The IRS released a recent Private Letter Ruling (PLR 201538021) that surprisingly allows a Limited Liability Company (“LLC”) to adopt an ESOP. This is a new development that should be considered with caution since a PLR only applies to the taxpayer that asked for the ruling and there are some pre-requirements that may continue to create a tax problem if implemented.
Here’s the story:
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.
In a the recent Private Letter Ruling mentioned above, 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 shareholder
- 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 opens up the possibility of an LLC using an ESOP. However, caution is advised because a PLR is only applicable only to the taxpayer that requested it. If you wish to adopt an ESOP to acquire LLC 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 corporation into the decision-making process before you choose to use an ESOP.