Hidden Risks in LLC Operating Agreements: How IRS Relief Protects S Corporation Status During M&A

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:

1. 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.
2. Heightened Due Diligence in M&A: More deal teams are flagging LLC operating agreements that do not comply with S corporation requirements. Increased IRS
3. 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.