity. An LLC does have the option to be taxed as a C corporation, and many do make this choice, but a C corporation doesn't offer the advantage of pass-through taxation that S corporations enjoy. So, in many cases, the C corporation business format is the preferred choice for business owners.

Reasons Investors Opt-Out of Pass-Through Taxation

Pass-through taxation isn't always the best option for investors, such as when:

  • It's a 501(c)(3) qualified business entity
  • The chance to get an exclusion is only available to C corporation shareholders under section 1202 of the Code
  • A single equity owner finds the options to choose to include only either a subchapter S or disregarded entity business format

Payroll tax savings is a common reason solo business owners choose to form an S corporation. However, making this election means a separate tax return for the business is required each year.

Capital Account Maintenance

Operating agreements for LLCs that choose to set up as S corporations for tax purposes often include the full range of provisions regarding capital account management. These provisions are intended to fulfill the required substantial economic effects section of the operating agreement, as detailed in section 704 of the Code. Along with the provisions about capital management, the agreements must also include the details on how liquidation distributions will be handled if the business fails, to make sure each investor receives the appropriate portion in connection to his or her investment.

Operating Agreement Provision Examples

Some types of provisions that must be factored in when preparing an operating agreement for an LLC that elects to be taxed as an S corporation include:

  • The heading: It's important to note in the heading of the agreement that the LLC is being formed as an S corporation. This needs to be noted on the cover page, the first page, the signature page, and the page that lists the unit share of each investor.
  • Recitals of filing form number 2553: This notes that the entity is going to be classified as a C corporation but taxed as an S corporation. It also notes that any wholly-owned corporate subsidiaries of the entity have also elected to be taxed as subchapter S subsidiaries.
  • Company purpose: This provision considers why the company exists, mainly to participate in any form of legal enterprise and actions as long as it doesn't cause the corporation to become ineligible or to lose its S corporation status.
  • S election: This provision notes that the company and the interest owners must take any necessary and appropriate actions to protect the company's S corporation status.

When to Use a Sample Operating Agreement for LLC Taxed as S Corporation

A sample operating agreement is a useful starting point for small businesses seeking clarity and structure in forming or converting to an S corp tax election. Here are ideal use cases:

  • New LLCs Electing S Corp Status: Business owners creating an LLC with the intent to file IRS Form 2553 immediately.
  • Existing LLCs Switching to S Corp Taxation: When an LLC changes its tax status, updating the operating agreement ensures alignment with IRS requirements.
  • Solo LLCs Seeking Payroll Tax Advantages: Solo entrepreneurs often use an S corp operating agreement to support their new tax filing framework.
  • Businesses Seeking Investor Confidence: Formalizing provisions around ownership and compliance can bolster credibility with investors or lenders.

However, while sample templates offer convenience, legal review is highly recommended to customize the agreement for your business's specific needs and to avoid triggering loss of S corp status.

Sample Structure of an S Corp-Optimized Operating Agreement

Below is a simplified structure often found in a sample operating agreement for LLC taxed as S corporation. This framework helps ensure that the agreement is both legally sound and tailored to S corp status:

  1. Title Page
    • Indicate the agreement is for an LLC electing S corporation tax treatment.
  2. Recitals
    • Mention the filing of IRS Form 2553 and the intended S corp tax status.
  3. Article I: Formation and Purpose
    • Include business purpose language that preserves S corporation eligibility.
  4. Article II: Membership and Capital Contributions
    • Describe initial contributions and affirm that members meet IRS eligibility.
  5. Article III: Allocation and Distributions
    • Confirm equal treatment of ownership interests and outline distribution methods in line with S corp rules.
  6. Article IV: Management and Voting
    • Designate managers or officers and define voting rights while preserving pass-through characteristics.
  7. Article V: Restrictions on Transfers
    • Detail restrictions on transferring interests to avoid disqualifying S corp shareholders.
  8. Article VI: Tax Election and Compliance
    • Reiterate intent to maintain S corp status and cooperation among members.
  9. Article VII: Dissolution
    • Outline conditions and procedures for dissolution and asset distribution.
  10. Signature Blocks
    • Include member signatures, confirming consent to the terms and the S corp designation.

Additional Required Provisions for S Corporation Compliance

When tailoring an operating agreement for an LLC electing S corporation taxation, it’s vital to go beyond standard LLC provisions. A robust document should ensure ongoing S corp compliance by including the following additional clauses:

  • One Class of Stock Requirement: Reinforce that all membership interests represent a single class of stock, as required under IRS regulations for S corporations.
  • Eligible Shareholders: Clarify that only allowable entities (e.g., U.S. citizens, certain trusts) can be members, and exclude nonresident aliens, corporations, or partnerships.
  • Prohibition on Transfer to Ineligible Persons: Specify that any transfer of membership interest must receive approval and cannot violate S corp eligibility.
  • Income and Loss Allocation: State that all income, losses, and distributions will be shared pro rata based on ownership percentages, in compliance with IRS rules against disproportionate allocations.
  • Revocation Protocols: Provide procedures for how the entity or members may revoke the S corporation election, if needed.

Frequently Asked Questions

  1. Why does an LLC taxed as an S corporation need a different operating agreement?
    Because S corp tax status requires specific provisions (like one class of stock and eligible shareholders), a standard LLC agreement may violate IRS rules if not updated.
  2. Can I use a generic LLC operating agreement template for an S corp?
    It’s not recommended. Generic templates often include partnership-style tax language that’s incompatible with S corporation rules.
  3. What’s the most important clause in an S corp operating agreement?
    The most crucial clauses address shareholder eligibility, equal treatment of ownership interests, and compliance with S corporation tax status.
  4. Does the IRS require an operating agreement for an S corp?
    The IRS doesn’t require it, but it’s essential for legal structure, member expectations, and protecting the S corp election.
  5. Where can I get help drafting or reviewing this kind of agreement?
    You can connect with top-tier attorneys on UpCounsel who specialize in LLC and S corporation agreements tailored to your business.

If you need help with an operating agreement for an LLC taxed as an S corporation, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.