Different Redemption Rights Did Not Create Second Class of Stock

Generally under Sec. 1361 (b)(1)(D) and Regs. Sec. 1.1361-1(l)(1), S corporations are allowed to have only a single class of stock (SCOS); all shares must participate equally in distribution and liquidation rights. This has its foundation in the policy rationale that S corporations should be confined to simple capital structures; see U.S. Treasury Dept, Technical Explanation of Tax Reform Proposals, 91st Cong., 1st Sess. (1969), p. 5232 and GCM 38419. Although the SCOS rules appear clear (i.e., simply ensure that the S corporations articles of incorporation authorize only one class of stock), there are several traps that could give rise to a prohibited second class of stock and terminate S status. Two recent Letter Rulings, 200329011 and 200329012, address whether differences in shareholder rights that do not specifically affect distribution or liquidation rights cause the termination of S status.

Letter Ruling 200329011

Facts: In Letter Ruling 200329011, a cash-basis personal injury law firm sought guidance on a stock arrangement that remained after the firms S election. Although the firm had only one class of stock outstanding, there were two different arrangements as to redemption rights that potentially challenged the SCOS requirement.

The first type of agreement, the Incentive Shareholder Agreement, tailored for younger firm members, required each contracting shareholder to sell his or her shares on death, disability, retirement or termination of employment (terminating event) at a price determined through complex formulas engineered to reward long-term employment. The second type of agreement, the Old Redemption Agreement, only applied to two senior firm members and required them to sell their shares back to the firm at book value on a terminating event, determined as of the last day of the firms prior tax year. The two agreements created different redemption rights on the occurrence of a terminating event.

Ruling: Citing Regs. Sec. 1.1361-1(l)(2)(iii)(A), the Service concluded that, in general, buy-sell agreements among shareholders, agreements restricting stock transferability and redemption agreements are disregarded in determining whether a corporations outstanding shares confer identical distribution and liquidation rights. That regulation also provides that a good-faith determination of fair market value (FMV) is respected, unless it can be shown that it was substantially in error and determined without reasonable diligence. Regs. Sec. 1.1361-1(l)(2)(iii)(A)(1) and (2) provide exceptions if a principal purpose of the agreement is to circumvent the SCOS requirement and the agreement establishes a purchase price that significantly exceeds or is below the stocks FMV when the agreement is entered into.

The IRS summarily ruled that, under Regs. Sec. 1.1361-1(l)(2)(iii)(A), the co-existence of the Incentive Shareholders Agreement and/or the Old Redemption Agreement did not violateeither alone or integrated as a single set of agreementsthe SCOS requirement. Thus, the differing redemption rights did not create an SCOS in determining S eligibility.

Letter Ruling 200329012

Facts: In Letter Ruling 200329012, four S shareholders executed a shareholders agreement that contained an anti-dilution clause applicable to only two of the shareholders. The taxpayer asked the Service whether the anti-dilution clause created an SCOS that would terminate its S status.

Ruling: Although this ruling does not directly address whether such an anti-dilution clause terminates a corporations S election, the Service concluded that if the shareholders anti-dilution clause created an SCOS, such termination would be inadvertent under Sec. 1362(f). Alternatively, if the anti-dilution clause did not create an SCOS, the corporations S status was not terminated. Thus, without ruling whether the anti-dilution clause terminated S status, the Service ruled that S status would be preserved.

From Michael R. Gould, Washington, DC