Second class of stock rules for S corporations.

SECOND CLASS OF STOCK RULES FOR S CORPORATIONS

One of the major limits on S corporations is that they may have only one class of stock. If this rule is violated, a corporation's S status is terminated and it will be treated as a regular corporation.

In October 1990, the Internal Revenue Service issued proposed regulations explaining this requirement.

PROPOSED REGULATIONS

Under the proposed regulations, an S corporation has one class of stock if all outstanding shares confer identical distribution and liquidation proceed rights. The key to analyzing this is the actual economic benefit conveyed by each share; if differences in rights arise because of state law, corporate charters or corporate articles or bylaws, the corporation will be considered to have more than one class of stock.

DISPROPORTIONATE

DISTRIBUTIONS

S corporations that make distributions to shareholders that vary with respect to timing or amount have made "nonconforming distributions." These distributions will create a second class of stock and will terminate the corporation's S status.

This rule could come into play for even a one-time payment or a minor amount (such as a corporation's payment of a shareholder's monthly credit card bill). There is no de minimis exception.

There is an exception for distributions with time differences that are otherwise pro rata with respect to all outstanding shares. These distributions will not create a second class of stock if the differences in the timing are unintentional (this term is not defined) or if the distributions were intentional but are corrected within three months. (This three-month period may not extend beyond the corporation's yearend.)

Effective date. Because these regulations will be retroactive to the enactment of the Subchapter S Revision Act, every S corporation election after 1982 could be affected.

The effective date could present a very serious trap, especially with respect to other sections of the Internal Revenue Code. If amounts distributed by an S corporation are later classified by the IRS as distributions under other IRC provisions (such as the reasonable compensation rules), the reclassification will create non-conforming distributions after the fact, and the corporation's S status will be considered terminated.

STOCK ISSUED FOR SERVICES

Stock that is substantially non-vested will not be treated as outstanding for S corporation purposes. However, if a shareholder who receives stock in return for services elects to include the value of the stock in income (under what is known as a section 83(b) election), the stock will be considered outstanding and the holder must be treated as a shareholder. Thus, if the stock received does not have the same rights for distribution and liquidation proceeds, as well as for profit and loss sharing, a termination of S status will have occurred.

INCENTIVE ARRANGEMENTS

Under the proposed regulations, deferred compensation arrangements will not create a second class of stock if

* They do not convey the right to vote.

* They involve unfunded, unsecured promises to pay.

* They are issued to an employee in connection with the performance of services.

Options, warrants or other arrangements will be considered a second class of stock if it is substantially certain that the instruments will be exercised by the holder, regardless of whether they would be treated as stock under general tax law.

Note: The IRS previously had taken the position that warrants or options would not create a second class of stock if they did not have other attributes of stock, such as the right to vote or the right to receive dividends.

In addition, buy-sell agreements will not create a second class, as long as all stock has equal liquidation rights.

DEBT AS SECOND CLASS

OF STOCK

The proposed regulations say the general corporate rules will be applied to determine if a purported debt instrument is in fact equity. However, debt will be considered straight debt if it involves an unconditional written promise to pay on demand or on a specified date a sum certain in money; the interest rate and payment dates are not contingent on profits or the borrower's discretion; there is no convertibility (direct or indirect) into stock; and the creditor otherwise would be a qualified S shareholder.

For a detailed discussion of these proposed regulations, see "The One Class of Stock Requirement for S Corporations," by William Dunn, in the January 1991 issue of The Tax Adviser.