Ruling highlights risks of using SMLLCs to hold S corporation stock
TAX ALERT |
A recent private letter ruling (LTR 201730002) highlights an issue that can arise when S corporation shareholders transfer stock to wholly-owned, single-member limited liability companies (SMLLCs). Shareholders who do so can inadvertently jeopardize the company’s suchapter S status, particularly when subsequently engaging in certain estate planning activities.
The ruling involved a taxpayer who was the sole owner of an S corporation. For reasons that aren’t obvious from the ruling, the taxpayer transferred 100 percent of his shares in the S corporation to a SMLLC. This is not unusual; taxpayers may prefer to insert a legal entity between themselves and an operating entity for liability protection, among other reasons. The transfer did not impact the corporation’s subchapter S status because SMLLCs are ignored for federal income tax purposes, meaning that the individual was still treated as the owner of the shares.
Similarly, a subsequent transfer by the taxpayer of a portion of his interests in the SMLLC to a grantor trust, which is also disregarded for federal income tax purposes, did not jeopardize the company’s subchapter S status. The taxpayer was still treated for federal income tax purposes as the sole owner of 100 percent of the S corporation’s shares.
The problem, however, arose when the taxpayer died. At that point, the trust ceased to be a grantor trust and was no longer disregarded for federal income tax purposes. That also caused the former SMLLC to lose its status as a disregarded entity, and instead become a partnership. As such, the death of the taxpayer caused the S corporation to be owned, for federal tax purposes, by an ineligible shareholder. This resulted in the immediate termination of the company’s subchapter S status.
The Ruling and Takeaways
Not surprisingly, the IRS granted the corporation’s request for relief, concluding that the termination of the company’s subchapter S status was inadvertent, while granting retroactive relief to the date of the termination. The more important takeaway, however, is that utilizing SMLLCs to hold S corporation shares can create l risks, particularly if events could occur that would cause the SMLLC to lose its disregarded entity status.
Taxpayers who use SMLLCs to hold S corporation shares should be aware of these risks and take steps to minimize the chances that an event might put the company’s subchapter S status at risk. Taxpayers should consider, for example, whether transferring S corporation shares to a SMLLC creates any real advantages. Furthermore, taxpayers can also consider whether elections may be available that might cause the trust to retain its disregarded entity status, even after the death of the grantor. Failing to plan for these types of scenarios can result in an unintentional termination of an S corporation’s status. The IRS will generally grant requests to remedy a termination, but doing so is an expensive proposition.