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One class of stock requirement: final regulations.

Under Sec. 1361(b)(1)(D), a corporation having more than one class of stock does not qualify as an S corporation. The purpose of the one class of stock requirement is to confine S corporation eligibility to entities with simple capital structures and avoid the complexities associated with allocations of income and loss among multiple classes of stock.(1) Although the one class of stock requirement appears to promote simplicity in corporate structure, it has raised many questions as to what constitutes a second class of stock.(2)

Identical Distribution and Liquidation Rights

The IRS suggests in general that "... a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds."(3) As long as all shares have identical rights to distribution and liquidation proceeds, it is acceptable for the S corporation to have voting and non-voting common stock, a "class" of stock that may vote only on certain issues, irrevocable proxy agreements or groups of shares that differ with respect to rights to elect members of the board of directors.(4)

The governing provisions determine whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. Included in the governing provisions are the corporate charter, articles of incorporation, bylaws, applicable state law and binding agreements relating to distribution and liquidation proceeds. Commercial contractual agreements such as leases, employment agreements or loan agreements are not governing provisions unless a principal purpose is to circumvent the one class of stock requirement.(5)

Generally the final regulations apply to taxable years of a corporation beginning on or after May 28, 1992. However, they do not apply to an instrument, obligation, or arrangement issued or entered into before May 28, 1992 and not materially modified after that date. The final regulations also do not apply to a buy-sell agreement, redemption agreement, or agreement restructuring transferability entered into before, or a call option or similar instrument issued before, May 28, 1992 and not materially modified after that date. S corporations and their shareholders have the option to apply the final regulations to earlier tax years.(6) A grandfather rule applies for stock issued on or before May 28, 1992 which has been treated as outstanding by the corporation even though substantially nonvested and for which no Sec. 83(b) election has been made. Thus, such stock would not be treated as a second class of stock.(7)

Applications of One Class of Stock

Rev. Rul. 73-525(8) held that an S corporation which owned a nursing home did not create a second class of stock by amending its certificate of incorporation to provide that shareholders over age 65 who had owned at least ten shares of stock for more than five years and who were in need of nursing home care could be admitted to the corporation's nursing home at a reduced rate. The Service stated there was no difference as to voting rights, dividend rights or liquidation preferences of the outstanding stock. It was also noted that the benefits granted the shareholders under the amendment were determined by much more than stock ownership and therefore were not attributable to the stock as such. Although the corporation amended its incorporation agreement, a governing provision, do all shares still have identical rights to distribution and liquidation proceeds? To the extent eligibility for special admission is not treated as a preferential distribution, Rev. Rul. 73-525 would remain valid under the final regulations.

Tax planning in a family owned business can be enhanced as a result of being able to structure ownership utilizing both voting and non-voting stock. Control could be maintained by certain shareholders who operate the business through ownership of voting stock. Non-voting stock could permit family members who are not active in the business to share in the equity of the corporation without controlling the corporation's activities.

The one class of stock requirement prohibits S corporations from being recapitalized to accomplish an "estate freeze." However, non-voting stock can be utilized to shift appreciation to a junior generation with the senior generation retaining control of the S corporation by holding the majority of the voting shares.

Issued and Outstanding Stock

Only stock which is issued and outstanding is considered in determining whether a corporation has more than one class of stock. Treasury stock and unissued stock of a different class held by the shareholders do not disqualify an S corporation.(9) The Service has also ruled the relevant stock is the outstanding, not the authorized, stock in the instance of a C corporation seeking to qualify for an S election. The C corporation reorganized and converted two classes of stock into one new class of stock. However, at the time of its S election the corporation had not yet filed revised articles of incorporation accordingly the new stock was outstanding but not authorized. Under applicable state law the two classes of stock were deemed canceled on the date of conversion, so the one class of stock requirement was met.(10)

BUY-SELL AND REDEMPTION AGREEMENTS

Regulation 1.1361 - 1(1)(2)(iii)(B) provides a special rule that bona fide agreements to redeem or purchase stock at the time of death, divorce, disability or termination of employment are disregarded in determining whether a corporation's shares of stock confer identical rights. Also disregarded are buy-sell agreements among shareholders, agreements restricting the transfer of stock and redemption agreements, which do not qualify under the special rule, unless a principal purpose of the agreement is to circumvent the one class of stock requirement and the agreement establishes a redemption price significantly in excess of or below the stock's fair market value.(11)

An agreement providing a redemption price at book value or between fair market value and book value is not considered significantly in excess of or below fair market value. A good faith determination of fair market value is acceptable unless it can be shown that the value was substantially in error and the determination of value was not performed with reasonable diligence.(12) A safe harbor is provided for the book value amount when it is determined in accordance with generally accepted accounting principles or the book value is used for any substantial nontax purpose.(13)

The final regulations appear consistent with a previous ruling by the Service that a stock purchase agreement between an S corporation and one of its shareholders did not create a second class of stock where the sale was to be made at book value and did not affect the shareholder's rights to the corporation's profits and assets.(14) In this ruling the S corporation had two classes of common stock which were identical in all respects except for voting rights and a restriction on the non-voting shareholder's right to dispose of the stock. The shareholder was allowed to transfer his stock only with the consent of the owners of the voting shares. Without such consent he could only sell the stock to the corporation or the other shareholders at book value. In event of the non-voting shareholder's death, disability or termination of employment, the corporation or the other shareholders had the right to purchase his stock.

Letter Ruling 8920016 also seems compatible with the regulations in holding that a second class of stock was not created by a stock purchase agreement requiring either the corporation or the other shareholders buy the stock of a terminating employee for the greater of the shareholder's equity or a price determined under a formula based on corporate net income.

COMPENSATION ARRANGEMENTS

Unreasonable Compensation

As employment agreements are not governing provisions,(15) a second class of stock does not result if excessive compensation is paid a shareholder in accordance with such an agreement. However, the agreement must not have been used to circumvent the one class of stock requirement of Sec. 1361(b)(1)(D).(16) In addition, to the extent such excessive compensation is recharacterized as a distribution, the S corporation may not be allowed a deduction.(17)

Tax planning may be enhanced by the ability to distribute different amounts to different shareholder employees, avoid disproportionate distribution treatment and not be subject to a second class of stock challenge. Salary differentials should be useful in differentiating between and among shareholders to the extent they do not conflict with the circumvention requirement.

Deferred Compensation Plans

An instrument, obligation or arrangement utilized in connection with a deferred compensation plan is not considered outstanding stock providing it meets all of the following requirements:

1. It does not convey the right to vote;

2. It is an unfunded and unsecured promise to pay money or property in the future; and

3. It is issued to an individual who is an employee or an independent contractor in connection with and commensurate with the performance of services for the corporation under a plan in which the recipient is not currently taxed.(18)

However, a beneficial interest in assets, including money, which is transferred or set aside from the claims of creditors of the transferor (e.g., a trust or escrow account) would be considered property and would not qualify as a deferred compensation plan.(19)

Letter Rulings 9109025 and 9032027 are consistent with the regulations in holding that performance units issued under a deferred compensation and performance unit plan are not a class of stock. In Letter Ruling 9032027 the Service referenced Rev. Rul. 67-269(20) which stated ". . . options, warrants and convertible debentures have none of the attributes of immediate stock ownership, such as the right to receive dividends."

Restricted Stock

Stock issued in connection with the performance of services which is substantially nonvested stock (for which no Sec. 83(b) election has been made) is not treated as outstanding stock of the corporation.(21) In event a Sec. 83(b) election is made, the stock is treated as outstanding stock of the corporation and as a second class of stock unless such stock confers identical rights to distribution and liquidation proceeds as those of the other outstanding shares.(22)

Thus, incentive plans such as "phantom stock" which provide key employees with economic benefits linked to the performance of the corporation but do not involve a capital investment or risk of loss should continue to be acceptable. The Service has earlier determined that a phantom stock plan did not constitute stock for purposes of Sec. 1362(b)(1) when a corporation proposed to grant certain employees "units" under a "stock appreciation rights plan." Holders of the units would be entitled to payments in connection with:

1. Termination based on the increase in net asset value of the common stock between the time of the issuance of the units and the time of termination of employment;

2. Payments based on the amount of dividends (other than stock) paid on the common stock, to be paid at the time of the dividends; and

3. Payments upon liquidation of the corporation based on the difference between the liquidation proceeds and the net asset value of the corporation at the time of the issuance of the units.

The units would not constitute stock under state law, plan participants would have no voting rights, no right to approve or reject the sale of the corporate assets or no right to participate as stockholders in current or liquidating distributions.(23)

The Service has also found that "performance units" which may be elected by employees in lieu of cash bonuses and which are used to determine the amount of benefit distributions upon an employee's death or termination of employment do not constitute a second class of stock.(24)

Call Options, Warrants or Similar Instruments

A call option, warrant or similar instrument issued by a corporation is treated as a second class of stock if, taking into account all the facts and circumstances, such instrument:

1. Is substantially certain to be exercised by the holder or a potential transferee; and

2. Has a strike price substantially below the fair market value of the underlying stock on the date that the call option is issued, transferred by a person who is an eligible shareholder to a person who is not an eligible shareholder under Sec. 1361(b)(1) or materially modified.(25)

However, a call option does not have a strike price substantially below fair market value if the price at the time of exercise under the terms of the option cannot be substantially below the fair market value of the underlying stock. A material modification does not include the extension of the time period in which the option may be exercised if the option is issued in connection with a loan and the extension is in connection with and consistent with a modification of the loan terms.(26)

The regulations make further inquiry required before relying on Rev. Rul. 67-269.(27) Such ruling held that options and warrants have none of the attributes of immediate stock ownership, such as the right to vote in the capacity of a shareholder or the right to receive dividends; and, therefore, the mere issuance of such options and warrants would not constitute a second class of stock. Examination of all the facts and circumstances including the certainty of exercise as well as the strike price of the instrument must now be reviewed in determining whether a second class of stock may be deemed to exist.

Exceptions

A call option is not treated as a second class of stock if issued by a corporation to a person actively and regularly engaged in the business of lending and the loan to the corporation is commercially reasonable. The lender is also permitted to transfer a call option together with the related loan to another lender without losing the benefit of this exception.(28)

A second class of stock likewise is not created as a result of a call option being issued to an individual who is an employee or an independent contractor in connection with the performance of services for the corporation or a related corporation if the option is:

1. Not excessive by reference to the services performed;

2. Nontransferable within the meaning of Regs. 1.83-3(d) (subject to a substantial risk of forfeiture); and

3. Does not have a readily ascertainable fair market value as defined in Regs. 1.83-7(b) (generally actively traded on an established market) at the time the option is issued.(29)

A corporation is related to the issuing corporation if more than 50% of the total voting power and total value of its stock is owned by the issuing corporation.(30) Should such call option become transferable, it would be treated as a second class of stock if:

1. The option is materially modified or is transferred to a person who is not an eligible shareholder; and

2. On the date of such modification or transfer, the option is substantially certain to be exercised and has a strike price substantially below the fair market value of the underlying stock.(31)

Call Option Safe Harbor

In event the strike price of a call option is at least 90% of the fair market value of the underlying stock on the date the option is issued, transferred to an ineligible shareholder or materially modified, the option is not treated as a second class of stock. A good faith determination of fair market value by the corporation will be respected unless it can be shown the value was substantially in error and the determination of the value was not performed with reasonable diligence.(32)

Utilization of Options

Call options, warrants or similar instruments are not treated as a second class of stock unless, considering all the facts and circumstances, they are substantially certain to be exercised by the holder and have a strike price less than 90% of the market value of the stock. Observing these requirements, such instruments could be used as a medium to effect special allocations among qualifying persons by allowing losses to be distributed among current shareholders and at the occurrence of an event, such as the profitability of the corporation, or after a period of time, allowing exercise or conversion. The exercise or conversion should, of course, provide the holders with the same class of stock that was previously issued (identical rights to distribution and liquidation proceeds) so that the one class of stock rule is observed.

Fringe Benefits

Different amounts paid for accident and health insurance premiums by an S corporation for shareholder-employees under binding employment agreements do not cause the corporation to be treated as having more than once class of stock. Although there may not be identical rights to distribution as to amounts for premiums, the agreements are not governing provisions. However, the agreements cannot be utilized to circumvent the one class of stock requirement of Sec. 1361(b)(1)(D).(33)

A below market rate loan to which Sec. 7872 applies made by an S corporation to a shareholder who is deemed to receive a distribution with respect to S stock does not cause the corporation to be treated as having a second class of stock. The loan agreement is not considered to be a governing provision. However, a principal purpose of the loan must not have been to circumvent the one class of stock requirement of Sec. 1361 (b)(1)(D).(34)

OTHER DISTRIBUTIONS

State laws which require corporations to pay state income taxes on behalf of nonresident shareholders may not cause the corporations to be treated as having more than one class of stock. However, when the constructive distributions resulting from the payment or withholding of taxes by the corporation are taken into account, the outstanding shares must confer identical rights to distribution and liquidation proceeds. The timing difference between the constructive distributions and the actual distributions to the other shareholders are ignored under the "identical rights" tenent.(35)

A governing provision requiring distributions to be made in the current taxable year on the basis of the shareholders' varying interest in the S corporation's income in the immediately preceding taxable year, does not result in a second class of stock. However, such distributions which are not made within a reasonable time after the close of the taxable year may be recharacterized, depending on the facts and circumstances, without a second class of stock consequence.(36)

SECOND CLASS OF STOCK

Legal Restrictions

A state law which alters the rights of outstanding shares so all such shares are not entitled to identical distribution and liquidation proceeds creates a second class of stock. Thus a corporation could not qualify as a small business corporation if holders of stock issued for property and not cash had to waive all rights to receive distributions until shareholders who contributed cash had received distributions equal to their cash contributions.(37)

Binding Agreement

Distributions which differ in timing do not create a second class of stock unless they result from a binding agreement relating to distribution or liquidation proceeds. Thus an S corporation with two shareholders entitled to equal distributions makes a distribution to one shareholder of $50,000 in the current year and $50,000 to the other shareholder a year later. The corporation will not be treated as having a second class of stock if the difference in timing did not occur as a result of a binding agreement. However, Sec. 7872 or other recharacterization principles may apply to determine the appropriate tax consequences.(38)

A binding agreement which under the regulations is treated as a governing provision, does cause an S corporation to be treated as having more than one class of stock. Thus, a corporation which makes a binding agreement with its shareholders to modify its normal distribution policy by making upward adjustments of its distributions to those shareholders with larger state tax obligations has created a second class of stock. Such adjustments were based on a formula to give the shareholders equal after-tax distributions.(39)

Convertible Debt

A convertible debt instrument is considered a second class of stock if it is treated as equity under general principles of federal tax law (such as Sec. 385) governing the distinction between debt and equity and a principal purpose is to circumvent either the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock or the limitation on eligible S shareholders.(40) A second class of stock is also deemed to be created when a convertible debt instrument includes rights equivalent to those of a call option that is substantially certain to be exercised and:

1. Has a strike price that is substantially below the fair market value of the underlying stock on the date of issue;

2. Is transferred to a person who is not an eligible shareholder; or

3. The instrument is materially modified according to the guidelines for call options.(41)

The regulations do not recognize the nonstock equity concept developed in case law under which debt that had equity characteristics was deemed to be a capital contribution but did not create a second class of stock.(42) Rather the regulations treat all convertible debt that is reclassifled as equity as creating a second class of stock.(43)

The regulations contain certain tests (including whether the instrument is used as a means to violate existing shareholders' rights to distributions or to overcome the limitations on eligible shareholders) not included in Rev. Rul. 67-269(44) which held that convertible debentures have none of the attributes of immediate stock ownership, such as the right to vote in the capacity of a stockholder, or the right to receive dividends and therefore do not constitute a second class of stock. Careful review of all the facts and circumstances before relying on such ruling after the effective date of the regulations seems imperative.

SAFE HARBORS

Straight Debt

Straight debt is not treated as a second class of stock.(45) To qualify as straight debt there must be a written unconditional obligation, which need not be a formal note, to pay a sum certain on demand or on a specified due date provided that:

1. The interest rate and payment dates are not contingent on profits, the borrower's discretion, the payment of dividends with respect to common stock or similar factors;

2. The obligation is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation; and

3. The creditor is a party who would be an otherwise eligible S corporation shareholder.(46)

Subordination of an obligation to other debt of the corporation does not prevent the obligation from qualifying as straight debt.(47) However, an obligation ceases to qualify as straight debt if materially modified so it no longer meets the straight debt definition or is transferred to a third party who is not an eligible shareholder.(48)

An obligation of an S corporation that qualifies as straight debt under the guidelines just noted is not treated as a second class of stock even if it is considered as equity under general principles of federal tax law. Interest paid or accrued on straight debt does not constitute a distribution to which Sec. 368 applies. An unreasonably high rate of interest on a straight debt obligation which may, in part, be recharacterized and not treated as interest does not result in the obligation being treated as a second class of stock.(49) Also, straight debt that is considered equity under the general principles of federal tax law is not treated as a second class of stock if the C corporation converts to S status. In addition, conversion from C corporation to S corporation status does not cause the straight debt instrument to be treated as an exchange of debt for stock.(50)

Application of Straight Debt

The straight debt safe harbor can serve as a vehicle to shift some appreciation in S corporation stock to a younger generation while senior shareholders retain voting control as well as receive current income. Senior shareholders can in effect recapitalize the corporation by taking straight debt in lieu of cash distributions while gifting non-voting stock to a younger generation.

Short Term Unwritten Advances

Unwritten advances from a shareholder that do not exceed $10,000 in the aggregate at any time during the taxable year of the corporation, are treated as debt by the parties and are expected to be repaid within a reasonable time, are not treated as a second class of stock. Treatment as debt is appropriate even though the advances are considered equity under the general principles of federal tax law. However, second class of stock treatment is the norm when:

1. The advance constitutes equity or results in the holder being treated as owner of stock under general principles of federal tax law; and

2. The advance is used to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock or to circumvent the limitation on eligible shareholders.(51)

Proportionately Held Obligations

Proportionately held obligations are obligations of the same class that are recharacterized as equity for federal tax purposes, but are owned solely by the shareholders of the corporation in the same proportion as the corporation's outstanding stock. Such obligations are not treated as a second class of stock. Obligations owned by the sole shareholder of a corporation are always held proportionately. The failure of obligations to meet this safe harbor will not result in a second class of stock unless a principal purpose is to circumvent the rights of the outstanding shares of stock or the limitation on eligible shareholders.(52)

INADVERTENT TERMINATIONS

The Service has the authority to waive the effects of a termination if a corporation ceased to be a small business corporation through failure to satisfy one of the definitional components of Sec. 1361 when it takes steps within a reasonable time after discovery to correct the deficiency. (53) Regs. 1-1361-1(l)(6) specifically references Sec. 1362(f) as "relating to inadvertent termination in cases where the one class of stock requirement has been inadvertently breached." However, inadvertent termination relief is not available if the second class of stock conditions existed at the date of conversion from the C to S status. In such instances, the S election is deemed never to have been effective, which precluding the Service from granting a waiver.(54)

Conclusion

The final regulations interpreting the one class of stock requirement for S corporations continue the stance that differences in voting rights are not enough to create a second class of stock. A second class of stock will exist, however, if all outstanding shares do not confer identical rights to distribution and liquidation proceeds. The regulations base the determination of identical rights on the "governing provisions" which include the corporate charter, articles of incorporation, bylaws, applicable state law and binding agreements relating to distribution and liquidation proceeds.

Distributions that differ in timing, excessive compensation paid to a shareholder, agreement to pay fringe benefits, state law requirements for payment of income tax for shareholders and redemption agreements which would have been treated as a second class of stock under the first proposed regulations are now generally not subject to such a challenge.

In addition, there are safe harbors for instruments, obligations or arrangements treated as equity under general principles of tax law, for straight debt and for certain call options under the final regulations. A number of planning techniques involving buy-sell and redemption agreements and deferred and restricted compensation plans which would have created a second class of stock under the first proposed regulations can now continue to be utilized in an S corporation environment.

Footnotes

1 Senate Report No. 830, 88th Cong., 2d Sess., 146 (1964).

2 See for instance, Portage Plastics Co., 73-1 USTC 9261 (CA-7, 1973).

3 Regs. 1.1361-1(l)(1).

4 Ibid.

5 Regs. 1-1361-1(l)(2)(i).

6 Regs. 1-1361-1(l)7.

7 Regs. 1-1361-1(b)(6).

8 1973-2 C.B. 311.

9 Pre-SSRA Regs. 1.1371-1(g).

10 Letter Ruling 9027007.

11 Regs. 1-1361-1(l)(2)(iii)(A).

12 Ibid.

13 Regs. 1-1361-1(l)(2)(iii)(C).

14 Rev. Rul. 85-161, 1985-2 C.B. 191.

15 Regs. 1-1361-1(l)(2)(i).

16 Regs. 1-1361-1(l)(2)(v) Example 3(i).

17 Regs. 1-1361-1(l)(2)(v) Example 3(ii).

18 Regs. 1-1361-1(b)(4).

19 Regs. 1.83-3(e).

20 1967-2 C.B. 298.

21 Regs. 1-1361-1(b)(3).

22 Regs. 1.1361-1(l)(3).

23 Letter Rulings 9040035, 8834085 and GCM 39750.

24 Letter Ruling 9032027.

25 Regs. 1-1361-1(l)(4)(iii)(A).

26 Ibid.

27 1967-2 C.B. 298.

28 Regs. 1-1361-1(l)(4)(iii)(B)(1).

29 Regs. 1-1361-1(l)(4)(iii)(B)(2).

30 Ibid.

31 Regs. 1-1361-1(l)(4)(v) Example 2.

32 Regs. 1-1361-1(l)(4) (iii)(C).

33 Regs. 1-1361-1(l)(2)(v) Example 4.

34 Regs. 1-1361-1(l)(2)(v) Example 5.

35 Regs. 1-1361-1(l)(2)(ii) and 1-1361-1(l)(2)(v) Example 7.

36 Regs. 1-1361-1(l)(2)(iv).

37 Regs. 1-1361-1(l)(2)(v) Example 1.

38 Regs. 1-1361-1(l)(2)(v) Example 2.

39 Regs. 1-1361-1(l)(2)(v) Example 6.

40 Regs. 1-1361-1(l)(4)(iv)(A).

41 Regs. 1-1361-1(l)(4)(iv)(B).

42 Portage Plastics Co., Inc., op. cit.

43 Regs. 1-1361-1(l)(4)(iv).

44 1967-2 C.B. 298.

45 Sec. 1361(c)(5).

46 Regs. 1-1361-1(l)(5).

47 Regs. 1-1361-1(l)(5)(ii).

48 Regs. 1-1361-1(l)(5)(iii).

49 Regs. 1-1361-1(l)(5)(iv).

50 Regs. 1-1361-1(l)(5)(v).

51 Regs. 1-1361-1(l)(4)(ii)(B)(1).

52 Regs. 1-1361-1(l)(4)(ii)(B)(2).

53 Sec. 1362(f).

54 Sec. 1362(f)(1).

Henri Pusker, DBA, CPA, is a professor of accounting at Savannah State College in Savannah, Georgia. He received his doctor of business administration from Indiana University. He has published in numerous tax and accounting journals.
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Title Annotation:tax code provisions on S corporations
Author:Pusker, Henri K.
Publication:The National Public Accountant
Date:Oct 1, 1992
Words:4976
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