Update on Second Class of Stock Issues for S Corporations

Panelists at an American Bar Association (ABA) Tax Section webinar updated tax professionals on second class of stock issues for S corporations on June 24, 2020.

One of the speakers was Michael R. Gould, Counsel at the Chief Counsel’s Office, Passthroughs and Special Industries.

Topics covered in the webinar included:

  • deferred compensation plans
  • restricted stock
  • stock options and warrants
  • buy-sell and redemption agreements
  • disproportionate distributions
  • LLC operating agreements
  • Private Letter Ruling policies

Stock of an S Corporation 

An S corporation can have only one class of stock.

A corporation has one class of stock when the each of the shares has the same rights to:

  • distribution proceeds; and
  • liquidation proceeds.

Governing Provisions 

The “governing provisions” of an S corporation show whether it has one class of stock.

  • Governing provisions include:
  • charter documents,
  • articles of incorporation and bylaws, and
  • binding agreements that relate to the distribution or liquidation proceeds.

For example, a commercial contract, which is a binding agreement, would be a governing provision if a “’principal purpose” of the contract is get around the one class of stock requirement.

Prohibited Agreements and “Principal Purpose”

What kinds of contracts are designed with a principal purpose of creating a second class of stock?

Mr. Gould noted that the question of “principal purpose usually comes up in audit” from an IRS perspective.

However, taxpayers must be aware of whether their contracts and agreements have a principal purpose of acting like a second class of stock for the corporation.

Tax practitioners Kevin D. Anderson of BDO USA, LLP and Sarah Ritchey Haradon of Holland & Hart LLP mentioned several examples or agreements where they’ve seen potential second class of stock issues:

  • brother/sister entity transfer pricing agreements;
  • 51/19% ownership agreements for women-owned and minority owned entities;
  • entities that provide management services for real estate; and
  • debt arrangements where the interest is based on the performance of a company.

IRS No Ruling Policy on Disproportionate Distributions 

The IRS has a no ruling policy on whether a binding agreement would result in a disproportionate S corporation distribution.

However, they are working on guidance as binding agreements are an “area of concern.” These are “questions we are currently grappling with”, noted Mr. Gould. He also stated that, “as far as [S corporation] terminations are concerned, look to the regulations.”

Mr. Gould also emphasized that the IRS is looking for taxpayer input on disproportionate distributions.

Section 1362 Relief 

When asked about automating or expediting section 1362 relief for S corporations, Mr. Gould said the Chief Counsel’s Office is looking into it and may issue a revenue procedure covering the issue. “It does cause second class of stock issues,” he said. “We’re looking to get this corrected in an automated form. This is a problem we’d like to solve.”

An S corporation seeks relief under section 1362(f) when:

  • an S corporation election was ineffective; or
  • an S corporation was inadvertently terminated.

By Lisa Lopata, J.D. 

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