The Single Class of Stock Rules

These restrictive rules are found in Internal Revenue Code Section (“§”) 1361. In

particular, the final requirement of § 1361(b)(1)(D) states simply that a corporation making an

S election can not have “more than 1 class of stock.” This statement seems straightforward

but, as with many issues in tax, it is not. For example, the next subsection, §1361(c)(4),

provides that “a corporation shall not be treated as having more than 1 class of stock solely

because there are differences in voting rights.” In effect, this first qualification to the general

rule allows an S corporation to have two distinct types of stock, voting and non-voting common,

that are not treated as different classes for tax purposes even though they are separate

classes for other legal purposes. This allows some flexibility in the capital structure of S

corporations. Plus it is only one example of the exceptions and modifications which make up

this ostensibly simple single class of stock requirement.

For example, an S corporation will be treated by the IRS as having only one class of stock

if all outstanding instruments evidencing equity ownership confer identical rights to proceeds

upon distribution and liquidation. Treasury Regulations Section (“Regs. §”) 1.1361-1(I)(1).

Whether identical rights exist depends on the “realities” of the governing provisions of the

corporation. These consist of the corporation’s charter, its articles of incorporation, its bylaws,

applicable state law, and binding agreements not found in these sources. Regs. §1.1361-

1(I)(2). Not only is legal structure on paper at issue, but also the intent behind the formation

of equity interests. Because intent is a question of fact for a “jury” to decide, if a company issues

anything resembling equity other than common stock, the owners can never be sure of

whether these other obligations will destroy Subchapter S status. [For an excellent analysis

of this issue, see Hamil (1995).]

Although the single class of stock rule applies to all the outstanding shares of stock of a

corporation, the IRS has provided no definition of the term “outstanding stock”. There are

examples, however, of what is not outstanding stock. The first exclusion from outstanding

stock is restricted stock. Regs. §1.1361-1(I)(3). This is stock promised to an employee (or a

non-employee such as a member of the Board of Directors, a retiree, or an independent

consultant) but which is subject to a “substantial risk of forfeiture.” That is, the promise of the

stock would disappear if the employee leaves the company before a certain date, underperforms,

or some other contingency occurs. This risk of forfeiture shackles the employee with “golden

handcuffs”. (Note that until the risk is eliminated, the employer gets no tax deduction for this

compensation. However, the employee does not have to recognize any taxable compensation,

but can elect to do so under §83(b).) So long as the risk remains and the employee does

not make the §83(b) election, restricted stock is ignored by the IRS when determining whether

the single class of stock rules have been violated.

The second exclusion concerns deferred compensation plans. Some plans are simple:

compensation simply is not paid until a determinable future date. These plans are very much

like typical defined contribution retirement plans, except that deferred compensation is not

deductible by the employer until it is paid out. One difference is that contributions to qualified

retirement plans are deductible when made, but qualified plans are subject to a variety of

complex restrictions. For example, such plans must be currently funded, the funds must held

in a trust separate from the employer, and the benefits withheld until retirement or a break in

service. More importantly, qualified plans cannot be restricted to key employees, but must

cover almost all long term, permanent employees.

 

Plain vanilla deferred compensation plans raise little risk of being recast as a second class

of stock. So do some more exotic variants. For example, phantom stock plans are not

considered a second class of stock, provided only employees are covered by the plan. Regs.

§1.1361-1(b)(4). No stock is actually issued in a phantom stock plan. Instead, employees are

treated as if they own stock. For example, they receive a payment equivalent to the dividends

they would have earned had they actually received stock. Furthermore, employees can cash

out of the plan by “selling” the imaginary stock back to the company. (A similar result applies

to plans involving stock appreciation rights. In such plans, no phantom dividends are earned,

and the amount received when cashing out is limited to the appreciation of the imaginary

stock.)

The third exclusion exempts straight debt from being included as outstanding stock.

Regs. §1.1361-1(b)(5). Straight debt 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.” This exception is not trivial. The U.S. income tax system strongly favors the use of debt

in capitalizing companies. Current return on debt — interest — typically is deductible, whereas

current return on equity — dividends — is not. Similarly, repayment of debt rarely triggers tax,

whereas repurchase of equity in a successful corporation typically does. Thus, entrepreneurs

have strong incentives to disguise equity as debt. What actually is debt, and what is equity,

suffers from a dearth of guidance from the IRS: although Congress laid down the basic rule

by enacting §385 in 1969, the IRS has yet to issue final regulations interpreting it.

In order for even straight debt to be excluded from classification as a second class of

stock, however, certain qualifications have to be met. First, the loan must not have interest

rates or payment dates that are contingent upon profit. Second, the loan must not be

convertible into stock or any other equity interest. Third, the debt must be held by an individual

who is U.S. citizen or resident alien, an estate, or certain qualifying trusts. Although minor

modifications to debt contracts will not cause a reclassification into a prohibited second class

of stock, Regs. §1.1361-1(I)(5)(iii)(A), some modifications may. For example, transfer of debt

to a third party who cannot be an S corporation shareholder can cause straight debt to be

reclassified. Regs. §1.1361-1(I)(5)(iii)(B). However, most debt meets the requirements of the

straight debt safe harbor unless the debt’s principal purpose is to circumvent the single class

of stock rule. Taken together, these rules fairly well show that a commercially reasonable loan

will not trigger the loss of S corporation status.

Other Arrangements

Arrangements other than those discussed above can be treated as a second class of

stock. For example, if they result in the holder being treated as the owner of stock under

general principles of Federal tax law, S corporation status is lost unless there was no tax

avoidance purpose to the arrangement. Regs. §1.1361-1(I)(4)(ii)(A). As with straight debt,

there are safe harbors for such other arrangements, too. One is that the typical, small

employee advance — in effect, a short-term unwritten loan — does not constitute a second class

of stock. Even advances by a shareholder to the corporation are not a second class, provided

they 1) do not exceed $10,000 in the aggregate at any time during taxable year, 2) are treated

as debt by the parties, and 3) are expected to be repaid within a reasonable time. Regs.

§1.1361-1(I)(4)(ii)(B)(1). Even if these conditions are not met, the advances will not be treated

as a second class of stock unless the purpose of the advances was to circumvent the single

class of stock rule (or the limitation on eligible shareholders).

Thus, short term advances do not destroy S corporation status. Nor do obligations that

are proportionately held by the S shareholders, even when considered equity under other

 

 

aspects of existing tax law. Again, there is the caveat that this is true only when the purpose

is not to circumvent the single class of stock rule or the limitation on eligible shareholders. Note

that when there is only one shareholder, debt would always be covered under this safe harbor.

Reg §1.1361-1(I)(4)(ii)(B)(2).

Call options — a term which includes not only traditional call options but also warrants and

similar instruments — can be considered a second class of stock, but generally are only if: 1)

taking into account all the facts and circumstances the call option is substantially certain to be

exercised, and 2) the stock has a strike price of less than 90% of its fair market value. These

tests are applied on three different dates: the date the option is issued, the date it is transferred

to a non-eligible shareholder, and the date it is materially modified. Regs. §1.1361-1(I)(4)(iii)(A).

Two exceptions apply to the call option rules. The first is when the option holder is actively

or regularly engaged in the business of lending, and the option is issued in connection with

a commercially reasonable loan to the corporation. This exception also applies in the case

where the option is transferred along with the loan. If the option is not transferred with the loan,

the preceding tests must be applied. The second exception to the general rules covering call

options addresses the issue of call options issued as compensation to either independent

contractors or employees. As long as the call options are not excessive compensation, they

are not considered a second class of stock if they are nontransferable within the meaning of

Regs. §1.83-3(d) and they do not have a readily ascertainable fair market value at issuance.

Regs. §1.1361-1(l)(4)(iii)(B)(2).

Convertible debt can be considered a second class of stock, but only if it would be treated

as a second class of stock under the general criteria for instruments, obligations, or

arrangements treated as equity (e.g., under §385), or if it grants rights equivalent to those of

a call option. Because convertible debt has two ways to be classified as a second class of

stock, S corporations should be careful in issuing any kind of convertible debt.