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
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.
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.
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.
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.