In the past, a limited liability company (LLC) that wished to establish an employee stock ownership plan (ESOP) would have first had to convert to a corporation in order to have “qualifying employer securities,” as defined in section 4975(e)(8) of the Internal Revenue Code (Code), one of the core requirements for an ESOP. However, the IRS has always allowed LLCs to be taxed as a corporation under the Code for other purposes, particularly federal tax purposes, so there had always been hope that the IRS would someday allow an LLC to be treated as a corporation for ESOP purposes.
Well, it seems that day has finally come. The IRS recently issued Private Letter Ruling 201538021, which allows an LLC to adopt an ESOP under the following circumstances:
- The LLC has elected to be taxed as a corporation
- The LLC issues ownership interests to its members in the form of “unit shares”
- The unit shares have identical liquidation and voting rights
- The unit shares have the greatest voting and dividend rights of any class of unit shares issued by the LLC
- Distributions (i.e., dividends) on the unit shares are paid in proportion to the outstanding unit shares
- The profits and losses are allocated in proportion to the number of unit shares held by each unit shareholder
Although this ruling is welcome, one might wonder, “Why not just convert an LLC to a corporation before adopting an ESOP?” Such a conversion can usually be done seamlessly and in a tax-free manner, and doing so would avoid any concern about whether a business is permitted to adopt an ESOP. However, sometimes such a conversion will result in adverse tax consequences (e.g., depending on how the conversion takes place, an LLC member-owner can end up with a different tax basis in the resulting corporate stock that he or she owns and may have a tax liability at the time of conversion). An LLC that wishes to adopt an ESOP should weigh the advantages and disadvantages of converting to a corporation or remaining an LLC. In addition, until the IRS issues more generally applicable guidance on this issue, if an LLC chooses to remain an LLC but wants to proceed with an ESOP, it should strongly consider applying for a private ruling of its own, because a private letter ruling may only be relied on by the taxpayer requesting it.