An operating agreement for LLC taxed as S corporation is the LLC's main governing document. By default, an LLC is treated like a partnership for tax purposes. 4 min read updated on 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.
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 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.
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.
Pass-through taxation isn't always the best option for investors, such as when:
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.
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.
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:
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