A corporation electing under IRC section 1362 to be taxed as an S corporation is subject to various ownership restrictions, including the requirement that shareholders must be individuals (section 1361(b)(1)(B)). Although very limited exceptions to this rule exist for entities such as estates and trusts, they do not address whether a limited partnership or a limited liability company (LLC) can be an owner. It would be reasonable, therefore, to conclude that the acquisition of an S corporation’s stock by a limited partnership or an LLC would immediately terminate the corporation’s S election.
However, letter ruling 200107025 recently stated that the acquisition of stock by a limited partnership and an LLC would not terminate a corporation’s S election. The ruling is very narrow and applies only to single-owner entities.
The scenario. The letter ruling describes three shareholders who planned to restructure their ownership of an S corporation with the same series of transactions. Each shareholder was to transfer some of his S corporation stock to an LLC in return for 100% of the LLC stock. The LLC and the shareholder would then contribute their respective S corporation stock to the limited partnership in return for a partnership interest in it—the shareholder was to receive a limited partnership interest and the LLC would get a general partnership interest. After this transfer, the shareholders and the LLC would own 100% of the limited partnership.
Under the “check-the-box” rules of Treasury regulations section 301.7701-3(a), a business entity that is not automatically classified as a corporation can elect its classification for federal tax purposes. For a single owner entity, the choices are to be taxed as a corporation or to be “disregarded” as an entity separate from its owner. As the LLC and the limited partnership are not automatically classified as corporations, they choose the latter, or “default,” classification. Since for federal tax purposes, the LLC is “disregarded,” the shareholder is deemed to own all of its S corporation stock; therefore, it is the sole owner of the limited partnership. Because the limited partnership also is not regarded as a separate entity, the shareholder is deemed to own all its S corporation stock. Therefore, for tax purposes, the S election is valid.
Observation. The ruling does not indicate the shareholders’ reasons for this restructuring; it refers to these transactions only as part of an overall business plan. It stated that the LLC and the limited partnership would be formed in a state other than that of the S’s incorporation, so presumably this has some nontax benefit. The shareholders may have been trying to limit the liability associated with their S corporation ownership because it is based on their limited partnership interest and LLC membership. However, direct ownership of the S corporation would presumably provide the same limited liability. But those facts do not seem relevant to the restructuring, and the ruling does not indicate whether the lack of a business purpose would affect the result.
This ruling may provide CPAs with planning opportunities for clients who are S corporation shareholders in similar situations, but the lack of specific business reasons for such an arrangement may make it difficult to determine when this may be most useful.
—Cheryl Metrejean, CPA, PhD,
assistant professor at the
E. H. Patterson School of Accountancy,
University of Mississippi, Oxford.