The Final S Corporation Single-Class-of-Stock Regulations

By Barragato, Charles A. | The CPA Journal, May 1993 | Go to article overview
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The Final S Corporation Single-Class-of-Stock Regulations

Barragato, Charles A., The CPA Journal

On May 28, 1992, final regulations were adopted in connection with the single-class-of-stock (SCOS) requirement of IRC Sec. 1361(b)(1)(D). These regulations are the IRS's third attempt at promulgating rules in an area that unexpectedly became quite controversial. The saga began back in October 1990, after the original version of Prop. Reg. Sec. 1.1361(1)(1) was issued. Commenters observed significant differences between many of the positions adopted by the proposed regulations and those considered acceptable under past practices. Two areas of concern surfaced immediately.

The first concern dealt with "nonconforming distributions"--those distributions that varied as to timing or amount. A corporation's failure to comply with the strict distribution guidelines of the proposed regulations would cause its S election to terminate.

The second concern dealt with the reclassification of certain debt instruments to equity (creating a second class of stock) if the instruments failed to qualify under the straight-debt safe harbor and could be treated as equity under general principles of tax law. To heighten the turbulence, these proposed regulations were given retroactive effect, thereby risking the termination of S elections on the basis of completed historical transactions. The IRS withdrew these proposed regulations after much pressure. In August 1991, revised proposed regulations were issued. The IRS incorporated many of the suggestions provided by commenters, and the proposed regulations were not retroactive in effect. About one year later, the evolution of the SCOS regulations was complete. The end result is a new and improved set of more pragmatic regulations that incorporate common sense.


The definition of a small business corporation under IRC Sec. 1361(b) includes, among other requirements, that the corporation not have more than one class of stock. A corporation is treated as having one class of stock provided all outstanding shares confer identical rights to distributions and liquidation proceeds. Differences in voting rights are ignored for qualification purposes. Therefore, an S corporation can have more than one class, provided the distribution and liquidation principle is not violated. Examples of allowable differences include:

* Differences in voting rights,

* Irrevocable proxy agreements, and

* Groups of shares which allow for differences in rights to elect members of the board of directors.

The final regulations refer to a set of criteria (governing provisions) which must be considered collectively in determining whether an S corporation's outstanding shares confer identical rights in distribution and liquidation. These governing provisions consist of the corporation's by laws, charter, articles of incorporation, applicable state law, as well as binding agreements related to distribution and liquidation proceeds. With respect to binding agreements, commercial contractual agreements, such as leases or employment, and loan agreements, are not considered binding unless a principal purpose of an agreement is to circumvent the SCOS requirement.

Certain states require withholding income taxes from distributions to some or all of their S corporation shareholders. The final regulations address this by stating such laws are to be disregarded in determining whether shares of stock confer identical rights to distribution and liquidation proceeds. The timing of constructive versus actual distributions or withholdings between shareholders may also be ignored for this purpose.


Buy-sell agreements, agreements restricting the transferability of stock, and redemption agreements may also be ignored in determining whether shares confer identical distribution and liquidation rights unless-

* A principal purpose of the agreement is to circumvent the SCOS requirement, and

* The agreement establishes a purchase price that, at the time the agreement is entered into, provides for consideration considerably in excess of or below the fair market value of the stock.

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