A corporation may elect S status for federal income tax purposes in order to operate on a "flow-through" basis for tax purposes. If the company experiences unexpected growth or a transition to a new family member, the company may want to consider issuing equity to a new investor in exchange for an investment to fuel additional growth of the company's operations or to partially buy-out a shareholder.
The company may experience a snag if the new investor is an ineligible S corporation shareholder. Ineligible shareholders include a corporate entity, an LLC that has multiple members, a limited partnership, a nonresident alien (i.e.: a foreign investor living abroad). Alternately, the investor may require a preferred class of equity as a condition to making the investment, which is not allowed by an S corporation.
If an S corporation were to issue shares to an ineligible shareholder or issue ineligible preferred shares, the corporation would lose its tax flow-through status and become a C corporation. In some instances, the company may choose to become a C corporation as part of the investment process. The choice may depend in part on the company's future exit plan.
However, if the company prefers to maintain its tax flow-through status, another solution is required. One technique to facilitate the investment involves a restructuring of the company whereby its business is contributed to a newly formed limited liability company subsidiary. The new investor becomes a partner in the LLC, which would elect flow-through tax treatment as a partnership. The company becomes the other partner to the new LLC. A tiered flow-through structure would be in place for tax purposes, where the LLC conducts operations and its income or loss flows through to its members, including the S corporation company. The S corporation's portion of the income or loss in turn would flow through to the original shareholders.
If the S corporation desires to redeem a portion of its historic shareholders' equity as part of the transaction, some of the investment funds can be distributed or paid to the S corporation company, which may in turn distribute the funds or redeem some of its shares. Some complications can arise depending on the facts at issue.
One disadvantage to the structure is that the company's overall holding structure becomes more complicated as a result. If there is more than one shareholder of the S corporation, a future exit of one (but not all) of the S corporation shareholders can raise tax complications as well.
In some cases, the growth company will use the opportunity of the company recapitalization under the new structure to issue incentive equity to key management. For example, the new LLC operating company may issue profits interests that an S corporation would not be eligible to issue to employees without a negative tax consequence.
In summary, restructuring an S corporation growth company into an S corporation holding company with an LLC operating company, with an investor member receiving preferred equity in the operating LLC often allows a company to facilitate growth capital while maintaining its tax flow-through status.
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