Updated November 16, 2020:

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.

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