By Foodman CPAs & Advisors
One Clause. Big Consequences.
A boilerplate clause in an LLC’s operating agreement can silently jeopardize an entire transaction.
For financial institutions, legal advisors, and family offices involved in M&A, losing S corporation status is not just a technical error. It creates real tax exposure and can reduce deal value significantly. The Overlooked Risk in Standard Agreements
Many LLCs elect to be taxed as S corporations. However, default operating agreements, often adapted from partnership templates, may include language that violates the IRS’s “one class of stock” rule.
- These silent violations can trigger major consequences: 21% federal corporate tax applied retroactively
- State tax liability depending on jurisdiction
- Disqualification from private equity acquisition targets
- IRS scrutiny, during transaction due diligence
Why the Risk Is Escalating.
Three developments have brought this issue to the forefront:
- IRS Revenue Procedure 2022-19 (October 2022): Introduced a self-correction process for certain S corporation violations that does not require a private letter ruling.
- Heightened Due Diligence in M&A:
- More deal teams are flagging LLC operating agreements that do not comply with S corporation requirements. Increased IRS Enforcement:
- The IRS has begun auditing entities that attempt corrections after a transaction has already taken place. Relief Is Available, but It Comes with Conditions
Revenue Procedure 2022-19 provides a way to retroactively correct specific S corporation compliance errors. However, eligibility depends on several factors:
- The error must be inadvertent
- Documentation must be complete and submitted in a timely matter
- The correction must be made before the IRS initiates contact
If these elements are not met, buyers may reduce the offer price or withdraw entirely from the transaction.
What M&A Stakeholders Should Evaluate
Whether you are preparing for exit, evaluating a target, or advising clients on either side, confirming S corporation compliance is now essential.
S Corporation Compliance Checklist:
- Was the LLC’s operating agreement based on a partnership template?
- Do any distribution clauses suggest unequal treatment of shareholders?
- Has the entity properly filed an S corporation election with the IRS?
- Have any past agreements or amendments created preferential rights?
- Has the LLC proactively resolved these issues using Revenue Procedure 2022-19?
Missing any of these points can delay or disrupt the transaction.
Why Private Equity Firms Are Focused on This Issue
Roughly 72% of private equity deals now require the target to be an S corporation at closing. Letters of intent increasingly request compliance certifications to reduce the risk of post-closing tax liability.
This trend means due diligence must include a review of legal structure and tax compliance, not just financials.
The Bigger Picture
This is not only about tax classification.
- S corporation status issues can materially impact deal valuation
- Invalidation can trigger unexpected tax costs
- Post-transaction audits expose both parties to risk
Foodman’s Perspective
At Foodman CPAs & Advisors, we help clients identify and resolve structural tax risks before they affect transaction value. Our team brings deep experience in complex entity structure, IRS procedures, and cross-border deal considerations. We work closely with legal and financial stakeholders to make sure nothing is overlooked before a transaction moves forward.
Ready to evaluate your LLC operating agreements? We can help you uncover and correct issues before they affect the outcome.
