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

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

John previously met with his tax adviser and agreed to incorporate the 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 stock. John meets again with his tax adviser to discuss the S election details. The tax adviser learns that 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; he wants the new S corporation to continue this practice.

As an example of John's willingness to keep his key employees satisfied, he casually mentions that a fire recently destroyed the lead technical engineer's home; the business loaned the employee $15,000 at no interest to help defray short-term living expenses. John 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 employee-shareholders be structured to avoid the risk of S status termination?

Analysis

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

One employee incentive that does not involve stock issuance is some form of a deferred compensation plan. Because John wants to limit benefits to only key technical employees, he will use a non-qualified plan. Further, because of expected cashflow constraints during the corporation's formative years, John wants to delay funding the plan until his employees are eligible to receive the compensation. A common form of deferred compensation plan ties such compensation to the value of the company's stock (olden to the increase in the value of such stock over a particular period).

Outstanding shares are taken into account when determining whether the corporation has a second class of stock. Generally under Regs. Sec. 1.1361-1(1)(1), a corporation has more than a single class of stock (SCOS) if all outstanding shares do not confer identical distribution and liquidation rights. However, a deferred compensation plan that does not involve Sec. 83 property receives special treatment under these rules.

Such a plan (including one tying compensation to the value of the company's stock) will not be treated as outstanding stock, if the following safe harbor under Regs. Sea 1.1361-1(b)(4) is met:

1. The plan does not convey the right to vote.

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

3. The stock is 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 that it will not be difficult to tailor a deferred compensation plan to meet these rules.

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

2. Under Regs. Sec. 1.83-3(e), "property" for Sec. 83 purposes excludes an "unfunded and unsecured promise to pay money or property in the future." Thus, the proposed unfunded and unsecured plan will not be "property."

3. Because the plan is unfunded, a participating employee's earned but deterred compensation will be taxed when paid, rather than when earned, under Rev. Rul. 60-31. As required by the deterred compensation safe harbor, an employee will not be taxed currently on income deferred under the plan.

In IRS Letter Ruling 9233005, the IRS held that a restrictive "phantom stock" plan, in which an employee receives deferred compensation, does not constitute a second class of stock. The plan issues units that entitle the holder to payments on termination of service, retirement or death. Before termination, etc., the participant has the same property and security interest as may unsecured creditor. The benefits are payable from the corporation's general assets and cannot be assigned, transferred, pledged or otherwise encumbered. The ruling provides that the plan does not represent a second class of stock, because the stock issued (1) does not convey the right to vote, (2) is an unsecured promise to pay compensation and (3) is issued by a plat a under which the employee is not taxed currently on income.

Next, the tax adviser reviews the proposed employee business expense reimbursement policy. John states that to encourage an informal business atmosphere and because he trusts his employees, a formal written policy requiring substantiation of the business expenses and the return to the company of unsubstantiated amounts is not needed. After discussing the negative income and employment tax aspects of such an informal plan, the tax adviser must determine whether the proposed 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," including the corporate charter, articles of incorporation, bylaws, applicable state law and "binding agreements" on distribution and liquidation proceeds. According to Regs. Sec. 1.1361-1 (1)(2)(i), only the rights conferred by the governing provisions are considered in determining whether more than an SCOS exists.

The regulations add that a commercial contractual agreement (such as a lease, loan or employment agreement) is not a binding agreement and is not a governing provision, unless a principal purpose is to circumvent the SCOS requirement. A company's employee business expense reimbursement policy (whether written or unwritten) presumably would be treated the same way, which means that the reimbursement policy will not pose a problem unless entered into to circumvent the requirement. Further, inadvertent or occasional payments to shareholder-employees for unsubstantiated personal expenses should not expose the company to S status termination. 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 an SCOS.

Finally, the tax adviser adds that the non-interest-hearing 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 earlier, the regulations state that a commercial contract, such as a loan, is not a binding agreement and not a governing provision, unless a principal purpose is to circumvent the SCOS requirement. Further, Kegs. Sec. 1.1361-1(1)(2)(vi), Example 5, involves a below-market loan to a shareholder and reaches the same result.

Conclusion

The tax adviser can structure the incentives John wants to offer his key employees to avoid the pitfalls presented by the SCOS 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 "property" under the Sec. 83 regulations, and the participants will not be currently taxed on the benefits. So structured, the plan complies with the regulations' "deferred compensation" safe harbor.

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

Although 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 a binding agreement and will not be a governing provision, unless entered into with a principal purpose of circumventing the SCOS requirement. The loan should be in writing, should include standard payment and default provisions and should not alter the outstanding stock's distribution and liquidation rights under the corporation's governing provisions. However, 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 employee accident and health insurance coverage, including those of 2% shareholder-employees under Sec. 1372. Rev. Rul. 91-26 provides that premiums paid on behalf of 2% shareholder-employees will be treated the same as partnership guaranteed payments and will be deductible by the S corporation and includible in a shareholder's income as wages.

In that ruling, the IRS added that it "does not consider payments of accident and health insurance premiums ... on behalf of the 2% shareholder-employees to be distributions" for purposes of the SCOS requirement. Further, in Regs. Sec. 1.1361-1(1)2)(vi), Example 4, an agreement by a corporation to pay different premium amounts to maintain accident and health insurance coverage for certain employee-shareholders does not result in a second class of stock, because the agreement was not entered into to circumvent the SCOS requirement.