The 2024 Small Business Profile compiled by the US Small Business Administration indicates that 99 percent of New Hampshire businesses are small businesses. The most recent data from the New Hampshire Secretary of State shows that the vast majority (94.4 percent) of the businesses formed in New Hampshire during the reported period (2019-2021) were formed as limited liability companies (LLCs). Corporations constituted the next largest category (5.6 percent), followed by a small number of limited liability partnerships and limited partnerships.
Small business owners favor LLCs because they perceive them as being simpler to form and operate than corporations. The trend is clear, so attorneys who advise small businesses must often help their clients form LLCs and prepare LLC Operating Agreements.
Customary Treatment of LLCs Under Federal Tax Law
Under federal tax law, a single member LLC is treated as a “disregarded entity” unless the owner opts out of that treatment; and the business is treated much like a sole proprietorship, in that the owner uses Schedule C to report the profits or losses of the business on an individual IRS 1040 tax return. If an LLC has more than one owner, it is treated as a tax partnership unless the owner opts out of that treatment. Thus, owners of a multi-member LLC must file a partnership tax return to report the income, gain, deduction, loss, and tax credits received at the partnership level. The items reported on the IRS 1065 Partnership Tax Return flow through to the owners’ individual tax returns via K-1 Schedules issued to them by the LLC.
In either case, federal tax law provides for a single level of taxation at the owner level, which is often preferable to the federal tax treatment of a C-Corporation, which pays a corporate income tax at the entity level, and whose shareholders must also pay income tax on dividends and distributions, generally. Readers should note that New Hampshire’s state business income tax laws, and those of certain other states, do not follow the federal tax regime. New Hampshire taxes all business organizations at the entity level, much as if the business organization was a C-Corporation.
Why would an LLC Elect to be Taxed as an S-Corporation?
Many individuals who form small businesses are surprised by the time and expense associated with the self-employment tax regime. The way to preserve a single level of “flow-through” taxation at the federal level, while avoiding self-employment tax obligations, and limiting employment taxes to a portion of the LLC’s income, is to have the LLC elect to be taxed as an S-Corporation. This is because an S-Corporation can distribute a portion of its income to its owners as regular W-2 payroll (subject to employment taxes), and the remainder as a profits distribution which is not subject to employment taxes (if the LLC is careful to avoid the traps discussed in this article).
Electing S-Corporation Status
To elect S-Corporation status, the LLC first must file an IRS Form 8832 on which the LLC elects to be classified as an association taxable as a corporation. Then, the owners of the LLC must elect S-Corporation status by filing IRS Form 2553. While it is possible, in some circumstances, to file Form 2553 without having first filed the entity classification election (See Treas. Reg. §301.7701-3(c)(1)(v)(C)), many practitioners prefer to follow the formality of filing both forms in the order outlined above.
While the process of electing S-Corporation status may be deceptively simple, the owners of the LLC must be careful to comply with eligibility requirements. If they fail to do so, they will be deemed to have terminated the S-Corporation Election.
Basic S-Corporation Requirements
The formal requirements are stated in Internal Revenue Code (IRC) §1361 and its implementing Treasury Regulations. Some key requirements include: (1) the LLC cannot be an “ineligible corporation” such as a financial institution or an insurance company; (2) the LLC cannot have more than 100 equity owners (100 shareholders); (3) the LLC cannot have as a shareholder a “person” who is not an individual – other than an estate or a trust that meets certain requirements described in IRC §1361(c)(2), or any organization described in IRC §1361(c)(6); (4) the LLC cannot have a non-resident alien as a shareholder, and (5) the LLC cannot have more than one class of equity (one class of stock). Since IRC §1361(b)(1)(B) requires every shareholder of an S-Corporation to be an individual, an estate, or a certain type of trust, this means that corporations and partnerships are prohibited from owning S-Corporations.
All shareholders of an S-Corporation must be a US resident, an estate, or a qualifying trust. The following trusts are qualifying trusts under IRC §1361(c)(2)(A): (1) a trust which is treated as owned by an individual who is a citizen of the United States under IRC §§671-679 (a Grantor Trust); (2) a trust that was a Grantor Trust immediately before the death of the deemed owner and which continues to exist for the two-year period following the deemed owner’s death; (3) a trust to which stock has been transferred by a will, but only for the two-year period beginning on the day on which such stock is transferred to it (meaning, a testamentary trust); (4) a trust created primarily to exercise the voting power of stock transferred to it and meeting certain other requirements (meaning, a voting trust); (5) an electing small business trust (an ESBT); and (6) certain types of IRAs holding stock of a bank or a depository holding company.
Likewise, IRC §1361(d) provides that a qualified subchapter S trust (a QSST) may qualify as an eligible S-Corporation shareholder. Because the deemed owner of a Grantor Trust, and not the trust itself, is treated as the shareholder for purposes of the S-Corporation rules, the grantor must be a US citizen or resident. A Grantor Trust remains an eligible S-Corporation shareholder for two years after the deemed owner’s death. To avoid loss of S-Corporation status, at the expiration of the two-year period, the trust must transfer the stock to an eligible shareholder or make an election to be treated as an ESBT or a QSST.
Depending on the facts and circumstances, a trust may make an election under IRC §645 to treat the trust as part of the deemed owner’s estate, which provides an extended period for the trust to hold the stock beyond two years, but only for a “reasonable” period of estate administration.
Some IRS regulations seem to permit a disregarded entity to qualify as an eligible S-Corporation shareholder under IRC §1361(b)(1)(B) if the owner qualifies under IRC §1361(b)(1)(B). See Treas. Reg. §301.7701-3(b); Treas. Reg. §1.1361-1(e); and Treas. Reg. §1.1361-1(e)(3)(ii)(F). However, the use of disregarded entities as S-Corporation shareholders can result in some traps for the unwary.
The other most fundamental S-Corporation requirement is that an S-Corporation may have only one class of stock. For purposes of the S-Corporation regulations (See Treas. Reg. §1.1361-1(l)(1)), a corporation has only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. However, an S-Corporation may have voting and non-voting stock if the other requirements are met. See IRC §1361(c)(4). Even if an S-Corporation’s stock meets the foregoing requirements, Treas. Reg. §1.1361-1(l)(2)(i) provides that any distributions that differ in timing or amount, including actual, constructive, or deemed distributions, are to be taxed in accordance with the facts and circumstances.
Common Traps for the Unwary
Defective Election: If an entity fails to qualify as an S-Corporation on the date it makes the election, then the election will be deemed defective. This can happen for many reasons, including making the election before the entity is legally formed, filing a late election, errors in completing the election (for example, if one of the owners is not listed or fails to sign), or simply because the entity fails to meet the S-Corporation eligibility requirements on the effective date (for example, if there is an ineligible owner or there is more than one class of stock).
When organizing an LLC as an S-Corporation, always document in writing who is responsible for filing the S-Corporation elections. If the plan is for the accountant to prepare and file the elections, then you want a written communication in your file, sent to the client and the accountant, confirming that the accountant is responsible. Review the elections before they are filed regardless of who prepares them.
Defective LLC Operating Agreement or Certificate of Formation: It is important to ensure the form satisfies the applicable legal requirements. It is fairly common to be engaged by clients after they have been in business for some years, so there is a need to familiarize oneself with the business and how it operates. Always make sure that the LLC Operating Agreement and Certificate of Formation satisfy all S-Corporation eligibility requirements. If there are other material agreements governing the business, make sure they do not operate in a manner that causes the business to be ineligible for S-Corporation status.
Most standard LLC Operating Agreements satisfy the requirements of IRC §704(b). Such agreements often permit disproportionate allocations of income, gain, loss, or deduction, or disproportionate distributions of cash. More sophisticated partnership-style LLC Operating Agreements provide for different classes of equity with different economic rights. These provisions will typically violate the single-class-of-stock requirement, even if the business never actually makes a disproportionate allocation or distribution.
Although unlikely, the business may have additional, separate agreements among LLC members that cause the business to operate as if there were multiple classes of stock with different economic rights. Such agreements would also cause the business to violate the S-Corporation eligibility requirements.
Ineligible Owners: If an eligible member ceases to be an eligible shareholder, then the LLC will no longer meet the S-Corporation eligibility requirements. For example, if a married individual held S-Corporation stock through a single member LLC, got divorced, and was required to transfer a portion of the LLC’s equity to the former spouse, then the disregarded entity would become a partnership and, as such, an ineligible S-Corporation stockholder.
As noted previously, a Grantor trust is eligible to hold S-Corporation stock for up to two years following the grantor’s death. Similarly, a testamentary trust is an eligible S-Corporation shareholder for two years following the death of an eligible shareholder. If the two-year deadline is overlooked, or probate continues for what is deemed to be an unreasonable period and no qualifying transfer, QSST election, or ESBT election is timely made, then the trust shareholder will be deemed to be ineligible.
Multiple Classes of Stock: The owners of an S-Corporation may be incented to minimize employment taxes by paying themselves very low salaries (subject to employment taxes) and taking the remainder of profits as equity distributions (not subject to employment taxes). The IRS and the New Hampshire Department of Revenue (DRA) are well aware of this incentive, and it is a frequent focus of federal and state tax audits. On audit, if the IRS or the DRA determines that the salaries paid to owners are unreasonably low, they will seek to recharacterize the two streams of income (salary and distributions).
Any such recharacterization may cause the distributions made to shareholders to become disproportionate. The same dynamic can happen in reverse, if an employee-shareholder inflates his or her own salary, to reduce distributions to other owners. The result, in either scenario, is multiple classes of stock, which cause the business to be ineligible for S-Corporation status.
The problem of multiple classes of stock can occur for other reasons, too. These include agreements that have the effect of providing a preferred return to certain owners and shareholder loans that do not meet certain safe harbors. See Treas. Reg. §1.1361-1(l)(5)(iv).
If a shareholder loan to the business is recharacterized as equity, then the business could be deemed to have a second class of stock. Under the safe harbor, a shareholder loan to the business will not be recharacterized as equity if: (1) there is a written unconditional promise to pay a sum certain in money; (2) the interest rate and interest payment dates are not contingent on profits, the borrower’s discretion, the payment of dividends with respect to common stock, or similar factors; (3) the debt is not convertible into stock; and (4) the debt is held by an eligible S-Corporation shareholder.
Incentive compensation, if improperly structured, can also lead to a finding that there is more than one class of stock. If properly structured, performance bonuses, phantom stock, or stock appreciation rights may be used to incentivize the employees of the business, without causing a determination that such incentive compensation constitutes a second class of equity. The Treasury Regulations implementing the S-Corporation requirements also provide safe harbors for restricted stock and deferred compensation that meet the requirements described in the safe harbors. See Treas. Reg. §1.1361-1(b)(3) and (4).
What Can the Business Do If It Falls Into a Trap?
IRC 1362(f) provides that the Secretary of the Treasury may provide relief to taxpayers who have “inadvertently” violated the S-Corporation rules. The IRS has also issued certain programs to streamline the relief process for S-Corporations under Revenue Procedure 2013-30 and Revenue Procedure 2022-19. If the business does not qualify for relief under either of these procedures, the business may file a private letter ruling (PLR) request with the IRS asking to be treated as an S-Corporation, though this can be cost prohibitive (the current filing fee is generally $38,000).
S-Corporation Fixes in the Context of a Business Sale
It is increasingly common for private equity firms and other out-of-state buyers to come to New Hampshire seeking small businesses to “roll-up” as part of a larger strategy. These sophisticated buyers understand small businesses may not have complied with the S-Corporation eligibility requirements or cannot clearly document compliance. For this reason, it is fairly common for these buyers to condition the acquisition on the seller going through an “F” reorganization immediately prior to the closing of the sale. This process is described in IRS Rev. Rul. 2008-18, and if done properly, will protect the buyer from potential liability for the seller’s violation of the S-Corporation rules.
When representing a seller, be aware of this trend, and determine if the buyer intends to require an “F” reorganization. In such scenarios, factor in the time and expense of the reorganization and negotiate who will pay the cost of the reorganization. As seller’s counsel, you do not want the expense to reduce the net proceeds to the seller.
Dodd Griffith is admitted in New Hampshire.
This article is featured on page 27 of the February 19, 2025 edition of the the NH Bar News.