The One Class of Stock Rule
An S corporation must be a small business corporation, which can have only one class of stock. If an S corporation issues a second class of stock, it ceases to meet the definition of a small business corporation, and its S corporation status is automatically terminated triggering significant adverse tax ramifications for its owners. A corporation that has issued only one class of stock may conduct its business or enter into agreements that treat certain shareholders or creditors in a manner that causes the company’s actions/agreements to be considered a second class of stock.
The one-class-of-stock rule prevents the corporation from having the complexity related to allocating earnings to multiple classes of owners. A corporation has only one class of stock if all outstanding shares provide for identical rights to stockholders regarding distribution and liquidation proceeds. However, differences in voting rights among shares of stock of a corporation do not automatically indicate that there is more than one class of stock.
A 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. Relevant to a determination of whether all outstanding shares of stock are of the same class requires that the stock confer identical rights to distribution and liquidation proceeds (versus voting rights) and is based on the terms of the articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds.
Second Class of Stock Court Case
A shareholder used the second-class-of-stock rule in a court case when the shareholder’s parents had a janitorial and paper-supply company that elected S status. As the shareholder’s parents aged, the shareholder and her brother took control of the company, each owning half of the stock. The corporation retained most of its earnings, but did distribute enough dividends to enable shareholders to pay their personal income tax on their shares of corporate income. The corporation suddenly stopped making the tax-payment dividends, leaving the shareholder with substantial income tax liabilities and no company distributions to cover the taxes. The shareholder knew this was part of an effort by the father and brother to squeeze the shareholder out of the business.
As a stockholder, the shareholder took a very unusual position: that the S election had been lost, and the tax on corporate earnings be imposed on the corporation rather than on the shareholders. According to the shareholder, certain extra payments made to the parents from the S corporation indicated that the parents had preference as to dividends. This preference meant there was a second class of stock. If the shareholder won, then the S election had been lost and no taxes would be owed.
The court found little evidence on which to base a conclusion regarding the nature of the extra corporate payments to the parents. The shareholder was unable to meet the burden of proof needed to show that there was a second class of stock and was liable for the income taxes. Too bad for the shareholder, but an interesting legal argument since shareholders rarely try to terminate an S election as they usually fight to maintain it.
Situations that create a second class of stock.
- S Corporation has a binding 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. The adjustments are based on a formula that will give the shareholders equal after-tax (i.e. after state tax) distributions. The agreement relates to distribution or liquidation proceeds and is a governing provision that alters the rights conferred by the outstanding stock of S to distribution proceeds therefore, those rights are not identical thereby treating the company as having more than one class of stock.
- Interest on debt is paid only if the corporation has earnings, or is interest payments are tied in some way to dividend policy. The corporation may be treated as having more than one class of stock.
Cases that typically do not create a second class of stock.
The IRS regulations list the following situations that do not involve a second class of stock. Caution is advised, because the result may be different if the circumstances indicate there is an attempt to avoid the one-class-of-stock requirement, etc. When in doubt seek appropriate counsel.
- Straight Debt. Debt is not treated as a second class of stock if: it is 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; it 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; It is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation; it is held by an individual (other than a nonresident alien), an estate, or certain trusts.
- Debt held proportionately. Obligations of the same class that are considered equity under general principles of federal tax law, but are owned solely by the owners of, and in the same proportion as, the outstanding stock of the corporation, are not treated as a second class of stock.
- Buy-sell agreements. Agreements among shareholders restricting the transferability of stock, are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation.
- Redemption Agreements. Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation’s shares of stock confer identical rights.
- Fringe Benefits. S Corporation is required under binding agreements to pay accident and health insurance premiums on behalf of certain of its employees who are also shareholders. Different premium amounts are paid by S Corporation for each employee-shareholder. S Corporation is not treated as having more than one class of stock.
- Employment Agreements. A and B are shareholders of S Corporation. A is also an employee of the company. By agreement, the company will redeem A’s shares on the termination of employment. The agreement is disregarded in determining whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds.
- Change in Stock Ownership. An S corporation governing instrument provides that the amount of distribution will be adjusted to take into account the fact that a stockholder owned stock for less than the full year. The corporation is not treated as having more than one class of stock.
The Subchapter S Revision Act of 1982 added the flexibility of allowing a company to issue voting and non-voting stock without running afoul of the one-class-of-stock requirement. Voting stock may be given to those family members who are most qualified to run the business, with non-voting stock given to other family members. However, the stock must have the same rights to distributions, or the S election will be lost.
Given the impact that losing an S election can have on a company and its shareholders, one is well advised to seek counsel before undertaking matters that could cause the loss of the election.