DDIY: Don’t Do it Yourself


The do-it-yourself (DIY) movement has been very popular in recent years. Some people are attracted to the idea of DIY because they like the feeling of satisfaction that comes with accomplishing a task, whatever it may be. Others perceive DIY as a way to save money (i.e., they are just cheap). Some tasks are more suitable for DIY than others. Tax law is not one of them. A recent private letter ruling illustrates the perils of DIY-law. The ruling concluded that the taxpayer, an entity organized as limited liability company under state law, had inadvertently terminated its S-corporation election by the inclusion of a provision in its operating agreement that created a second class of stock.

Background and Context

For federal tax purposes, a business entity with two or more members is classified as either a partnership or a corporation.1 Certain business entities, including those incorporated under state law,2 insurance companies,3 most banks,4 and certain specified foreign entities,5 are automatically classified as corporations for federal tax purposes.6 Others business entities, including limited liabilities companies, may be disregarded as entities separate from their owners or they may be classified partnerships or corporations depending on the number of members and whether the entities has elected to be classified as something other than the default classification. Absent an election to be classified as a corporation, a domestic limited liability company (i.e., a limited liability company formed under the laws of any State of the United States) with a single member is disregarded as an entity separate from its owners, and a domestic limited liability company with two or more members is classified as a partnership.7 A limited liability company may change its default classification by filing Form 8832, Entity Classification Election (“Form 8832”).

Corporations are taxed as either a C-corporation or an S-corporation for federal income tax purposes. The “C” and “S” refer to the subchapter of the Code that contains the rules applicable to the two types of corporations for federal income tax purposes. The biggest difference between C-corporations and S-corporations is that the income of C-corporations is effectively taxed twice: first at the corporate level when it is earned by the corporation8 and at the individual level when it is distributed to the shareholders.9 By contrast, the income of S-corporation is essentially subject to only a single layer of tax.10 From 1987 to 2018, the maximum effective rate applicable to the distributed earnings of C-corporation was significantly higher than the maximum effective rate applicable to the income of S-corporations, thus making S-corporations significantly more desirable than C-corporations.11

In order to qualify for taxation as an S-corporation, the entity must meet the statutory requirements, and its timely file an election with IRS. A limited liability company that elects to be taxed as a corporation may choose to be treated as S-corporation if it meets the statutory requirements and makes the required election.12 The requirements for qualifying as an S-corporation are set forth in section 1361(b)(1) of the Code. Under that section, an S-corporation must be a domestic corporation which is not an ineligible corporation and which does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in section 1361(c)(2) of the Code, or an organization described in section 1361(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock.

With respect to the fourth requirement of section 1361(b)(1), Treas. Reg. § 1.1361-1(l)(1) provides that a corporation is generally treated as having only one class of stock if all outstanding shares of the corporation confer identical rights to distribution and liquidation proceeds. Pursuant to Treas. Reg. § 1.1361-1(l)(2)(i), the determination of whether all outstanding shares of stock confer identical rights to distributions and proceeds of liquidation is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements between the shareholders.

An S-corporation election is effective for the taxable year to which it first applies and all succeeding taxable years until revoked or terminated. An s-corporation’s status will be terminated if fails to meet the requirements of section 1361(b) at any point after making an S-corporation election. A termination occurring because the corporation or its shareholders fail to meet the requirements of section 1361(b) is effective on the date the failure first occurs.13 When a termination occurs, the S-corporation’s taxable year ends on the day preceding the effective date of the termination and a new taxable year begins for the corporation as a C-corporation on the following day.14 When a termination occurs, the reason for the termination is generally irrelevant. Because the consequences of a termination can be rather draconian, Congress granted the Commission of Internal Revenue authority to grant relief in certain cases.

Section 1362(f) of the Code provides, in relevant part, that if

  • an S-corporation election (A) was not effective for the taxable year for which it was made by reason of a failure to meet the requirements of section 1361(b) or to obtain shareholder consents, or (B) was terminated under section 1362(d)(2) or (3) of the Code,
  • the Secretary of the Treasury determines that the circumstances resulting in the ineffective election or termination was inadvertent,
  • no later than a reasonable period of time after discovery of the circumstances resulting in the ineffective election or termination, steps were taken to cure the failure, and
  • the corporation and each person who was a shareholder of the corporation at any time during the period specified in section 1362(f) agrees to make such adjustments as may be required by the Secretary with respect to such period,

Then, notwithstanding the circumstances resulting in the ineffective election or termination, the corporation will be treated as an S-corporation during the period specified by the Secretary.

Pursuant to Treas. Reg. § 1.1362-4(b), the determination of whether a termination was inadvertent is made by the Commissioner. The corporation has the burden of establishing that the Commissioner should determine that the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or that the terminating event took place without knowledge of the corporation despite its due diligence, tends to establish that the termination was inadvertent.

PLR 201918004

This PLR involved a multi-member LLC that made an election to be treated as an S-corporation. At a later date, the shareholders entered into an operating agreement governing the rights of shareholders with respect to the LLC. Section 10 of the operating agreement provided in pertinent part as follows:

Upon dissolution of the Company . . . the proceeds from the liquidation of the Company’s assets shall be distributed . . . to the Members in accordance with their respective positive Capital Account Balances; and, the balance, if any, to the Members, in accordance with their respective Percentage Interests.15

This language is standard in LLC operating agreements when the entity is taxed as a partnership and, as a result, is likely in most form operating agreements anyone would find online or through a commercial DIY resource.

The LLC later engaged in a reorganization. During the course of the reorganization, outside counsel become concerned that Section 10 of the operating agreement created a second class of stock by allowing for disproportionate distributions to the shareholders upon liquidation. As noted above, an s-corporation can only have one class of stock. Under Treas. Reg. 1.1361-(1)(l)(1), the right to disproportionate distributions creates a second class of stock. Under Section 10 of the operating agreement, the shareholders would have the right to disproportionate distributions to the extent their capital accounts varied at the time of liquidation. Section 10 of the operating agreement thus created a second class of stock. IRS concluded that the LLC’s S-corporation election terminated on the date the operating agreement was executed. IRS further concluded, however, that the termination was inadvertent and, therefore, reinstated the S-election retroactive to the date of the termination.

Although the letter ruling does not indicate whether the operating agreement was a DIY or professionally drafted agreement, most tax professionals would understand that Section 10 of the operating agreement would cause the corporation to have a second class of stock for purposes of section 1361(b)(1)(D) of the Code. As indicated above, Section 10 of the operating agreement is a common provision in the operating agreements of multiple-member LLCs taxed as partnerships. It is intended to comply with the rules under section 704(b) of the Code for making special allocations, and it is not unusual for such provisions to be included in DIY agreements. Here, LLC was able to get relief from the inadvertent termination, but the mistake was likely costly. In addition to paying a user fee to request relief from the IRS, the LLC most certainly incurred additional accounting and attorney’s fees. These costs could have easily been avoided with proper professional advice when the operating agreement was drafted.

While it may appear simple, organizing a limited liability company and properly drafting an operating agreement requires careful consideration of a number of factors. It is not something you should do yourself. Although professional services entail incurring some costs, they can save you money in the long run.


  1. Treas. Reg. § 301.7701-2. For these purposes, the term “business entity” is broadly defined to include, not only corporations, partnerships (both general and limited), and limited liability companies formed under state law, but also less formal “associations,” business trusts, and “financial operations,” “ventures,” and “trades and businesses” from which the participants divide the profits. Treas. Reg. § 301.7701-1(a)(2).
  2. Treas. Reg. § 301.7701-2(b)(1).
  3. Treas. Reg. § 301.7701-2(b)(4).
  4. Treas. Reg. § 301.7701-2(b)(5).
  5. See Treas. Reg. § 301.7701-2(b)(8) (listing foreign entities that are per se corporations for federal tax purposes).
  6. Treas. Reg. § 301.7701-2(b).
  7. Treas. Reg. § 301.7701-3(a), (b).
  8. See IRC § 11 (imposing corporate income tax).
  9. See IRC § 1 (imposing individual income tax); see also IRC § 61(a)(7) (providing that gross income includes dividends).
  10. See IRC § 1363(a) (providing, in general, that S-corporations “shall not be subject to the taxes imposed by [Chapter 1 of the Code]”).
  11. Paul R. McDaniel, Martin J. McMahon, Jr., and Daniel L. Simons, Federal Income Taxation of Corporations 376 (Foundation Press 3d ed. 2006). Changes in preferential rates applicable to capital gains, the imposition of the 3.8% Medicare surtax, reductions in corporate and individual rates resulting from The Tax Cuts and Jobs Act of 2017 (“TCJA”), and the enactment of the deduction for pass-thru income by the TCJA narrowed the disparity in effective rates applicable to C-corporations and S-corporation shareholders. In most, but not all cases, S-corporations continue to be preferable to C-corporations for most taxpayers.
  12. A corporation elects to be an S-corporation by filing Form 2553, Election by a Small Business Corporation (“Form 2553”). A limited liability company that otherwise meets the requirements of section 1361(b) may elect to become an S-corporation by timely filing Form 2553. If the Form 2553 is timely filed and the statutory requirements are otherwise met, the limited liability company need not file Form 8832 to change its classification from a disregarded entity or partnership to a corporation prior to filing Form 2553. Treas. Reg. § 301.7701-3(c)(1)(v)(C).
  13. IRC § 1362(d)(2).
  14. IRC § 1362(e).
  15. PLR 201918004 at *2.


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