Question

S, a corporation, executes 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 distributions.Does a second class of stock exist violating the S corporation requirements and on what grounds?

Answer 1

• The IRS has issued final regulations on the issue of S corporation single-class-of-stock requirement specified in IRC Sec 1361(b)(1)(D). Under the new ruling, small business corporations are described as possessing a single class of stock only. A corporation is considered to have one class of stock if all of its outstanding shares bestow equal rights to distributions and liquidation yield. The code also includes a list of allowable differences and criteria that need to be considered in ascertaining if the outstanding shares confer similar rights. Nine examples are likewise given to describe provisions pertinent to distribution and liquidation rights. The final statute also elucidates on issues related to other instruments, obligations and arrangements, replaces the contravention test with a principal purpose standard, and limits treatment of options, warrants and related instruments. The regulation takes effect for calendar year S corporations in 1993.

On May 28, 1992, final regulations were adopted in connection with the single-class-of-stock (SCOS) requirement of IRC Sec. 1361(b)(1)(D). These regulations are the IRS's third attempt at promulgating rules in an area that unexpectedly became quite controversial. The saga began back in October 1990, after the original version of Prop. Reg. Sec. 1.1361(1)(1) was issued. Commenters observed significant differences between many of the positions adopted by the proposed regulations and those considered acceptable under past practices. Two areas of concern surfaced immediately.

The first concern dealt with "non-conforming distributions"--those distributions that varied as to timing or amount. A corporation's failure to comply with the strict distribution guidelines of the proposed regulations would cause its S election to terminate.

The second concern dealt with the reclassification of certain debt instruments to equity (creating a second class of stock) if the instruments failed to qualify under the straight-debt safe harbor and could be treated as equity under general principles of tax law. To heighten the turbulence, these proposed regulations were given retroactive effect, thereby risking the termination of S elections on the basis of completed historical transactions. The IRS withdrew these proposed regulations after much pressure. In August 1991, revised proposed regulations were issued. The IRS incorporated many of the suggestions provided by commenters, and the proposed regulations were not retroactive in effect. About one year later, the evolution of the SCOS regulations was complete. The end result is a new and improved set of more pragmatic regulations that incorporate common sense.

Identical Rights to Distributions

The definition of a small business corporation under IRC Sec. 1361(b) includes, among other requirements, that the corporation not have more than one class of stock. A corporation is treated as having one class of stock provided all outstanding shares confer identical rights to distributions and liquidation proceeds. Differences in voting rights are ignored for qualification purposes. Therefore, an S corporation can have more than one class, provided the distribution and liquidation principle is not violated. Examples of allowable differences include:

* Differences in voting rights,

* Irrevocable proxy agreements, and

* Groups of shares which allow for differences in rights to elect members of the board of directors.

The final regulations refer to a set of criteria (governing provisions) which must be considered collectively in determining whether an S corporation's outstanding shares confer identical rights in distribution and liquidation. These governing provisions consist of the corporation's bylaws, charter, articles of incorporation, applicable state law, as well as binding agreements related to distribution and liquidation proceeds. With respect to binding agreements, commercial contractual agreements, such as leases or employment, and loan agreements, are not considered binding unless a principal purpose of an agreement is to circumvent the SCOS requirement.

Certain states require withholding income taxes from distributions to some or all of their S corporation shareholders. The final regulations address this by stating such laws are to be disregarded in determining whether shares of stock confer identical rights to distribution and liquidation proceeds. The timing of constructive versus actual distributions or withholdings between shareholders may also be ignored for this purpose.

Buy-Sell Agreements

Buy-sell agreements, agreements restricting the transferability of stock, and redemption agreements may also be ignored in determining whether shares confer identical distribution and liquidation rights unless--

* A principal purpose of the agreement is to circumvent the SCOS requirement, and

* The agreement establishes a purchase price that, at the time the agreement is entered into, provides for consideration considerably in excess of or below the fair market value of the stock.

In determining whether an agreement's purchase price is significantly in excess of or below fair market value, amounts between book value and fair market value fall within a safe haven. The determination of book value should be made in accordance with GAAP or a book value used for any other substantial non-tax purpose. Fair market values will be respected provided a good-faith determination has been made. Good faith presumes reasonable diligence and accuracy when calculating value.

Bona fide agreements for the purchase or redemption of stock at death, divorce, disability, or termination of employment are disregarded in determining whether shares confer identical liquidation and distribution rights. Stock which is substantially non-vested, as defined in IRC Reg. Sec. 1.83-3(b), and issued in connection with the performance of services is not treated as outstanding unless an election under IRC Sec. 83(b) is made. The regulations also reserve the right of the Commissioner to provide other published guidance as to other types of bona fide agreements that may be disregarded for this purpose.

Distributions

Varying distributions made as a result of a change in stock ownership will not result in a second class of stock provided the distributions are made within a reasonable time period after the close of the taxable year in which the changes occurred. However, the IRS still may recharacterize such distributions based upon existing facts and circumstances. Such a reclassification will not result in a second class of stock.

The regulations offer the following nine examples to illustrate the provisions applicable to rights in distribution and liquidation:

Example 1 -- State Law Restrictions. The law of State A requires permission be obtained before stock can be issued. The state grants permission, but requires stockholders who are issued stock for property and not cash waive their rights to receive distributions until shareholders who contributed cash recover their investment.

The restriction imposed by the state alters the rights to distributions and liquidation proceeds, therefore, the corporation is treated as having more than one class of stock.

Example 2 -- Timing of Distributions. An S corporation has two equal shareholders A and B, each entitled to equal distributions of $50,000. Shareholder A receives the distribution in the current year and shareholder B receives the distribution in the following year.

The difference in timing does not cause the corporation to be treated as having a second class of stock. However, other recharacterization principles may apply to determine the proper tax consequences.

Example 3 -- Excessive Compensation. An S corporation has two equal shareholders C and D, each employed under binding employment contracts. C's compensation is reasonable, but a portion of D's compensation has been deemed excessive.

Employment agreements are not governing provisions, therefore the corporation is not deemed to have a second class of stock, even though the corporation may not deduct the excess compensation paid to D. This result assumes the employment agreements themselves did not reflect a principal purpose to circumvent the SCOS requirement.

Example 4 -- Fringe Benefits. An S corporation is required by binding agreement to pay accident and health insurance premiums in differing amounts for certain employees who are also shareholders.

This agreement is not a governing provision; therefore the corporation is not deemed to have a second class of stock, even though the premiums paid are of differing amounts. This assumes the agreements themselves did not reflect a principal purpose to circumvent the SCOS requirement.

Example 5 -- Below-Market Loans. E, a shareholder of an S corporation, is granted a below market loan that is a corporation/shareholder loan to which IRC Sec. 7872 applies. Under IRC Sec. 7872, E is deemed to receive a distribution of the foregone interest by reason of the loan.

This agreement is not a governing provision; therefore the corporation is not deemed to have a second class of stock, even though E received a deemed distribution related to the foregone interest. This result assumes that the agreements themselves did not reflect a principal purpose to circumvent the SCOS requirement.

Example 6 -- Adjusting Distributions for State Tax Burdens. An S corporation executes a binding agreement with its shareholders to modify its normal distributions policy to make upward adjustments on distributions to shareholders who bear a heavier state tax burden. The adjustment is based on a formula that will give each shareholder the same after-tax distributions.

This agreement is a governing provision which alters the shareholders' rights to distribution proceeds; therefore, the corporation is deemed to have more than one class of stock outstanding.

Example 7 -- State Law Requires Withholding of Income Tax. State law requires withholding of income tax on all nonresident shareholders of an S corporation. Resident shareholders have the right to distributions that take into account the amounts withheld and paid in connection with the nonresident shareholders.

Since the resident shareholders have the right to equal distributions, taking into account the constructive distribution for the withholding tax on nonresident shareholders, such withholdings and payments would be disregarded in determining whether the corporation has more than one class of stock outstanding. There would be a similar result if the withholdings were treated as advances and subsequently were repaid or reduced future distributions.

Example 8 -- Redemption Agreements. F, G, and H are all shareholders of an S corporation. F is also an employee of the S corporation. By agreement, F's shares are to be redeemed on termination of F's employment.

This agreement would be disregarded in determining whether all the corporation's outstanding shares confer identical rights to distribution and liquidation proceeds.

Example 9 -- Analysis of Redemption Agreements. J, K, and L are all shareholders of an S corporation. L is also an employee of the S corporation. L's shares were not issued in connection with the performance of services. By agreement, L's shares are to be redeemed for an amount significantly below fair market value on termination of L's employment or if the corporation's sales fall below certain levels.

The portions of the agreement dealing with redemption on termination of employment and reduced sales levels are disregarded. This result assumes that the agreements themselves did not reflect a principal purpose to circumvent the SCOS requirement.

Other Instruments, Obligations, or Arrangements

The final regulations have clarified some topics of concern in this area, particularly the treatment of debt arrangements. The predecessor proposed regulations provided a very limited list of exceptions to the SCOS requirement. Additionally, these proposed regulations adopted a "contravention test" for determining whether an arrangement altered a shareholder's rights to distribution or liquidation proceeds. Practitioners commented on the term "contravention," stating that the proposed regulations lacked specificity with respect to its definition. The final regulations dropped the contravention test and have now substituted a "principal purpose" standard. Under the final regulations, instruments, obligations, or other arrangements will not be considered a second class of stock unless--

* The instrument, obligation, or arrangement constitutes equity or otherwise results in the holder being treated as the owner of stock under general principles of Federal tax law; and

* 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 outstanding shares of stock or circumvent the limitation on the number of eligible shareholders.

The final regulations also provide for the following two safe harbors:

Short-term Unwritten Advances. Unwritten advances that do not exceed $10,000 in the aggregate at any time during the taxable year, are treated as debt by the parties, and are expected to be repaid within a reasonable period are not treated as a second class of stock for such taxable year. This exception applies even if the obligation would be treated as equity under other principles of Federal tax law. It appears the writers of the regulations have tied this short-term advance safe harbor to the imputed interest de minimis exception under IRC Sec. 7872(c)(3).

Proportionately held Obligations. Obligations which 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. An obligation or obligations owned by the sole shareholder of a corporation are always held proportionately.

Failure to qualify under these safe harbors will not result in a second class of stock unless a principal purpose is to circumvent the rights of the outstanding shares of stock or the limitation on the number of eligible shareholders.

Options, Warrants, or Similar Instruments

The treatment of options, warrants, or similar instruments has been made more restrictive under the final regulations. Prior to the proposed and final regulations, practitioners followed the guidelines of Rev. Rul. 67-269, 1967-2 CB 298, which stated that options or warrants were disregarded for purposes of the SCOS requirement provided they did not possess attributes of stock ownership. Attributes of ownership generally included rights to vote or receive dividends.

Under the final regulations, call options, warrants or similar instruments (collectively, "call options") will be treated as a second class of stock if the call option is substantially certain to be exercised (by the holder or potential transferee) and has a strike price substantially below the fair market value of underlying stock on the date the call is issued is transferred from an eligible to ineligible shareholder, or is materially modified.

A call option is not treated as a second class of stock in the following circumstances:

1. The call option is issued to a person actively engaged in the business of lending and issued in connection with a commercially reasonable loan to the corporation. The exception remains effective even if the call option is transferred with the loan.

2. The call option is issued to an individual who is either an employee or independent contractor in connection with the performance of services for the corporation or related corporation, is non-transferable, and does not have a readily ascertainable fair market value. For this purpose, a related corporation is any corporation more than 50% owned by vote and by value by the issuing corporation.

3. The call option has a strike price of at least 90% of the fair market value of the underlying stock. A good faith determination of fair value will be respected.

Care must be exercised when issuing call options, particularly where options are transferred from an eligible shareholder to an ineligible shareholder.

The regulations illustrate this point, as summarized in the following example: LaMar, an S corporation with 10 shareholders, issues call options to 3 eligible shareholders. The options have a strike price and fair value of $40 on the date of grant. A year later, partnership P purchases these options when the fair value of the underlying stock is $80. Since the strike price is substantially below the fair value of the underlying stock, the call option would be treated as a second class of stock, if, based on all the facts and circumstances, the options are substantially certain to be exercised.

As the foregoing demonstrates, S corporation shareholder agreements should be reviewed and modified to restrict these types of transfers.

Convertible and Straight Debt

Convertible debt will be considered a second class of stock if either--

* The debt would be treated as a second class of stock under IRC Sec. 1.1361-(1)(4)(ii), relating to instruments, obligations, or arrangements treated as equity under general principles of Federal tax law, or

* It embodies rights equivalent to those of a call option that would be treated as a second class of stock.

The straight debt safe harbor described in the final regulations reiterates the rules of IRC Sec. 1361(c)(5). Straight debt will not be considered a second class of stock if the debt is a written, unconditional obligation, regardless of whether or not embodied in a formal note, to pay a sum certain on demand, or on a specified due date which--

* 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;

* Is not convertible, directly or indirectly, into stock or any other equity interest of the S corporation; and

* Is held by an individual (other than a nonresident alien), an estate, or trust described in IRC Sec. 1362(c)(2).

The final regulations also state that subordination of a straight-debt obligation will not affect its qualification. However, modification of an existing obligation may change its qualification. A transfer of a straight-debt obligation to a third party who is not an eligible shareholder will cause the obligation to cease as qualifying. If a C corporation has an outstanding obligation that satisfies the definition of straight-debt, but is considered equity under general principles of Federal tax law, the obligation is not treated as a second class of stock if the C corporation converts to S status. Additionally, the conversion from C to S status is not treated as an exchange of debt for stock with respect to such an instrument. Again, if an S corporation relies on the straight-debt exception, proper planning is necessary when drafting shareholder agreements to restrict transferability.

Effective Dates

The final regulations are generally effective for taxable years of a corporation beginning on or after May 28, 1992. Therefore, the regulations become effective for calendar year S corporations in 1993. A corporation and its shareholders may elect to apply the regulations to prior tax years. Additionally, the regulations contain grandfather provisions for the following items entered into before May 28, 1992:

* Any instrument, obligation, or arrangement;

* Buy-sell agreements, redemption agreements, or agreements restricting transferability; or

* A call option or similar instrument.

Material modification of any of the above items occurring on or after May 28, 1992, will render the grandfather provision inapplicable.

Abusers Not the Unwary

The controversial, protracted evolution of the final SCOS regulations has ended with a product that most practitioners feel is straightforward and pragmatic. Additionally, the focus of the regulations has been redirected to the abusive rather than the unsophisticated or unwary taxpayer. The regulations, in their final form, prove that the IRS and taxpayers can work together to develop rules that are fair and equitable to all parties involved.