Structuring corporate payments to shareholder/employees to avoid creating a second class of stock.

Facts: John Thornberg, an inventor with an electrical engineering background, started a sole proprietorship three years ago to develop superior automobile audio systems. He recently negotiated a lucrative development contract with two different foreign luxury auto manufacturers and enticed several of his friends to leave the security of large corporate engineering departments and join his business.

John previously met with his tax adviser; the two agreed John would incorporate his business and elect S status. John will own the majority of the stock, while his key technical people will each own a small amount of the stock. John is interested in providing deferred compensation to his key employees to encourage them to stay and develop state-of-the-art audio components. John also states that his employees' previous employer reimbursed their business-related expenses, and he wants the new S corporation to continue this practice.

As an example of John's willingness to keep his key employees happy, he casually mentions that a fire recently destroyed the lead technical engineer's home, and the business loaned the employee $15,000 at no interest to help defray the engineer's short-term living expenses. John explains that he is more than willing to extend a similar loan to other key employees who suffer unexpected or extraordinary losses in the future. Issue: How can various forms of corporate payments to shareholder/employees be structured to avoid the risk of termination of the corporation's S election?

Analysis

The tax adviser confirms that John does not want to change the proposed capitalization of the company within the first few years. Thus, John is not now interested in offering restricted stock or stock options to his key employees.

One type of employee incentive that does not involve stock issuance is some form of deferred compensation plan. Because John wants to limit the benefits to only key technical employees, a nonqualified plan that does not meet the nondiscrimination rules applicable to qualified employee plans will be used. Further, because of expected cash flow constraints during the formative years of the corporation, John wants to delay funding the plan until the employees are eligible to receive the compensation. The tax adviser explains that a common form of deferred compensation plan ties the amount of the employee's compensation to the value of the company's stock (often to the increase in the value of the company's stock over a particular period).

Under the one-class-of-stock regulations, generally all outstanding shares of stock will be taken into account when determining whether the corporation has a second class of stock. A corporation has more than one class of stock if all outstanding shares do not confer identical distribution and liquidation rights. However, a deferred compensation plan that does not involve Sec. 83 property (i.e., property transferred in connection with the performance of services) will not be treated as outstanding stock if the following safe harbor requirements are met:

1. The plan must not convey the right to vote;

2. The plan must constitute an unfunded and unsecured promise to pay money or property in the future; and

3. The stock must be issued to an employee or independent contractor in connection with the performance of services for the corporation under a plan in which the employee or independent contractor is not subject to current income taxation.

The tax adviser explains to John that it will not be difficult to tailor a deferred compensation plan to meet these rules:

1. The plan documents will expressly state that the employees are not entitled to any voting privileges due to their participation in the plan.

2. "Property" for Sec. 83 excludes an "unfunded and unsecured promise to pay money or property in the future." Thus, the proposed unfunded and unsecured plan will not be considered "property."

3. Finally, because the plan is unfunded, the participating employee's earned but deferred compensation will be taxed when it is paid rather than when it is earned. As required by the safe harbor, the employee will not be taxed currently on income deferred under the plan.

In Letter Ruling 9233005, the IRS ruled that a restrictive "phantom stock" plan in which the employee received deferred compensation was not a second class of stock. The plan issued units that entitled the holder to payments on termination of service, retirement or death. Before termination, etc., the participant had the same property and security interest as any unsecured creditor. The benefits were payable from the corporation's general assets and could not be assigned, transferred, pledged or otherwise encumbered. The plan did not represent a second class of stock, because the stock issued (1) did not convey the right to vote, (2) was an unsecured promise to pay compensation and (3) was issued by a plan under which the employee was not taxed currently on income.

To encourage an informal business atmosphere and because he trusts his employees, John does not feel a formal written policy requiring substantiation of the business nature of expenses and the return to the company of unsubstantiated amounts is necessary. After discussing the negative income and employment tax aspects of such an informal plan, the tax adviser must determine whether the impending employee business expense reimbursement policy could jeopardize the company's S election. The regulations look to the rights granted the corporation's stock by state law and relevant corporate documents, rather than the consequences of transactions involving the corporation and its shareholders. Whether all outstanding shares confer identical distribution and liquidation rights depends on the "governing provisions," which include the corporate charter, articles of incorporation, bylaws, applicable state law and "binding agreements" that relate to distribution and liquidation proceeds. Only the rights conferred by the governing provisions are considered in determining whether more than one class of stock exists.

A commercial contractual agreement (such as a lease, loan or employment agreement) is not a binding agreement and so is not a governing provision, unless a principal purpose is to circumvent the one-class-of-stock requirement. The company's employee business expense reimbursement policy (whether written or unwritten) presumably would be treated the same way, meaning that the reimbursement policy will not pose a problem unless entered into to circumvent the one-class-of-stock requirement. In addition, inadvertent or occasional payments to shareholder/employees for unsubstantiated personal expenses should not expose the company to termination of its S election. Assuming the governing provisions provide for identical distribution and liquidation rights, any distributions (whether actual, constructive or deemed) that differ in timing or amount are to be given appropriate tax treatment in accordance with their facts and circumstances, but will not result in a second class of stock.

Finally, the noninterest-bearing employee loan will not jeopardize the corporation's S status. A loan from a corporation to a shareholder that bears an inadequate rate of interest is treated under Sec. 7872 as a distribution to the shareholder equal to the amount of the forgone interest, followed by an interest payment in the same amount by the shareholder to the corporation. However, as noted, a commercial contract such as a loan is not a binding agreement and so is not a governing provision unless a principal purpose is to circumvent the one-class-of-stock requirement. Further, Regs. Sec. 1.1361-1(1)(2)(v) includes a specific example involving a below-market loan to a shareholder that reaches the same conclusion.

Conclusion

The tax adviser can structure the incentives John wants to offer his key employees to avoid the pitfalls presented by the one-class-of-stock regulations. The nonqualified deferred compensation arrangement will not provide voting rights to the participants and will not be currently funded by the company. Thus, the arrangement will not be considered "property" under the Sec. 83 regulations, and the participants will not be currently taxed on the benefits. So structured, the plan complies with the "deferred compensation" safe harbor provided by the regulations.

The company's employee business expense reimbursement policy will not include any provisions that could have a principal purpose of circumventing the one-class-of-stock requirement (in particular, the policy will not alter the distribution and liquidation rights given to the outstanding stock by the corporation's governing provisions). Thus, the policy will not be considered a "binding agreement relating to distribution and liquidation proceeds" and so will not be considered to be a governing provision. Further, the inadvertent or occasional corporate payment of personal shareholder/employee expenses will be given appropriate tax treatment in accordance with the facts and circumstances, but should not result in a second class of stock. (A pattern of payments to certain shareholders, however, could be construed as a "binding agreement relating to distribution and liquidation proceeds.")

While market interest should be required and paid on related-party loans, under the current regulations, a below-market interest rate on an employee loan will not be considered to be a binding agreement and so will not be a governing provision, unless entered into with a principal purpose of circumventing the one-class-of-stock requirement. The loan should be in writing, include standard payment and default provisions, and not alter the distribution and liquidation rights granted to the outstanding stock by the corporation's governing provisions. But again, a pattern of loaning money to certain shareholders at low (or no) interest could be construed to create a "binding agreement relating to distribution and liquidation proceeds" that would jeopardize S status.

Variation

Assume that John wants to pay the premiums for accident and health insurance coverage on behalf of his employees, including the key employees who would be considered to be "2% shareholders" under Sec. 1372. In Rev. Rul. 91-26, the IRS ruled that premiums paid on behalf of 2% shareholder/employees would be treated the same as partnership guaranteed payments and would be deductible by the S corporation and includible in the shareholders' income as wages.

In that ruling, the IRS added that it did "not consider payments of accident and health insurance premiums ... on behalf of the 2% shareholder/employees to be distributions for purposes of the single class-of-stock requirement." Further, Regs. Sec. 1.1361-1(1)(2)(v) includes an example in which an agreement by a corporation to pay different premium amounts to maintain accident and health insurance coverage for certain employees who are shareholders does not result in a second class of stock, because the agreement was not entered into to circumvent the one-class-of-stock requirement.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Corporations," 12th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 1998.

Albert B. Ellentuck, Esq. Of Counsel

King and Nordlinger, L.L.P. Washington, DC