When an LLC elects to be taxed as an S-Corp, for tax purposes, the members of the LLC are treated as shareholders of an S-Corp. Under Colorado statutes, the fact that an LLC member is treated as a shareholder does not alter their designation as a member or restrict how the LLC can operate. However, there can be serious consequences and conflicts between how the LLC works under its Operating Agreement and the treatment of the members as S-Corp shareholders for tax purposes.
Under the tax code, the persons, and number of persons, who can be shareholders of an S-Corporation are limited. For example, S-Corporations can have no more than 100 shareholders. And S-Corporations cannot have partnerships, LLCs, Corporations, or non-resident aliens as shareholders. Furthermore, S-Corporations can have only one class of stock.
LLCs under Colorado law do not have these limitations. An LLC could have a Corporation as a member, but if it does, it cannot be taxed as an S-Corp. Accordingly, if an LLC elects to be taxed as an S-Corp, but a member then transfers their interest to an LLC, the S-Corp tax status is undone. And this results in all of the members losing the benefits of the status, not just the member who makes the erroneous transfer.
As a way to address this, an LLC can include in its Operation Agreement provisions that restrict a member’s ability to transfer an interest if such transfer would disqualify the LLC’s election for S-Corp tax status. In short, the Operating Agreement can state that such transactions are void as if they never happened.
Operating Agreements are very flexible and should proactively be used by members to address this kind of situation, as well as a host of other situations to protect and reinforce the deal within which the members are engaged.