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Proposed S corp regs: is the sky falling?


the one-class-of-stock limitation remains secure under new proposed regulations.

Proposed regulations under Section 1361 have recently caused a lot of alarm bells to ring. Titles such as "Proposed Regulations Threaten S Corporations" left the impression that the sky was falling. Whether or not the sky has fallen is the subject of this article.

Circumventing the One

Class-of-Stock Rule

Presumably one does not have to be a genius to design the equity structure of an S corporation. The S corporation is limited to one class of stock.(1) However, one has to be wily and creative to get around this limitation.

In the past, several devious ways around the one-class-of-stock rule were suggested.

Voting Rights

The one-class-of-stock requirement does not mean that shares of stock must be identical. Differences in voting rights are permitted.(2) Thus an S corporation can issue class "A" voting and class "B" nonvoting common stock. The only restriction would be that all shares convey an equal interest in the profits and assets of the corporation.

The voting and nonvoting common stock could be used to recapitalize the S corporation. The holders of all shares of an S corporation could cause the corporation to create voting and nonvoting common stock. The nonvoting common stock could be given as a gift to a relative (son or daughter) at a lower value because of the lack of voting rights. At a later time the holders of voting shares might exchange them for nonvoting shares to lower the stock's value in their estates, discounting for the lack of voting rights.

By minimizing the number of shares of voting stock and maximizing the number of shares of nonvoting stock, the holder of the voting stock could control the business but pass the real economic value of the business on to others. For example, this could be done by gifting the nonvoting stock to one's children. Current compensation could be preserved through salary payments for services performed for the S corporation. Voting disparities between the two types of stock for directors could be used to facilitate control being invested in one type of stock over the other without loss of an S election.


The advantages of using debt in the capital structure of an S corporation are numerous. In a start-up mode, income can be completely sheltered through interest deductions creating, in reality, a special allocation of income to debt holders. It permits a risk-adverse investor to receive preferences in liquidation over the common shareholders. The challenge is to prevent the debt from being reclassified as a second class of stock.(3)

Subchapter S does contain a safe harbor for ensuring that debt will not be reclassified as a second class of stock.(4) To qualify, the debt must constitute straight debt without equity-participating features.(5) The lender must be qualified to hold stock in an S corporation.(6) The debt instrument must be in writing and contain an unconditional promise to pay on demand or on a specified date a sum certain in money.(7) The interest rate and interest payment dates must not be contingent on profits, the borrower's discretion, or similar factors.(8) There must be no convertibility, direct or indirect, into stock.(9)

Debt instruments that do not qualify for the safe harbor are not automatically classified as a second class of stock. Instead these instruments are evaluated on the general principles of the common law of debt-equity.(10) These principles include an inspection of the following factors: * Proportional ownership of equity

and debt. * Denomination of the instrument

in the documents evidencing the

purported indebtedness. * Presence or absence of a fixed

maturity date. * Subordination. * Security for the loan. * Participation of the debt holder

in management. * Compliance with terms of the

instrument. * Inadequate capitalization of the

entity. * Intent of the parties to create a

debtor-creditor or an equity relationship. * Ability of the corporation to obtain

loans from third parties.

Within the above rules for debt, the S corporation can create a class of debt with most of the characteristics of a preferred stock. The loan would have a fixed interest rate (dividend), a maturity date of long duration (50 years), a participation feature, and a percentage of appreciation of the corporation at the date of liquidation of the corporation or on maturity of the loan, whichever occurs first. In the early years of the S corporation, special allocation of income to the holder of debt is accomplished through interest payments.

Warrants and Options

The one-class-of-stock rule is limited to stock that is issued and outstanding.(11) A class of treasury stock that is not issued and outstanding does not cause an S corporation to violate the one-class-of-stock rule.(12) Similarly, options, warrants and convertible debentures do not constitute a second class of stock.(13) Warrants and convertible securities could be used to effect special allocations among qualifying investors. During the start-up phase, all losses of the S corporation are allocated to the current shareholders. When the corporation becomes profitable, the warrants could be exercised or the securities converted. The the holders participate equally in all profits and losses.


A nonequity, nondebt arrangement that avoids the one-class-of-stock rule is the use of a lease. A lease payment gives preference of income distribution to the lessor a disguised form of special allocation of income.

Compensation Arrangements

Another nonequity, nondebt arrangement that avoids the one-class-of-stock rule is a compensation arrangement. Unreasonable compensation paid to shareholders which might be recharacterized as a constructive dividend with respect to stock (which might result in the characterization of that class as a second class of stock) should be avoided. Also, contingent arrangements are to be avoided because they might be treated as equity, giving rise to a second class of stock. The simplest arrangement is to pay one shareholder a fixed salary for services. The other shareholder performs no services, and profits are shared. This amounts to a special allocation of income. These common arrangements(14) have been suggested as ways around the one-class-of-stock rules.(15) An interesting question is whether proposed regulations under IRC Section 1361 released in early October 1990 and to be made retroactive to tax years after December 31, 1982, make these arrangements obsolete and unworkable or a tax trap.(16)

Proposed Regulations Under

1361 Voting Rights

The proposed regulations address the issue of voting rights twice, first in proposed regulation Sec. 1.361-1 (b)(4) directed at deferred compensation plans. The regulation states that a second class of stock will not be created if the instrument does not convey the right to vote, is not property under regulation Sec. 1.83-3 (generally meaning an unfunded, unsecured secured promise to pay) and is issued to an employee in connection with the performance of services.

Second, in proposed Reg. Sec. 1.361-1(1)(2), the differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock. The regulation provides the following examples of differences in voting rights that will not result in a second class of stock: all shares of stock have identical rights to distribution and liquidation proceeds, an S corporation may have voting and nonvoting 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.

The proposed regulations do not prevent the uses of voting and nonvoting common stock to avoid the one-class-of-stock rule noted previously.


The possibility of debt being reclassified as a second class of stock becomes more crucial under the proposed regulations. The proposed regulations reject the nonstock equity concept(17) and treat all debt that is reclassified as equity in any form as creating a second class of stock.(18) Such a possibility makes the safe harbor for debt more important.

What the proposed regulations provide that is new is an additional factor which must be met to achieve the safe harbor. The debt must bear a reasonable rate of interest. All facts and circumstances will be used to determine if the debt bears a reasonable rate of interest. A variable interest rate index is allowed.(19)

The proposed regulation provides a safe harbor for reasonable interest rates. If the obligation has a yield to maturity that is at least but not greater than five points above the applicable federal rate as of the date the obligation is issued, the rate will be reasonable. If the obligation contains a variable interest rate, the rate will be reasonable if: 1. The issue price of the obligation

equals the obligation's stated

redemption price at maturity, 2. The obligation's interest rate is

expressed as a fixed multiple of a current objective interest index or as a constant number of percentage or basis points or basis points more or less than a current objective interest index, and 3. The rate resulting from the formula

at the time of issuance is at

least equal to but not greater

than five points above the applicable federal rate at the time.(20)

Rather than set a special rule for reclassifying debt as a second class of stock, the proposed regulations when the safe harbor is not achieved continue to evaluate the instruments under general principles.(21) The proposed regulations specifically provide that the fact that an obligation is subordinated to another debt of the corporation will not prevent the obligation from qualifying as straight debt.(22)

But for the need to observe the reasonable interest rate rules because of the harshness of the result of reclassification provided in the proposed regulation, unless one wants to live dangerously, the uses of debt previously noted survive(23) to get around the one-class-of-stock rule.

Warrants and Options

The one-class-of-stock rule continues to be limited to stock that is issued and outstanding under the proposed regulations.(24) However, the proposed regulations provide that a call option, warrant or similar instrument issued by a corporation is treated as a second class of stock if the call option is substantially certain to be exercised by the holder. This rule applies whether or not the owner of the call option is treated as the owner of the underlying stock under general principles of federal tax law.(25)

Substantial certainty of exercise is to be determined at the time of issuance, at the time of material modification by the corporation or at the time of subsequent transfer to another holder other than by gift or death.(26)

Certain call options are excepted. A call option will not be treated as substantially certain to be exercised if the strike price of the option is at least 90% of the stock's value.(27) A call option that is issued by a corporation to a qualified person(28) in connection with a loan to the corporation is not treated as a second class of stock if it is exercisable only if the corporation defaults on the repayment of the loan.(29) Also excepted is a call option that is issued to an employee in connection with the performance of service if it is nontransferable and the option does not have a readily ascertainable fair market value at the time the option is granted.(30)

The proposed regulations allow the investor to use options, warrants and convertible debentures to survive. Convertible debentures can be safely used when exercisable only in event of the default of the corporation. Warrants and options can be safely used if the strike price is at least 90% of the stock's value.


Leases are not impacted by the proposed regulations.

Compensation Arrangements

As discussed above, compensation arrangements for employees are protected by safe harbors.(31) Compensation techniques for owners also survive. However, under the proposed regulations, stock that is issued for services which are substantially nonvested (within the meaning of Section 1.83-3(b)) is not treated as outstanding stock of the corporation, and the holder of such stock is not treated as a shareholder solely by reason of holding such stock, unless the holder makes an election under Section 83(b).(32) Such held stock will violate the one-class-of-stock rule unless such stock confers rights to distribution and liquidation proceeds that are identical to those rights conferred by the other outstanding shares of stock.(33)

Moreover, indirect compensation to shareholders finds expression in the proposed regulations by noting that buy-sell agreements among shareholders and restrictions on the transferability of stock are disregarded in determining whether a corporation has more than one class of stock.(34) Agreements to redeem shares of stock are also disregarded in determining whether a corporation has more than one class of stock unless the agreement restricts the right of holders of the stock to share in liquidation proceeds or provides for distributions which are nonconforming.(35) Distributions made under Section 302(a) or 303(a) will not create a second class of stock. If the distribution is treated under Section 302(d) as a Section 301 distribution, it will create a second class of stock if it is made pursuant to a plan that provides a series of distributions resulting in the shareholders' owning essentially the same proportion of ownership as before the initial distribution.

Finally, if compensation is broadly construed as distribution to shareholders, it should be noted that distributions can result in a second class of stock. S corporations that make distribution to shareholders in which the timing or amount differs with respect to each share of stock have made nonconforming distribution that creates a second class of stock.(36)

Distributions that differ with respect to timing but are pro rata with respect to all outstanding shares of stock, taking into account the entire taxable year of the S corporation, are not treated as non-conforming distributions if the difference in timing of the distributions were unintentional or if the distributions that differ with respect to timing are made pro rata within a three-month period.(37)


The proposed regulations under 1361 have not caused the sky to fall on the subchapter S corporation. Certainly if one can believe the Wall Street Journal that the rules will be prospective and not retroactive, there is time to plan and become comfortable with the new requirements. Admittedly, with regard to distributions, one will have to be more careful in conducting the operations of the subchapter S corporation or the S corporation status will be terminated, resulting in reclassification to a C corporation. But it is comforting to note that the traditional vehicles around the one-class-of-stock limitation are still firmly in place.

Examples: Corporation Q has 500 shares of issued and outstanding common stock. A and B each own 250 shares of the stock. In addition, A and B each hold equal amounts of debt issued by Q that does not constitute straight debt and that is treated as equity under the general principles of federal tax law governing the distinction between debt and equity. The debt, although held proportionately by the shareholders, is treated as a second class of stock.

In the Revenue Reconciliation Act of 1989 (RRA), Congress instructed the Treasury to write regulations that will characterize a purported debt instrument as part debt and part equity (with an effective date no sooner than the date the regulations are published). According to the RRA House Report, "Such part-debt and part-equity treatment may be appropriate in circumstances where a debt instrument provides for payments that are dependent to a significant extent (whether in whole or in part) on corporate performance, whether through equity kickers, contingent interest, significant deferral of payment, subordination or an interest rate sufficiently high to suggest a significant risk of default." [RRA Section 7208(a); H. Rep. No.101-247, 101 st. Cong', 1st sess. 1235(1989).] If this position is eventually developed, the reference to general corporate concepts in these proposed S corporation regulations would expose S corporation debt to this hybrid characterization. And, because of the rejection of the nonstock equity concept, this would result in a second class of stock no matter how small the equity fraction resulting from the application of this approach by the RRA.

Corporation T, an S corporation with a calendar taxable year, has two shareholders, A and B, each owning 50% of the stock of the corporation. The corporate bylaws require that A and B receive equal distributions with respect to their stock. A $100 distribution is made to A on March 1, but because the corporation's bookkeeper inadvertently filed B's check instead of mailing it, a $100 distribution is not made to B until June 1 of the same taxable year. Because the distributions were not intentionally nonconforming and the distributions would be pro rata if the entire taxable year were taken into account, the distributions will not result in a second class of stock. Footnotes (1) IRC [Section] 1361(b)(1)(D). (2) IRC [Section] 1361(c)(4). (3) See Taylor, Debt-Equity and Other Tax Distinctions: How Far Can We Go?, 62 Taxes 848 (1984); Feder, Either a Partners or a Lender Be: Emerging Tax Issues in Real Estate Finance, 36 Tax Lawyer 191 (1982). (4) IRC [Section] 1361(c)(5). (5) IRC [Section] 1361(c)(5)(B). (6) IRC [Section] 1361(c)(5)(iii). (7) IRC [Section] 1361(c)(5)(B). (8) IRC [Section] 1361(c)(5)(B)(i). (9) IRC [Section] 1361(c)(5)(B)(ii). (10) See Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369 (1971). (11) Former Treas. Reg. [Section] 1.1371-1(g). (12) IRC [Section] 1361(b)(1)(D). (13) Rev. Rul. 67-269, 1967-2 C.B.298. (14) See for a technical in-depth development of the material in this section of this article Cuff, Observations on Several Techniques to Avoid the Application of the One Class of Stock Rule Under Subchapter S, 47 Inst. on Fed. Tax'n. 8.1-8.145 (1989). (15) Prop. Regs. Sec 1.1361-1(1)(2). In general, a corporation has more than one class of stock.... if all of the outstanding shares of stock of the corporation do not confer identical rights to distribution and liquidation proceeds, regardless of whether any differences in rights occur pursuant to the corporate charter, articles or bylaws, by operation of state law, by administrative action, or by agreement. See for example the following. The law of State A requires that permission be obtained from the State Commissioner of Corporations before stock may be issued by a corporation. The Commissioner grants permission to M, a corporation, to issue its stock subject to the restriction that any person who is issued stock in exchange for property, and not cash, must waive all rights to receive distributions until the shareholders who contributed cash for stock have received a stated amount of distributions per share. The shareholders who are issued stock for property execute an agreement with M based on the aforementioned condition. The condition placed by the Commissioner pursuant to State law upon the prospective holders of stock to be issued for property results in a difference as to the rights of stock and does not qualify as a small business corporation. (16) See Wall Street Journal, February 13, 1991, at 1,col.5 Tax Report. Assistant Treasury Secretary Gideon and the IRS now say the disputed rules will be prospective, not retroactive to 1983 as proposed in October. (17) See Portage Plastics Co., Inc., 486 F2d 632(7th Cir. 1973),aff'g 301 F2d 684 (W.D. Wisc. 1969) A concept under which debt that had equity characteristics was deemed to be a capital contribution but did not create a second class of stock. (18) Prop. Regs. [Section] 1.1361-1(1)(3)(ii). (19) Prop. Regs. [Section] 1.1361-1(1)(4)(ii)(B). An "objective interest index" is a rate made known publicly and offered contemporaneously to unrelated borrowers in private lending transactions by a financial institution or that is based on a similar objective interest index which is regularly published. (20) Prop. Regs. [Section] 1.1361-1(1)(4)(ii)(C). Note An obligation may have less than a reasonable interest rate or bear no interest if the term of the obligation is one year or less and the obligation is not part of a series of obligations designed to avoid the requirement that an obligation bear a reasonable interest rate. (21) Prop. Regs. [Section] 1.1361-1(1)(3)(ii). The regulation states general principles of Federal Tax Law which presumably includes the common law of debt-equity previously discussed in this article. (22) Prop. Regs. [Section] 1.1361-1(1)(4)(iii). (23) One author notes a particular pitfall that may happen in the future. Dunn, The One Class of Stock Requirements for S Corporations, The Tax Advisor p.37 (Jan. 1991). (24) Prop. Regs. [Section] 1.1361-1(1)(2)(iii). (25) Prop. Regs. [Section] 1.1361-1(1)(3)(iii). (26) Id. (27) Prop. Regs. [Section] 1.1361-1(1)(3)(iii)(C). (28) Prop. Regs. [Section] 1.1361-1(1)(3)(B)(1)(i)&(ii) a "qualified person" means any person that is actively and regularly engaged in the business of lending and is not a related person with respect to the corporation within the meaning of Sec. 465(b)(3)(c). (29) Prop. Regs. [Section] 1.1361-1(1)(3)(B)(1). See for example the following. Corporation N issues a debt instrument to another corporation that is convertible into stock on N corporation. The debt instrument does not satisfy the straight debt safe harbor both because it is convertible into stock of the issuing corporation and because it is held by a corporation. However, the instrument is considered a second class of stock only if it is treated as equity under the general principles of federal tax law governing the distinction between debt and equity, or if it is a call option that is substantially certain to be exercised. (30) Prop. Regs. [Section] 1.1361-1(1)(3)(B)(2). (31) Id. (32) Prop. Regs. [Section] 1.1361-1(3). (33) Prop. Regs. [Section] 1.1361-1(1)(2). (34) Id. (35) Prop. Regs. [Section] 1.1361-1(1)(2)(A)(B). (36) Prop. Regs. [Section] 1.1361-1(1)(2)(ii)(c). (37) Prop. Regs. [Section] 1.1361-1(1)(2)(ii). See for example the following. Corporation R, an S corporation, executes an agreement with its shareholders to modify its normal distribution policy by making upward-adjustments of its distributions to those shareholders who bear heavier state tax burdens based on a formula to give the shareholders the same after tax results. The agreement causes the stock of Corporation R to have different rights to distributions. Therefore, Corporation R is considered to have a second class of stock.
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Title Annotation:stock corporation regulations; perceived disadvantages of securities regulations
Author:Lantry, Terry L.
Publication:The National Public Accountant
Date:Sep 1, 1991
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