S Corporations and the Second Class of Stock Rule
Most small businesses are classified either as an S corporation or as a partnership for income tax purposes. One disadvantage of being taxed as an S corporation as opposed to a partnership is the inability to issue multiple classes of stock with different rights to distribution and liquidation proceeds. A violation of the so-called one class of stock rule can result in termination of a company’s S corporation tax status. In that event, the company will be subject to corporate tax on its net income and its shareholders will be taxed on distributions of that same income. That is clearly not the result intended by small business owners who elect S corporation tax status.
This month’s article analyzes three common business agreements in the context of the one class of stock rule. These are buy-sell and redemption agreements, corporation-shareholder loan agreements and employment agreements. The well advised small business owner should not be concerned that entering into any of these agreements will result in the termination of her company’s S corporation tax status. The same cannot be said for small business owners who are either not well advised or simply unaware of the strict rules surrounding companies taxed as S corporations.
S CORPORATIONS AND THE SECOND CLASS OF STOCK RULE
Most small business owners know that a “C corporation” is taxed on its net profits and that those profits are taxed again when distributed to the corporation’s shareholders as dividends (the so-called “double tax”). Likewise, most small business owners understand that S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. They also know that S corporation status generally allows the corporation’s shareholders to avoid double taxation on the corporation’s income when it is passed through to them in the form of a dividend (with a few exceptions).
Not surprisingly, many small business owners are unaware of the many traps awaiting them after making the S corporation election. Perhaps the most common, as well as the most limiting, of these traps is the requirement that all classes of S corporation stock must confer identical rights to distribution and liquidation proceeds. While many small business owners understand that a corporation cannot elect S corporation status if it has multiple classes of stock that confer non-identical rights to distribution and liquidation proceeds, they often fail to appreciate the types of everyday agreements that could be treated as an impermissible second class of stock (which, of course, will cause the termination of the company’s S corporation tax status).
This article will briefly summarize the one class of stock rule and discuss a few of the most common business transactions that may violate the rule.
II. What is a Second Class of Stock?
Treasury Regulations (“Regulation”) § 1.1361-1(l) provides rules interpreting the one class of stock requirement. In general, a corporation does not have an impermissible class of stock if all of its outstanding shares of stock confer identical rights to distribution and liquidation proceeds (“Proportionate Distributions”). However, as mentioned above, the foregoing does not preclude differences in voting and other rights between outstanding shares of stock. As long as the Proportionate Distributions standard is satisfied, a corporation may have voting and nonvoting shares of 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 (or managers in the case of a limited liability company).
III. What are Proportionate Distributions?
The determination of whether all outstanding shares of stock satisfy the Proportionate Distribution standard is based on a review of all of the facts and circumstances including:
(a) the corporate charter;
(b) articles of incorporation (or an LLC’s articles of organization);
(c) bylaws and shareholder agreements (or an LLC’s operating agreement);
(d) applicable state law; and
(e) binding agreements relating to distribution and liquidation proceeds (all of which are collectively referred to in the Regulation as “Governing Provisions”).
Importantly, regular and ordinary commercial contractual agreements such as lease agreements, employment agreements and loan agreements are typically not considered when determining whether all outstanding shares of stock satisfy the Proportionate Distribution standard, unless a principal purpose of entering into the agreement is to circumvent that standard.
On the other hand, although a corporation is not treated as having more than one class of stock so long as the Governing Provisions comply with the Proportionate Distributions requirement, any distributions (whether actual, constructive or deemed) that differ in timing or amount must be analyzed to determine whether they violate the Proportionate Distributions requirement. Distributions that violate the applicable standard (“Disproportionate Distributions”) may result in termination of the corporation’s S status.
IV. Examples of Binding Agreements That May Result in Termination of S Corporation Status.
A. Buy-Sell and Redemption Agreements.
Owners of S corporations commonly enter into buy-sell agreements and redemption agreements. Such an agreement typically restricts the rights of shareholders to transfer shares and establishes values at which shares may be sold or exchanged.
In general, buy-sell agreements, agreements restricting the transferability of stock and redemption agreements do not adversely impact the one class of stock rule unless:
(1) a principal purpose of the agreement is to circumvent the one class of stock rule; and
(2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock (together, the “Purchase Price Test”).
There is little guidance regarding the standards applicable to the first prong of the Purchase Price Test. Because of the difficulty in proving the first prong of the Purchase Price Test, most tax professionals simply merge the two tests into a single test focused solely on purchase price. If the purchase price established in a qualifying agreement is substantially above or below fair market value, the agreement will be considered an impermissible second class of stock. In such a case, the corporation’s S election will terminate at the time the agreement is made effective.
To avoid having a buy-sell or redemption agreement fall into the foregoing trap, it is advisable to rely on the safe harbor provided in the Regulation. Specifically, agreements providing for either cross-purchase or redemption at a purchase price between fair market value and book value will satisfy the Purchase Price Test.
The Regulation does not establish a magic formula for determining fair market value. Rather, the Regulation merely requires that taxpayers make that determination in good faith. A determination of fair market value that is substantially in error and is not performed with reasonable diligence will not be deemed to have been made in good faith. Therefore, it is best to have the purchase price determined pursuant to an appraisal performed by a qualified appraiser. More often than not, the cost of the appraisal will be far less than the professional fees required to defend an Internal Revenue Service (“IRS”) challenge to a purchase price determined without an appraisal.
The Regulation provides a safe harbor for determining book value. Specifically, a determination of book value will be respected by the IRS if:
(1) the book value is determined in accordance with Generally Accepted Accounting Principles (“GAAP”); or
(2) the book value used for purchase price purposes is also used for a substantial nontax purpose.
The likelihood that a buy-sell agreement or redemption agreement could inadvertently result in the termination of S corporation status is minimized when the shareholders follow the Regulation’s straightforward guidance. In short, a buy-sell agreement or redemption agreement should jeopardize S corporation status only when the shareholders are either ill-advised or intentionally ignore the Regulation’s guidance in order to save the cost of an appraisal.
B. Loan Agreements.
In general, instruments, obligations or arrangements are not treated as an impermissible second class of stock unless:
(1) the instrument, obligation or arrangement represents equity or otherwise results in the holder being treated as the owner of stock under general principles of Federal tax law; and
(2) a principal purpose of issuing or entering into the instrument, obligation or arrangement is to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock or to circumvent the limitation on the maximum number of eligible shareholders (together, the “Failed Loan Standard”).
As in the case of buy-sell agreements and redemption agreements, the Regulation provides a safe harbor for certain types of loan agreements. For example, unwritten advances from a shareholder to her S corporation not exceeding $10,000 in the aggregate at any time during the S corporation’s taxable year will not be treated as a second class of stock as long as the parties treat the advance as debt and the advance is expected to be repaid during a reasonable period of time. Another safe harbor is provided for obligations of the same class that are classified as equity under general Federal tax principles, but are owned solely by the owners of, and in the same proportion as, the outstanding stock of the corporation.
It is fairly common for some but not all shareholders to enter into a written loan agreement for an amount greatly exceeding $10,000. Since some but not all of the shareholders will receive interest payments, it is critical that the agreement not be viewed as a second class of stock. For example, assume S issues a note to 3 of its 5 shareholders. Further assume that S’s interest payments under its note are dependent on its profits. As such, in years when S has an operating loss, it does not make interest payments. In this case, the IRS may challenge the note as an impermissible second class of stock since it effectively provides for Disproportionate Distributions to S’s shareholders.
To provide a measure of certainty regarding shareholder-corporation loans, the Regulation provides a safe harbor for what it terms “straight debt.” According to the Regulation, “straight debt” means a written unconditional obligation, regardless of whether embodied in a formal note, to pay a sum certain on demand or on a specified due date, which:
(1) does not provide for an interest rate or payment dates that are contingent on profits, the borrower’s discretion, the payment of dividends with respect to common stock or similar factors;
(2) is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation; and
(3) is held by an individual (other than a nonresident alien), an estate, or certain trusts.
A potentially confusing aspect of the “straight debt” safe harbor is the requirement that the debt instrument not be convertible (directly or indirectly) into stock or any other equity interest of the S corporation. There are many instances when an S corporation must issue convertible debt to a potential investor, which would appear to call into question whether issuing such an instrument could potentially jeopardize the corporation’s tax status.
For example, assume that Casino Corporation, which is taxed as an S corporation, is in need of an immediate cash injection because of a string of recent losses at its tables. Ms. M is willing to make a cash contribution of $10,000,000 to Casino Corporation in return for a 10% common stock interest. Unfortunately, state regulatory authorities insist on performing a background investigation of Ms. M prior to allowing her to become a shareholder of Casino Corporation. The background investigation will take a minimum of 9 months. To eliminate its immediate cash crisis, Casino Corporation agrees to issue a convertible note to Ms. M. Under the convertible note, Ms. M loans $10,000,000 to Casino Corporation, and, at her option, on the date that state regulatory authorities approve Ms. M as a shareholder the principal on the note may be converted into the agreed 10% common stock interest. Could this type of arrangement jeopardize Casino Corporation’s S corporation status because it falls outside of the “straight debt” safe harbor?
Fortunately, the Regulation provides a safe harbor specifically addressing arrangements like that between Casino Corporation and Ms. M. If a convertible debt instrument satisfies either of the following tests, it will be treated as a second class of stock:
(1) It meets the Failed Loan Standard (see above); or
(2) It embodies rights equivalent to those of a call option that would be treated as a second class of stock under the Regulation (the details of which are beyond the scope of this summary).
In view of the Regulation’s straightforward approach to convertible debt, there should be few instances where a convertible note is treated as a second class of stock. The only time such a note should be treated as a second class of stock is when the parties to the note intend to circumvent the Proportionate Distribution standard, in which case the parties would likely be well aware of the consequences of losing the “audit lottery.”
C. Employment Agreements.
The Regulation specifically identifies employment agreements as not being among the recognized Governing Provisions, which would appear to suggest that employment agreements cannot be treated as a second class of stock. While that is a fair assumption, there is IRS guidance to the contrary.
In a 1997 Field Service Advisory (“FSA”), an S corporation made Proportionate Distributions to its two shareholders during the years in issue. The issue for resolution was whether the salary paid to the controlling shareholder should be treated as a second class of stock.
The FSA initially noted that the only guidance offered by the Regulation in the context of S corporation employment agreements involved an example where the facts and circumstances did not reflect that a principal purpose of the agreement was to circumvent the one class of stock requirement. Moreover, the example based its conclusion on the general principle that employment agreements do not qualify as Governing Provisions. Obviously, the Regulation was of little help in answering the IRS field office’s question.
Reviewing all of the facts and circumstances, the FSA concluded that the controlling shareholder “has unilateral control and the facts seem to indicate that through his control with respect to salary and distributions[,] he has created an ‘employment agreement’ to over compensate himself in derogation of true distribution rights, the result of which is to circumvent the one class of stock requirement….” Therefore, it seems clear that an employment agreement may be construed by the IRS as a second class of stock if exceptional compensation is viewed as an effort to avoid the restrictions on Proportionate Distributions.
V. Concluding Thoughts.
The foregoing is intended to highlight the importance of not overlooking the tax consequences of such common agreements as buy-sell and redemption agreements, corporation-shareholder loan agreements and employment agreements. In each case, it is relatively simple to avoid having the agreement construed as a second class of stock for tax purposes. A well advised small business owner entering into any of these types of agreements should not be concerned about accidentally terminating her company’s S election.
On the other hand, there may be instances when small business owners desire a disproportionate sharing arrangement. In such cases, serious consideration should be given to organizing the business venture as an LLC taxed as a partnership. Unlike an LLC taxed as an S corporation, there are no tax-based limitations on the classes of membership interests issued by an LLC taxed as a partnership.
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Please do not hesitate to direct any of your questions and comments regarding this article to Richard L. Lieberman, Jonathan W. Michael or Jeffrey D. Warren.
Richard L. Lieberman, Esq.
Burke, Warren, MacKay & Serritella, P.C.
330 N. Wabash Ave.
Chicago, Illinois 60611-3607
Jonathan W. Michael, Esq.
Burke, Warren, MacKay & Serritella, P.C.
330 N. Wabash Ave.
Chicago, Illinois 60611-3607
Jeffrey D. Warren, Esq.
Burke, Warren, MacKay & Serritella, P.C.
330 N. Wabash Ave.
Chicago, Illinois 60611-3607
Any tax advice included in this written communication was neither intended nor written to be used, and it cannot be used by the taxpayer, for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency.
 It also is not surprising that many business owners do not realize that an S corporation does not have to be formed as a state law business corporation. A limited liability company (“LLC”) can elect to be taxed as an S corporation. For simplicity, the term “corporation” as used in this article will refer to both business corporations and LLCs. Also, the shares issued by business corporations and the membership interests issued by LLCs will be referred to as “stock.”
 As discussed below, other class differences such as differences in voting rights are expressly permitted as long as all classes confer identical rights to distribution and liquidation proceeds.
 State law requirements related to payment and withholding of income tax will not generally result in Disproportionate Distributions.
 Field Service Advice (March 6, 1997), 1997 WL 33313692.