Christopher R. Hoyt (Missouri-Kansas City) shared with the TaxProf E-Mail Discussion Group his analysis of three private letter ruliongs released by the IRS on Friday (April 14, 2008):  PLR 200816002, 200816003, and 200816004 (Jan. 14, 2008).  He has agreed to let me share his thoughts on the rulings with the broader tax community on TaxProf Blog:

PLR 200816002 – 200816004 informs us that there is a new type of eligible shareholder of a Subchapter S corporation: a single-member LLC that is completely owned by an eligible S corporation shareholder (e.g., an individual).

The statutes provide that only an individual, an estate (including a bankruptcy estate), a charity, a qualified retirement plan, and certain specific types of trusts (grantor trust, QSST and ESBT) are eligible to be shareholders of an S corporation. §§ 1361(b)(1)(B), 1361(c)(2), 1361(c)(6) and 1361(d). One other eligible shareholder is another S corporation, but only when that S corporation is a 100% shareholder (making the controlled S corporation a 100% subsidiary). § 1361(b)(3). A partnership cannot own stock of an S corporation. On the day that an S corporation has an ineligible shareholder it loses its S corporation tax statutes and is instead treated as a C corporation. § 1362(d)(2).

In the PLR, the Service permitted a single-member LLC to be an S corporation shareholder. The logic is that the single-member LLC is disregarded for federal tax purposes. Reg. § 301.7701-2(a). The tax information of the LLC is reported on the sole owner’s personal income tax return, just as was the case when the individual personally owned the stock. In the ruling, an individual transferred his S corporation stock as well as other property to a single-member LLC, where the shareholder was the sole owner of the LLC.

Two questions:

1. Seems to me that if another person ever became a member of the LLC, the corporation would lose its S corporation tax status because the LLC would be deemed to be a partnership for tax purposes. By having an LLC as an owner of an S corporation, there may be a greater risk of an inadvertent termination?
2. Basic question: when would someone recommend putting S corporation stock into a single-member LLC? What are the advantages? Some sort of administrative convenience? Greater estate tax discounts if the other property contributed is marketable securities? Perhaps it is helpful when the LLC will engage in a business related to the S corporation and the financial activities will be consolidated?

Comments and suggestions are welcome.

Update:

• Alice Abreu (Temple):

This is very interesting, and it is consistent with prior IRS positions. For example, PLR 20000815 and 20010712 describe situations where each of two shareholders of an S corporation formed two entities. One entity was an LLC and the other was a state law limited partnership in which the partners were the LLC and the shareholder. The S shareholder then transferred part of the S stock to each of the two entities. The Service concluded that both the LLC and the partnership were disregarded entities and therefore for tax purposes, the shareholder was still the owner of the S corporation stock and the S election remained valid. To reach that conclusion the Service reasoned, correctly in my view, that the LLC was a disregarded entity because it had only the shareholder as its owner, and that the partnership was also a disregarded entity because it had only one owner – the shareholder. Ownership of a partnership interest by the LLC was disregarded because the LLC was disregarded, which left the partnership with only the shareholder as owner.

I’ve wondered why someone would do the transactions described in the ruling and I’m told that the reason is likely that more owners make the corporation a better vehicle for asset protection under state law.

• Brant Hellwig (South Carolina):

Like Alice, I have heard that the reason for holding S Corp shares through a single-member LLC is to gain the advantage of charging-order protection in the LLC context. Under most states’ LLC statutes, a creditor of an LLC member is entitled only to a charging order on the LLC member’s distributional interest, meaning that the creditor is entitled to whatever distributions are made to the debtor-member. Similar to a wage garnishment arrangement. Importantly, the creditor does not acquire the debtor-member’s managerial rights. So, in theory, the debtor LLC member could simply refuse to make any distributions from the entity, leaving the creditor with a charging order on a non-existent payment stream.

If all of this sounds too good to be true in the context of a single-member LLC, it probably is. Recent bankruptcy cases concerning single-member LLCs have blown through the charging order protection. See In re Modanlo, 2007 WL 2609470 (Bankr. D. Md. 2006); In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003). While these decisions rely on bankruptcy law to conclude that the bankruptcy trustee possessed the managerial rights of the debtor-member, each case characterizes the state-law charging order protection as essentially meaningless in the single-member context. [The Albright court in a footnote goes so far as to note the creation of "peppercorn" interests in other LLC members could be disregarded under fraudulent conveyance theory. Whether this "peppercorn" analysis would extend to the creation of a partnership between an individual and that individual’s single-member LLC is another question.]

So the purported asset-protection advantages of holding S corporation stock through a single-member LLC that is disregarded for tax purposes may not amount to much. On the other hand, having a multiple-shareholder S corporation that is organized under state law as an LLC that checks the box should provide the owners with the benefits of charging-order protection.