Greenlight: IRS lets LLCs adopt ESOPs

A recent IRS ruling creates opportunities for Limited Liability Companies (LLCs) that want to utilize an Employee Stock Ownership Plan (ESOP). Here’s why: For many years the LLC has been the business entity of choice. It offers liability protection, design flexibility, and certain tax advantages to the owners. One of the disadvantages, when compared to a corporation, was that the LLC and its owners could not adopt an ESOP as a technique for sharing ownership with employees, for succession planning purposes, or ownership liquidation. However, that is about to change.

The rules under the Internal Revenue Code have so far limited the use of ESOPs to C- or S-Corporations. One of the requirements for an ESOP is that it invests predominantly in qualifying employer securities. LLCs were not permitted to have ESOPs because the membership units were not considered qualifying employer securities.

As a result, an LLC had to be converted to a corporation in order to utilize an ESOP. Although the process may not be all that complicated, it sometimes created adverse tax consequences for a converting owner.

Under the IRS “check the box” regulation, the IRS permits LLCs to elect to be treated like corporations for tax purposes. In addition, many LLCs are designed to operate much like a corporation. Considering LLCs can be taxed like corporations and operate like corporations, many LLC owners and their advisors felt that the prohibition against LLCs utilizing ESOPs was a case of form over substance.

New developments

In a recent Private Letter Ruling (PLR 201538021), the IRS ruled that the membership units of an LLC will be considered as qualified employer securities under the Internal Revenue Code. This means that an LLC could establish an ESOP and have it hold LLC units.

The ruling is conditioned on the LLC and its units having the following characteristics:
  • The LLC must elect to be treated as a corporation for tax purposes
  • The LLC issues membership units which it calls unit shares 
  • All of the unit shares must have equal voting rights and liquidation rights
  • The unit shares to be sold or held by the ESOP must have the greatest voting and dividend rights of any unit shares issued by the LLC
  • If the LLC issues dividends, they must be distributed to the unit shareholders in proportion to the unit shares owned by the shareholders
  • If the LLC allocates profits or losses, they must be allocated to the unit shareholders in proportion to the unit shares owned by the shareholders 

What the ruling means for LLCs

The ruling is a welcome clarification of the rules and opens up the possibility of an LLC using an ESOP. However, there are some words of caution here. The ruling is a PLR and as such is applicable only to the taxpayer that requested it. If you wish to have an LLC adopt an ESOP for purposes of acquiring the LLC’s membership units, you are best advised to request your own private letter ruling. In addition, if an existing LLC has been taxed like a partnership, checking the box to be taxed as a corporation could result in adverse tax consequences. Since there may be tax issues for the members, it is important to carefully analyze and factor check the box and being taxed as a C-Corporation into the decision-making process before you choose to use an ESOP.

McDonald Hopkins has considerable experience structuring ESOP transactions and can help evaluate whether an ESOP would work for your corporation and now for your LLC. For more information, please contact one of the attorneys listed below. 
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