S Corporation Trap – The Second Class of Stock

Take-Away: An S election by a corporation can be inadvertently terminated if there is a deemed second class of stock

Background: An S corporation is something of a hybrid between the asset protection afforded to a C corporation and the passthrough tax attribute benefits of a partnership. However, the benefits of an S corporation have to be balanced against the numerous eligibility requirements that have to be observed at all times. These technical requirements apply to both state-law corporations that have made an S election as well as to state-law LLCs that have elected to be characterized as an S corporation. However, the inadvertent termination of the entity’s S corporate status can leave the business owner exposed to disastrous tax consequences. For example, if the S corporation was previously a C corporation before its S-election, the termination of the S corporation status would lead to the imposition of entity-level tax that dates back to the initial date of the S election termination, which could amount to years of unremitted income taxes. The problem is that many

S shareholders fail to understand the events that can cause an inadvertent termination of the S-election. A couple of the pitfalls that can lead to the inadvertent loss of an entity’s S-election include the following.

1. Deemed Second Class of Stock: An S corporation may only maintain one class of stock, with some possible exceptions identified in the Regulations.[Regulation 1.1361-1.] The S corporations can, however, have both voting and non-voting stock interests, but nothing more. If the S corporation issues stock with varying liquidation preferences or dividend preferences, the entity will probably be deemed to possess multiple classes of stock, thus endangering its S corporate status. Consequently,  in these instances, the S corporation can be deemed to have issued a second class of stock even when no issuance of separate shares occurs. There are two common instances when a second-class of phantom stock is deemed to have been issued:

Debt: Under Treasury Regulations the issuance of debt in the form of a shareholder or related-party loan that lacks the typical indicia and characteristics of a bona fide debt instrument, like low or no stated interest rate, no maturity date, a thinly capitalized borrower, etc., that debt may be classified instead for U.S. federal income tax purposes as an issuance of stock. Accordingly, the debt may be treated as a second class of stock.

Unreasonable Compensation: A comparable analysis applies with respect to unreasonably high or excessive compensation of the entity executives, or with respect to preferential or improper distributions of property or cash to the business owner. Under these circumstances, the IRS might view these excessive distributions to the business owner as based on an informal underlying equity interest in the S corporation.

2. Too-Creative Governing Documents: Perhaps the most frequent cause to new business owners is the unintentional creation of a second class of stock that is caused by poorly drafted governing documents of the S corporation. Treasury Regulations authorize the IRS to look to the Corporation’s governing instruments, e.g., Article of Incorporation or Organization and Bylaws, to determine if a second class of stock exists stemming from differing shareholder distribution or liquidation rights. Regulation 1.1361-1(l)(2).] An S corporation’s bylaws/operating agreement must allocate income, deductions, or losses among shareholders in a manner that is consistent with the rules set forth in the Tax Code. [IRC 1366] That section requires that allocations be strictly proportional to each shareholder’s ownership interest. The mistake sometimes made in the entity’s governing documents and buy-sell agreements, while aiming to facilitate governance and profit-sharing arrangements, may inadvertently introduce partnership tax concepts like: (i) capital accounts; (ii) special allocations; or (iii) curative allocations. These types of provisions can inadvertently  undermine the

S corporate status by inferring that distributions or liquidations may be made in a fashion that is inconsistent with the S corporate rules set-forth in the Tax Code and Regulations.

Practical Implications: The possibility of an inadvertent S-election termination can also cause headaches when the S shareholder tries to sell the entity. A potential buyer of the S corporation will always be concerned about the risk of a lurking second-class of stock, if the S shareholder seeks to sell the corporate entity, rather than the entity’s assets; if the buyer acquires the S corporation, the potential income tax liabilities that stem from an historical S-election termination will inure to, and be the responsibility of, the buyer. Accordingly, the buyer will often insist that rigorous tax due diligence be performed to uncover any inadvertent S termination prior to acquiring the corporation. If the buyer identifies a potential second class of stock in the corporation it will either bargain for a lower purchase price or it will seek even greater indemnification from the selling shareholders. Consequently, the price received on the sale of the S corporation could be lower and/or the time required for the prospective buyer to conduct its due diligence could delay the ultimate sale.

Conclusion: The shareholders of an S corporation should proactively manage their corporation by always: (i) Continuously assess shareholder agreements to ensure that they comply with the S corporation rules (statute and Regulations;) (ii) Monitor the number, eligibility and compensation of S shareholders; (iii) Intentionally structure any shareholder or related-party loans to be consistent with the IRS’s criteria for bona fide debt instruments; and (iv) periodically consult with tax professionals to ensure their ongoing compliance with the S corporation rules and  with an eye toward identifying the risk of a second class of stock.