By: Brad Johnson
Many companies in the lower middle market are initially set up as a Limited Liability Company (“LLC”), but as time passes and the business grows, a number of owners will consult with their CPA and make the appropriate elections for their company to be treated as an S-Corp for tax purposes. There are many well-documented advantages that come with this tax election, and we see this scenario quite frequently in our work with founder-led and closely held businesses in the lower middle market.
However, there are some nuances that come with S-Corp elections, and a misstep can create negative consequences which may only surface during the due diligence phase of a transaction. These missteps are generally unintended and often occur when entrepreneurs make certain corporate decisions without seeking the input of their legal counsel and tax advisors. We recommend owners spend some time investigating this area of their business well ahead of a transaction process given it will prevent time delays and increased costs when issues are uncovered by third-party financial due diligence teams.
We recently caught up with Jason Cummings, a Partner in the Corporate and Securities Practices of Morris, Manning & Martin LLP, to briefly discuss a few considerations related to S-Corp elections.
- What can go wrong in the S-Corp election process?
Many things, including the failure to become an S-Corp because of an ineffective S-Corp election, which makes your company a C-Corp for tax purposes even if your company has been filing tax returns as an S-Corp.
- How does the cap table and equity incentives impact election status?
An S-Corp can only have one class of stock (i.e., no preferred stock). With a LLC in particular, it’s not always apparent that an equity structure actually results in two classes of stock. Also, an S-Corp can only have certain types of stockholders.
- How does the election affect distributions based on existing operating agreements?
All distributions must be pro rata based on stock ownership. There can be no priority returns or disproportionate distributions. This may require an amendment to the operating agreement of an LLC that later elects to be taxed as an S-Corp.
- Are there ways to rectify issues?
The IRS has processes for founders to address inadvertent S-Corp terminations and ineffective S-Corp elections, but these processes can be lengthy and expensive depending on the facts. It is best to identify and address any potential S-Corp issues as soon as possible well in advance of a transaction with a buyer or investor.
- Any other transaction-related considerations entrepreneurs should keep in mind related to S-Corps?
Aside from the due diligence a buyer will conduct regarding valid S-Corp status, a buyer will often want a “step-up” in asset tax basis, which may result in additional taxes for founders.
While an S-Corp issue may not be a “deal killer” when selling your business or raising growth capital, it can curb momentum and meaningfully reduce your leverage during the final negotiation phase. If your business has made this S-Corp election at some point along the way, take some time to explore this area with your advisory team to ensure your company is well-positioned for due diligence.
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