S Corporation Elections for Tennessee LLCs: The Operating Agreement, the Owners, and Keeping the Election

An LLC can elect to be taxed as an S corporation. Whether it should is a question for your CPA. The legal question is whether the operating agreement, the owners, and the paperwork fit rules written for corporations, when many LLC agreements were written for partnerships.

This article covers what is specific to an LLC. For basic eligibility, shareholder consent, Form 2553 timing, and how C and S corporation tax compare, see forming a corporation in Tennessee.

How an LLC becomes an S corporation for tax purposes

By default, a domestic LLC with two or more members is a partnership for federal tax purposes, and a single-owner LLC is disregarded (26 C.F.R. § 301.7701-3(a), (b)(1)). An LLC can elect to be classified as an association, meaning a corporation for tax purposes, by filing Form 8832 (§ 301.7701-3(c)(1)(i)).

An LLC that wants S status usually does not need that separate step. A timely S election is treated as an election to be classified as an association, if the LLC meets the small business corporation requirements as of the effective date, and the Form 2553 instructions say no Form 8832 is needed (§ 301.7701-3(c)(1)(v)(C); Instructions for Form 2553, rev. December 2020).

Two points follow. The classification is for federal tax only; under Tennessee law the company is still an LLC, governed by its articles and operating agreement. And because the deemed classification lasts until the LLC elects otherwise, an LLC whose S election later ends is generally still taxed as a corporation, not a partnership (§ 301.7701-3(c)(1)(v)(C)).

The one-class-of-stock rule and the operating agreement

A corporation is treated as having only one class of stock if all outstanding shares confer identical rights to distribution and liquidation proceeds, judged from its governing provisions, which include binding agreements relating to those proceeds. Differences in voting rights alone are disregarded (26 C.F.R. § 1.1361-1(l)(1), (2)(i)).

The regulation is written in corporate terms. For an LLC, the operating agreement is the binding agreement that sets distribution and liquidation rights, so it is the document to review. Several provisions common in agreements written for partnership tax can give members rights that are not identical:

• Special allocations of profit or loss that do not follow ownership percentages, where those allocations feed capital accounts that drive distributions or liquidation.
• Preferred returns or priority distributions to one member or class.
• Liquidation in accordance with positive capital account balances, where capital accounts can drift away from percentage interests.
• Tax distributions that are adjusted for each member's own tax rate. One of the regulation's examples treats a binding agreement to increase distributions to shareholders with heavier state tax burdens as creating more than one class of stock (§ 1.1361-1(l)(2)(vi), Example 6).

Whether a particular provision creates a second class depends on its wording, and I am not aware of a Tennessee appellate decision applying this regulation to an LLC agreement. The IRS treats a non-identical provision as a problem even if no uneven distribution was made (Rev. Proc. 2022-19, § 2.03(6)(a)). Section 3.06 of that revenue procedure allows a retroactive fix without a private letter ruling only if, among other conditions, there has been no disproportionate distribution, every Form 1120-S was timely filed, and the required statements are completed before the IRS discovers the provision (§ 3.06(2)(b)).

Uneven distributions are treated differently. The IRS has said it will not treat disproportionate distributions as violating the one-class requirement so long as the governing provisions provide for identical distribution and liquidation rights (Rev. Proc. 2022-19, § 3.02). Distributions that differ in timing or amount are still given appropriate tax effect (§ 1.1361-1(l)(2)(i)), so uneven distributions are worth raising with your CPA.

Buy-sell agreements, transfer restrictions, and redemption agreements are generally disregarded for this test unless a principal purpose of the agreement is to get around the one-class requirement and the agreement sets a purchase price significantly above or below fair market value when it is made (§ 1.1361-1(l)(2)(iii)(A)). A buy-sell agreement can sit alongside an S election, but its price terms deserve a look.

Who can hold an interest

For these rules, the LLC's members stand in for shareholders. As the corporation article explains, each must be an individual, an estate, a permitted trust, or a qualifying exempt organization, and none may be a nonresident alien (26 U.S.C. § 1361(b)(1)(B), (C), (c)(6)). That matters when a member is a holding company or another multi-member LLC.

Permitted trusts include a trust treated as wholly owned by an individual who is a U.S. citizen or resident (a grantor trust), that trust for two years after the deemed owner's death, a trust holding stock received under a will for two years after the transfer, a voting trust, an electing small business trust, and a qualified subchapter S trust, whose single income beneficiary makes the election (§ 1361(c)(2)(A), (d), (e)). For an electing small business trust, each potential current beneficiary counts as a shareholder (§ 1361(c)(2)(B)(v)).

For the 100-shareholder limit, a husband and wife, and all members of a family, are treated as one shareholder. Family means a common ancestor, that ancestor's lineal descendants, and the spouses or former spouses of any of them (§ 1361(c)(1)).

Whether a particular trust qualifies depends on its terms, a question for the member's estate planning attorney and CPA. Requiring consent before any transfer gives the LLC a chance to check eligibility first.

Paying the owners: reasonable compensation

The IRS states that S corporations must pay reasonable compensation to a shareholder-employee for services before making non-wage distributions to that shareholder-employee. It also states that it has the authority to reclassify non-wage distributions, which are not subject to employment taxes, as wages, which are (IRS, S Corporation Compensation and Medical Insurance Issues). The factors the IRS lists include training and experience, duties, time devoted to the business, and what comparable businesses pay for similar services.

No statute that I found sets the amount. Among the decisions the IRS cites is David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), which affirmed treating part of a sole shareholder-employee's distributions as wages for FICA purposes. Watson is an Eighth Circuit decision; Tennessee is in the Sixth Circuit.

For a multi-member LLC, this is an operational change. The IRS says partners are not employees and should not be issued a Form W-2; an S corporation pays a working owner through payroll. How that compares with the owners' current self-employment tax is a calculation for your CPA.

There is a Tennessee wrinkle. In computing excise tax net earnings, an LLC taxed as a partnership, or a single-member LLC treated as an individual, subtracts the amount subject to self-employment tax, so long as that does not create or increase a net loss (Tenn. Code Ann. § 67-4-2006(a)(4)(B), (a)(7)(B)). The S corporation definition has no such subtraction (§ 67-4-2006(a)(2)). The election can change the Tennessee excise base too.

Late elections: Rev. Proc. 2013-30

The IRS's simplified relief for a late S election is in Rev. Proc. 2013-30. For an LLC that never filed Form 8832, a late Form 2553 also means a late corporate classification, because that classification comes only from a timely S election. The Form 2553 instructions give a separate list for that case. The LLC generally qualifies if:

1. It is an eligible entity that intended to be an S corporation as of the intended effective date.
2. It failed to qualify as a corporation solely because Form 8832 was neither filed nor deemed filed, and failed to qualify as an S corporation because Form 2553 was not filed on time.
3. It has reasonable cause for the late filing and acted diligently to correct the mistake once it was discovered.
4. Form 2553 is filed within 3 years and 75 days of the intended effective date, with no exception for a later filing.
5. It timely filed every Form 1120-S consistently with S status (or the first one is not yet due), and everyone who was a shareholder between the intended effective date and the filing date provides a statement that they reported their income consistently with the S election for every affected year.

An LLC that already had corporate classification, for example from an earlier Form 8832, follows the corporation list instead, which has a narrower path past the 3-year-and-75-day window. Otherwise, relief generally requires a private letter ruling and a user fee. A late election must say "FILED PURSUANT TO REV. PROC. 2013-30" at the top of the first page (Instructions for Form 2553; Rev. Proc. 2013-30, §§ 3.02, 4.02, 4.03(1), 5.01 to 5.04).

How the election ends

• Revocation: shareholders holding more than one-half of the shares on the day of the revocation can revoke the election (26 U.S.C. § 1362(d)(1)). That threshold may not match the operating agreement's voting rules, so the agreement can address how the members decide whether to consent.
• Ceasing to qualify: the election terminates whenever the company stops being a small business corporation (§ 1362(d)(2)(A)), for example through a transfer to an ineligible owner or a second class of stock.
• Passive investment income: the election terminates if the corporation has accumulated earnings and profits at the close of three consecutive S corporation years and more than 25 percent of its gross receipts in each of those years is passive investment income (§ 1362(d)(3)(A)). Because an S corporation's earnings and profits generally are not adjusted (26 U.S.C. § 1371(c)(1)), this mostly concerns companies with a C corporation history.
• Inadvertent termination relief: if an election failed or terminated because of an eligibility problem, missing consents, or the passive income rule, the IRS can treat the company as an S corporation anyway if it finds the circumstances inadvertent, the problem was fixed within a reasonable time after discovery, and the company and its shareholders agree to any required adjustments (§ 1362(f)).
• Waiting period: after a termination, the company (and any successor) generally cannot elect again before its fifth taxable year beginning after the first year the termination is effective, unless the IRS consents (§ 1362(g)).

Built-in gains for former C corporations

If a company with a C corporation history elects S status, § 1374 imposes a corporate-level tax on net recognized built-in gain for any taxable year beginning in the recognition period, which is the 5-year period beginning with the first day of the first S year, at the highest rate in § 11(b) (26 U.S.C. § 1374(a), (b)(1), (d)(7)(A)). The tax does not apply to a corporation that has had an S election in effect for each of its taxable years (§ 1374(c)(1)). For an LLC, this mainly matters if it was previously taxed as a C corporation, including after an earlier S election ended.

What the election does not change in Tennessee

These points come from the franchise and excise tax statutes, the Department of Revenue's website, and its Franchise and Excise Tax Manual (June 2026):

• Franchise and excise tax: the statutes define a taxpayer to include every subchapter S corporation and limited liability company (Tenn. Code Ann. § 67-4-2004(36)), so the S election does not remove an LLC that is chartered, registered, or doing business in Tennessee from either tax.
• Excise base: an S corporation's net earnings for excise tax are federal taxable income calculated as if it had not elected S status (§ 67-4-2006(a)(2)), as the corporation article explains.
• No separate state election: I did not find a Tennessee S election form. Taxpayers indicate their entity type when registering with the Department, and the return uses the excise schedule for that entity type (Schedule J3 for S corporations).
• Family-owned exemption: the statute exempts a "family-owned noncorporate entity" whose activity is substantially all passive investment income, with or without farming (Tenn. Code Ann. § 67-4-2008(a)(11)), and the manual says the exemption is not available to corporate entities, including S corporations. Neither source says directly how an LLC that has elected S status is treated. For federal tax, though, an LLC that elects S status is treated as having elected to be classified as a corporation (26 C.F.R. § 301.7701-3(c)(1)(v)(C)), and Tennessee classifies an entity for these taxes the way it is classified for federal income tax (§§ 67-4-2007(d), -2106(c)). That suggests the exemption may not be available, but no Tennessee source says so directly, so for an LLC relying on it, that is a question for the CPA before filing.
• Hall income tax: the Hall income tax on interest and dividends was repealed for tax periods beginning on or after January 1, 2021.

If your CPA has recommended an S election and you want the operating agreement, ownership, and paperwork to fit it, my office can review the documents and handle the legal side of the election.

Educational disclaimer: This article provides general Tennessee educational information only and is not legal or tax advice for any specific business or LLC.