Insights

Reason 1: Operating agreements can invalidate the S election

Many LLC operating agreements can result in the termination of the S election. Even if the LLC operating agreement does not terminate the S election, many of its provisions are inapposite to a corporation, as explained below.

An LLC operating agreement is the foundational governing document for LLCs, similar to the articles of incorporation and the bylaws for corporations. In many cases, the tax adviser is not the first professional who is consulted for the choice of business entity. Business clients concerned with personal liability seek the advice of an attorney who invariably recommends and organizes an LLC for the client and prepares the operating agreement. In the authors' experience, it seems in recent years, for small to medium-size business, LLCs are the chosen legal vehicle rather than corporations.

The default tax classification for a domestic multimember LLC is a partnership.2 The default classification for a domestic single-member LLC is a disregarded entity.3 LLC operating agreements are written under the applicable state statute and tend to conform to partnership tax law in the case of a multimember LLC. Operating agreements for single-member LLCs are typically much shorter without much of the partnership tax language but can still contain language that is not appropriate for corporations.

The important issue here is that operating agreements written with partnership tax law in mind have provisions that can invalidate an S election due to the Subchapter S prohibition of having more than one class of stock.4 It is critical that before making the S election for an LLC, the tax adviser read and provide recommendations for revisions to the operating agreement to conform to the S corporation rules. This article is not intended to create a comprehensive list of provisions in an operating agreement that would require review and revision; it highlights some of the more common provisions.

First, a corporation that has more than one class of stock is ineligible to become an S corporation.5 The Treasury regulations provide that "a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds."6 Further, the Treasury regulations provide that:

"The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions)."7

Therefore, the operating agreement is the governing instrument of the LLC for purposes of establishing whether the LLC has only one class of stock.

Most, if not all, operating agreements that are not structured for the S election have many references to capital accounts, which can be problematic. Equity interests in corporations are represented by capital stock and paid-in capital; not capital accounts. Partnerships are required to maintain capital accounts for the partners in order to meet the safe-harbor provisions of the substantial-economic-effect regulations under Sec. 704(b).8 Capital accounts can be the measuring device that determines which members receive distributions, the amount of the distributions, and when distributions are made.

For example, many operating agreements, for both business reasons and to meet the safe harbors under the substantial-economic-effect regulations under Sec. 704(b), provide that upon liquidation of an LLC, liquidating distributions are to be made to members according to the positive balance in their capital accounts.9 Such positive balances do not always correspond to the members' proportionate membership interest in the LLC. Such a provision would violate the single-class-of-stock rule and would invalidate the S election.

For an LLC electing S status, liquidating distributions are required to be made in proportion to the owners' membership interests in the LLC in order to satisfy the requirement to "confer identical rights to distribution and liquidation proceeds." If the operating agreement is silent with respect to liquidating distributions, the state LLC statute will be the default, which may not always be proportional.10 Accordingly, for LLCs treated as S corporations, all references to capital accounts should be removed from the operating agreement, and liquidating distributions should be proportionate to the ownership percentages.

Other provisions that will cause distributions, income, and deductions to be made or allocated disproportionately to the member's ownership percentage should also be removed. Many of these provisions are tax boilerplate and are critical for entities classified as partnerships but, nevertheless, present serious problems for LLCs classified as S corporations. For example, some of the more complex operating agreements have distribution "waterfalls" that provide for priority of distributions to certain members before other members receive distributions or provide for a guaranteed rate of return on capital. These provisions could result in a second class of stock. Operating agreements that create more than one class of membership interest are problematic (see reason No. 9, "Investor Opportunity Is Limited," for further discussion).

Examples of other provisions that should be removed include any special allocations of income and deductions, references to Sec. 754 elections, allocations of contributed built-in gains or losses under Sec. 704(c), the deficit restoration obligation and qualified income offset under the Sec. 704(b) substantial-economic-effect regulations,11 and provisions dealing with allocations of nonrecourse deductions.12

Another issue that arises is whether a multimember LLC that makes an S election, but fails to qualify as an S corporation because of a defective operating agreement, would be classified as a partnership or a C corporation. The regulations under the one-stop-shop procedure of merely filing a Form 2553 and the preamble to the temporary regulations issued in 2004 suggest that the LLC would default to the partnership classification rather than a C corporation.13 Query whether the filing of Form 8832 and then subsequently filing Form 2553 (two-step method) would change that result to a C corporation.14 Nevertheless, although better than a C corporation, defaulting to a partnership presents procedural issues related to employment taxes and self-employment tax. Because partners of a partnership cannot also be employees, the tax adviser would need to wrestle with incorrect payroll tax returns and self-employment tax issues at the member level for prior tax years that have already been filed.

An LLC that determines that its S election was terminated due to a defective operating agreement may avail itself of the inadvertent termination relief of Sec. 1362(f). The request for relief is in the form of a private ruling request to the IRS national office and requires a significant user fee be paid.15 For example, in IRS Letter Ruling 202111011, an LLC that elected S status applied for inadvertent termination relief under Sec. 1362(f). The LLC's operating agreement included partnership provisions that failed to provide identical distribution and liquidation rights to its members. The operating agreement required the LLC to make liquidating distributions to its members in accordance with the members' positive balances in their capital accounts rather than in proportion to their membership interests. The LLC was able to demonstrate that the circumstances surrounding its invalid election were inadvertent and unintended. Hence, the IRS granted relief.

Reason 2: Potential gain recognition at time of election

The second reason why LLCs should think carefully before electing to be S corporations is that an S election can result in gain recognition at the time of the election. The tax treatment of a change in classification of an entity for federal tax purposes by making an entity classification election is "determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine."16

If an LLC classified as a partnership elects to be classified as an "association" (the term the relevant regulations use for an S corporation),17 the LLC is treated as though it has contributed its assets to an association in exchange for stock in the association. Immediately after the deemed contribution, the LLC is deemed to liquidate (for tax purposes only) and distribute the stock of the association to its members.18 If an LLC classified as a disregarded entity elects to be classified as an association, the member of the LLC is deemed to contribute all of the assets and liabilities to the association in exchange for stock in the association.19 The regulations refer to "stock" even though under state law an LLC's equity ownership is normally represented by a membership interest.20

Whether a transferor recognizes gain or loss upon a transfer or contribution of assets to a corporation is governed by Sec. 351 and Sec. 357.21 Sec. 351 provides that no gain or loss is recognized (to a transferor(s)) if property is transferred to a corporation solely in exchange for stock in the corporation if immediately after the exchange, the transferor(s) are in "control" of the corporation.22 Unlike a transfer of property to an existing corporation where the transferor may not be in control of the corporation immediately after the transfer (and, hence, Sec. 351 would not apply and gain or loss could be recognized), an S election by an LLC should not theoretically present the same 80% control issue. In case of an LLC treated as a partnership, the partnership should be in control of the S corporation immediately after the deemed transfer of property. In the case of an LLC entity treated as a disregarded entity, the member of the LLC should be in control of the S corporation immediately after the deemed transfer of property.

Gain, but not loss, is recognized to the transferor(s) if money or other property ("boot") is received in the exchange in addition to stock of the transferee corporation.23 Because this is an election with a deemed exchange and not an actual exchange, it may be difficult to conceive of a situation involving an election by an LLC that could involve the receipt of boot by the transferor for purposes of Sec. 351(b). Nevertheless, where the corporation assumes liabilities of the transferor and the liabilities assumed exceed the adjusted tax basis of the assets transferred, gain is recognized to the transferor to the extent of such excess.24

It is important to have a definitive tax basis balance sheet before the LLC elects S status. Recognized partnership gain could result if the liabilities of the LLC exceed the tax basis of the assets at the effective date of the S election. Recognized individual gain could result if the liabilities of the disregarded entity exceed the tax basis at the effective date of the S election.

Reason 3: Potential gain recognition to new members contributing property

A new member that receives a membership interest in exchange for property contributed to an LLC that has elected S status may recognize taxable gain as though the property were sold to the LLC. New members of the LLC who contribute property to an LLC that has elected S status will need to consider the 80% control requirement of Sec. 351 rather than the more lenient requirements of Sec. 721 under the partnership provisions of Subchapter K. As referenced above,25 a transferor(s) of property to a corporation will generally not recognize gain or loss if the transferor(s) obtains the requisite 80% control of the corporation immediately after the transfer. In the partnership context, Sec. 72126 does not contain any such control requirement.

Example 1: For example, assume CPA firm XY LLC elected to be treated as an S corporation. X and Y each own 50%. Z has his own CPA firm, a single-member LLC treated as a disregarded entity. XY LLC has offered to admit Z as a 10% member in exchange for Z's contribution or transfer of his clients (represented by goodwill with no tax basis). XY LLC does not want to own Z's LLC or assume any of his liabilities. Immediately after the transfer to XY LLC, Z will only own 10% and thus fail the 80% control requirement. Z's contribution or transfer of clients to XY LLC will result in gain recognition to Z as though Z sold the clients, with a potential zero tax basis, to XY LLC in exchange for a membership interest. If XY LLC did not make an S election and was classified as a partnership for tax purposes, no gain or loss to Z would result upon Z's contribution or transfer of clients to XY LLC under Sec. 721(a).27

Reason 4: No special allocations

An S corporation offers no flexibility with respect to allocating items of income and deduction that are not in proportion to the shareholders' stock ownership interest. Sec. 1366 provides that "there shall be taken into account the shareholder's pro rata share of the corporation's (A) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and (B) nonseparately computed income or loss." (Emphasis added.)

The pro rata share is calculated on a per share, per day basis under Sec. 1377(a). Possibly the nearest concept to a special allocation would be through shareholder compensation adjustments; but there are limits to this technique, including reasonableness tests.

On the other hand, partnership taxation offers greater flexibility in allocating items of income and deduction. Provided that the allocations meet the substantial-economic-effect tests of Sec. 704(b) and the regulations promulgated thereunder, a partnership can allocate items of income and deduction among its partners without regard to the partners' ownership interest percentages. A comprehensive discussion of "substantial economic effect" is beyond the scope of this article. Only the highlights are presented below.

Determining whether an allocation meets the substantial-economic-effect test requires a two-part analysis. First, the allocation must have economic effect, and second, the allocation must be substantial.28 The regulations provide three safe harbors (all three must be met) to satisfy the economic-effect analysis and require that these be included in the partnership agreement or LLC operating agreement:

1. Partner capital      accounts must be maintained in accordance with the rules prescribed by the      regulations;

2. Liquidating      distributions are required to be made in accordance with the partners'      positive capital account balances; and

3. There exists      either a deficit restoration obligation or, in the alternative, a      qualified income offset.29

The second part of the analysis requires that the allocation be "substantial." Substantiality essentially looks to the ultimate tax consequences of the allocation and whether there is an after-tax benefit to the allocation or allocations. The regulations provide that:

"the economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement ..."30

Reason 5: S corporation member/shareholder tax basis excludes entity-level indebtedness

A significant advantage of partnership taxation versus S corporation taxation is the ability to include entity-level indebtedness in the partner's tax basis of his or her interest in the partnership.31 Most real estate investments are held in entities that are classified as partnerships principally for this reason. This leverage allows a partner to deduct losses in excess of contributed capital (subject, of course, to other limitations, such as tax basis, at-risk, the passive-activity-loss limitations, and the excess-business-loss limitation of Sec. 461(l)). It also allows a partner to receive nontaxable cash distributions, provided the cash distributions do not exceed the partner's tax basis of its interest in the partnership.

In contrast, a shareholder of an S corporation cannot include entity-level indebtedness in the shareholder's tax basis of his or her stock. Subchapter S of the Code does not have a counterpart to Sec. 752. Further, it is relatively settled law that a shareholder guaranty of corporate debt does not increase the shareholder's stock basis until, and unless, the shareholder is required to personally pay on the guaranty.32

Reason 6: Gain recognition for distributions of appreciated property

Distributions of appreciated property by an S corporation to a shareholder can result in gain recognition. In general, Subchapter C of the Code applies to S corporations and its shareholders. Accordingly, both current and liquidating distributions of appreciated property by the S corporation to its shareholders result in gain recognition at the S corporation level that passes through to its shareholders.33 The distribution of property is treated as if the property were sold to the distributee shareholder at its fair market value.34In addition, a corporate-level tax could result for recognized built-in gains for an S corporation that converted from a C corporation, or for an S corporation that receives a transfer of assets from a C corporation in a nonrecognition transaction, during the five-year recognition period.35

On the other hand, a partnership that distributes appreciated property to a partner generally does not recognize gain.36An exception to this general rule exists with respect to disproportionate distributions to a partner relating to certain ordinary income assets.37 Further, distributions of property in kind (not cash) generally do not result in a partner-level gain. Except as provided in Sec. 751(b) mentioned above, in the case of a distribution by a partnership to a partner, gain is only recognized to the extent that any cash distributed exceeds the adjusted basis of the partner's interest in the partnership.38

In the case of a current distribution, the tax basis of the distributed property in the hands of the partner is the same as the basis of the property to the partnership immediately before the distribution, limited to the adjusted tax basis of the partner's interest in the partnership reduced by any cash received in the same transaction.39 In the case of a liquidating distribution, the tax basis of the distributed property in the hands of the partner is equal to the adjusted basis of the partner's interest in the partnership, reduced by any cash received in the same transaction.40In addition, there is no counterpart for partnerships with respect to entity-level taxation that exists for S corporations under Sec. 1374.

Therefore, partnerships offer significantly more flexibility and planning opportunities. For example, partnership breakups where partners divide up partnership assets can be accomplished without immediate tax consequences (subject to Sec. 751 discussed above). Also, partnerships offer planning opportunities for distributions of real estate to the partners to be held as tenants in common where there is not unanimous agreement regarding a like-kind exchange under Sec. 1031.

Reason 7: No inside asset tax basis step-up when members change or exit

There is no provision in Subchapter S that permits the inside tax basis of the corporation's assets to achieve a step-up in tax basis when a shareholder dies, when a person acquires the stock of a shareholder, or when there is a distribution of property or cash to a shareholder.41 Conversely for partnerships, an election under Sec. 754 permits adjustment of the inside tax basis of assets with respect to an acquisition of a partner's interest by another, upon the death of a partner, or upon certain distributions of cash or property to a partner.42

Reason 8: Other S corporation restrictions and limitations

In addition to restrictions discussed above regarding the one-class-of-stock rule and pro rata allocations, S corporations have other qualifications and restrictions as follows:43

• The number of      shareholders is limited to 100.

• S corporations      restrict the type of shareholders to individuals and only certain trusts      and to estates. Corporations and partnerships cannot be shareholders in an      S corporation.

• Nonresident      aliens are not eligible shareholders of an S corporation.44

• S corporations      can be subject to entity-level taxation under Sec. 1374 (the built-in      gains tax) and Sec. 1375 (excess passive investment income).

Reason 9: Investor opportunity is limited

Except for differing rights with respect to voting, an S corporation cannot have different classes of owners under the one-class-of-stock rule.45 Many modern-day LLCs are structured with different membership classes (or C corporations with varying preferred and common stock classes) to entice investors that have disparate investment needs and requirements. Varying classes of membership, e.g., Class A, Class B, etc., that contain legal characteristics that offer the members priorities as to distributions and/or a rate of return on their investment would run afoul of the one-class-of-stock rule if the LLC were to elect S status. Therefore, an S corporation is not an attractive investment vehicle if the corporation is seeking new rounds of investment funds from individual investors that require an investment other than plain-vanilla common stock.

Reason 10: Maintaining passthrough treatment in an M&A transaction

Maintaining passthrough treatment and single-level taxation can be challenging for an acquirer that is not an eligible shareholder of S corporation stock. A corporate acquirer or a multimember LLC acquirer of S corporation stock would terminate the S election because they are ineligible S shareholders. There are no member eligibility rules for LLCs classified as partnerships for tax purposes.

There is, however, a possible workaround to this problem that has become popular in recent years due to the IRS's issuance of Rev. Rul. 2008-18. The workaround involves a pre-acquisition restructuring using an F reorganization.<46 The downside is that with any legal restructuring, there are several steps along with associated fees and costs. In Rev. Rul. 2008-18, the IRS ruled that the following facts meet the requirements of a nontaxable F reorganization:

1. B, an      individual, owns all of the stock in Y, an S corporation.

2. In year      1, B forms Newco.

3. B contributes      all of the Y stock to Newco.

4. Newco meets the      requirements for qualification as an S corporation.

5. Newco timely      elects to treat Y as a qualified Subchapter S subsidiary (QSub).47 Y then becomes a disregarded      entity.48

6. In year 2,      Newco sells a 1% interest in Y to D.

The IRS ruled that Y's original S election does not terminate but continues for Newco. Y retains its employer identification number (EIN). Newco must obtain a new EIN. Upon the sale of 1% of Y, Y's QSub election terminates (because it is not 100% owned after the sale of 1% to D).

Tax advisers have added another step to this transaction. Immediately after the QSub election for Y, Y is converted to an LLC under a state law conversion statute. Y will then become a single-member LLC and a disregarded entity. This step should be nontaxable because a disregarded entity (the QSub) is converting to another disregarded entity (the single-member LLC). After the conversion to an LLC, an investor purchases a membership in the LLC either from Newco or directly from the LLC under Sec. 721. Y would then transform into a multimember LLC treated as a partnership with Newco and the acquirer as members/partners. The acquirer could also purchase 100% of Newco's membership interest in Y. This would be treated as a deemed asset purchase, and Y would become a disregarded entity to the acquirer. In either case, the acquirer has preserved the passthrough treatment without causing Y to convert to a C corporation.

Often overlooked considerations

The discussion above offers at least 10 reasons why LLCs should not elect S status. There may be more. An LLC's election to be classified as an S corporation results in a hybrid entity with state law characteristics that align in many respects with a partnership while being treated for tax purposes as a corporation. This can create traps and can result in adverse tax consequences, including the disqualification of the S corporation election. In our view, in many cases, the payroll tax savings are outweighed by the disadvantages of Subchapter S. The failure to review the operating agreement for provisions incompatible with Subchapter S can result in the termination of the S election. When making the choice whether to elect S status for an LLC, a longer timeline should be considered that takes into account other "life events" of the entity and its members. Considerations of the ultimate and potential tax consequences of this choice should be reviewed carefully.

Footnotes

1An eligible entity that timely elects to be an S corporation under section 1362(a)(1) is treated as having made an election under this section to be classified as an association, provided that (as of the effective date of the election under section 1362(a)(1)) the entity meets all other requirements to qualify as a small business corporation under section 1361(b). Subject to § 301.7701-3(c)(1)(iv), the deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election, under §301.7701-3(c)(1)(i), to be classified as other than an association" (Regs. Sec. 301.7701-3(c)(1)(v)(C)). See also the instructions to Form 8832, Entity Classification Election,and the instructions to Form 2553, Election by a Small Business Corporation.

2Regs. Sec. 301.7701-3(b)(1)(i).

3Regs. Sec. 301.7701-3(b)(1)(ii).

4Sec. 1361(b)(1)(D). However, voting and nonvoting common stock are permitted (Sec. 1361(c)(4)).

5Id.; Regs. Sec. 1.1361-1(l)(1).

6Id.

7Regs. Sec. 1.1361-1(l)(2)(i).

8Regs. Sec. 1.704-1(b)(2)(ii)(b)(1); Regs. Sec. 1.704-1(b)(2)(iv).

9Regs. Sec. 1.704-1(b)(2)(ii)(b)(2).

10For example, if the operating agreement is silent with respect to liquidating distributions, the Connecticut LLC statute requires distributions to be first made to members in an amount equal to the respective values of the member's unreturned contributions and then proportionate to their membership interests (Conn. Gen. Stat. §34-267f). Such a provision could confer differing distribution rights among members and, thus, invalidate the S election.

11Regs. Sec. 1.704-1(b)(2)(ii)(b)(3); Regs. Sec. 1.704-1(b)(2)(ii)(c); Regs. Sec. 1.704-1(b)(2)(ii)(d).

12Regs. Sec. 1.704-2. See also Hamill, "Avoiding Traps When Electing S Corporation Status for an LLC," RIA Checkpoint (March 28, 2013).

13See fn. 1; "However, if the eligible entity's election is not timely and valid, the default classification rules provided in § 301.7701-3(b) will apply to the entity unless the Service provides late S corporation election relief or inadvertent invalid election relief. If the late or invalid election is not perfected, the default rules will maintain the passthrough taxation treatment by classifying the entity as a partnership or a disregarded entity" (T.D. 9139 (July 19, 2004)). See also Hamill, "Avoiding Traps When Electing S Corporation Status for an LLC," RIA Checkpoint (March 28, 2013).

14For an excellent discussion see Hamill, "Avoiding Traps When Electing S Corporation Status for an LLC," RIA Checkpoint (March 28, 2013).

15Regs. Sec. 1.1362-4(c). See the first issued revenue procedure of the year for the list of user fees, e.g., Rev. Proc. 2022-1. [Editor’s note: Shortly after this article was published, the IRS issued a revenue procedure that provides retroactive corrective relief procedures allowing LLCs in certain circumstances to preserve an invalidly made or inadvertently terminated S election without having to request a letter ruling. See Rev. Proc. 2022-19.]

16Regs. Sec. 301.7701-3(g)(2)(i).

16See Regs. Sec. 301.7701-2(b)(2). See also Sec. 7701(a)(3), which provides that "[t]he term 'corporation' includes associations, joint-stock companies, and insurance companies."

18Regs. Sec. 301.7701-3(g)(1)(i). The tax effects of the deemed liquidation would need to be considered. For example, in the partnership context, if there is LLC debt that is deemed relieved and is treated as a deemed distribution of money to the members under Sec. 752, gain at the member level could be recognized under Sec. 731(a)(1) if the deemed cash exceeds a member's tax basis of its membership interest.

19Regs. Sec. 301.7701-3(g)(1)(iv).

20"The term 'stock' includes shares in an association, joint-stock company, or insurance company" (Sec. 7701(a)(7)).

21For purposes of this article, it is assumed that the entity is not an investment company as defined in Sec. 351(e).

22Sec. 351(a). "Control" is defined as "ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation" (Sec. 368(c)).

23Sec. 351(b).

24Sec. 357(c). Further, if the principal purpose of the taxpayer with respect to an assumption of liabilities is tax avoidance of federal income tax or there is no bona fide business purpose for the assumption of liabilities, the total amount of the liabilities assumed (not merely the excess of liabilities over tax basis of assets) is treated as boot for purposes of calculating gain under Sec. 351(b). The burden of proof is on the taxpayer to prove by the clear preponderance of the evidence that the principal purpose did not involve the avoidance of federal income tax and that there was a bona business purpose for the assumption of the liabilities (Sec. 357(b)).

25See fn. 22.

26"No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership" (Sec. 721(a)).

27As a potential workaround, Z can also elect S status for his LLC prior to the transaction, and merge his LLC/S corporation into XY LLC under the corporate reorganization provisions of Sec. 368. However, under this structure, XY LLC would be succeeding to Z's entity (including liabilities) rather than merely the assets. In addition, there is an issue whether the "pre-incorporation" step violates the "immediately after test" of Sec. 351 under a step-transaction analysis due to the existence of a preconceived plan of a merger into the transferee S corporation.

28Regs. Sec. 1.704-1(b)(2)(i).

29Regs. Secs. 1.704-1(b)(2)(ii)(b) and (d) (dealing with the qualified income offset).

30Regs. Sec. 1.704-1(b)(2)(iii)(a). See Regs. Sec. 1.704-1(b)(2)(iii)(b) for allocations that have "shifting tax consequences" and Regs. Sec. 1.704-1(b)(2)(iii)(c) dealing with "transitory allocations."

31Partnership-level debt is accorded treatment under the aggregate theory (as opposed to the entity theory) of partnership taxation whereby a partner is deemed to "own" a pro rata share of assets and liabilities of the partnership. "Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership" (Sec. 752(a)). Conversely, "[a]ny decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership" (Sec. 752(b)).

32See, e.g., Brown, T.C. Memo. 1979-220; Albert, T.C. Memo. 1980-567; Estate of Leavitt, 875 F.2d 420 (4th Cir. 1989).

33Secs. 311(b) and 336(a).

34Id.

35Sec. 1374. Sec. 1374 is not likely implicated when an LLC initially elects S corporation status. Nevertheless, Sec. 1374 may be implicated for possible subsequent nontaxable transfers of assets from a C corporation.

36Sec. 731(b).

37Sec. 751(b).

38Sec. 731(a). This result is aligned with the aggregate theory of partnership taxation.

39Sec. 732(a).

40Sec. 732(b).

41A step-up in tax basis of the inside tax basis of assets of an S corporation can be achieved, however, when there is an 80% acquisition of the stock by a purchasing corporation making an election under Sec. 338(h)(10) or a sale of 80% of the stock of the corporation by a seller making an election under Sec. 336(e).

42The operative Code sections are Sec. 743(b), dealing with acquisitions of a partner's interest or death of a partner, and Sec. 734(b), dealing with partnership distributions.

43See Sec. 1361 for rules relating to S corporation qualifications.

44But see Sec. 1361(c)(2)(B)(v), as amended by the law known as the Tax Cuts and Jobs Act, P.L. 115-97, permitting nonresident aliens as potential current beneficiaries of an electing small business trust, effective Jan. 1, 2018.

45An S corporation can maintain voting and nonvoting common stock (Sec. 1361(c)(4)).

46An F reorganization is a nontaxable reorganization and is defined as "a mere change in identity, form, or place of organization of one corporation, however effected" (Sec. 368(a)(1)(F)).

47See line 14 of Form 8869, Qualified Subchapter S Subsidiary Election, which includes a question whether the QSub election is being made in combination with an F reorganization described in Rev. Rul. 2008-18.

48Sec. 1361(b)(3)(A).