The New S Corporation Regulations One Class of Stock Requirement

Article excerpt

On October 5, 1990 the IRS released proposed regulations under Sec. 1361 dealing with the requirement that an S Corporation have only one class of stock. The proposed regulations provide that, in order to avoid creating a second class of stock outstanding, shares must confer identical rights to both distributions and liquidation proceeds. Any instrument, obligation, or arrangement, regardless of whether designated as debt which constitutes equity or otherwise results in the holder being treated as the owner of stock under general principles of federal tax law, is treated as a second class of corporate stock. Additionally, options that are substantially certain to be exercised are classified as a second class of stock regardless of whether they would be treated as stock under general tax law principles.

Differences in voting rights, rights that arise from buy-sell agreements among shareholders, and restrictions on the transferability of stock are disregarded in determining whether a corporation has more than one class of stock.

All outstanding shares of stock are taken into consideration in determining whether a corporation has a second class of stock. However the proposed regulations provide that substantially nonvested stock under Reg. Sec 1.83-3(b) is not treated as outstanding stock unless the holder makes an election under Sec. 83 (b). The proposed regulations also state that most types of deferred compensation arrangements that do not involve property subject to Sec. 83 are not considered outstanding stock.

Straight Debt Safe Harbor

Sec. 1361(c)(5) and the proposed regulations provide that straight debt is not treated as a second class of stock even if it would otherwise be treated as equity under general principles of federal tax law. Straight debt is defined in Sec. 1361(c)(5)(8) as a written unconditional promise to pay on demand on a specified date a sum certain in money if 1) the interest rate and interest payment dates are not based on profits, the corporation's discretion, or similar factors; 2) there is no direct or indirect convertibility into stock; and 3) the creditor is an individual (but not a non-resident alien), an estate or a trust described in Sec. 1361(c)(2).

Further, the proposed regulations provide that to qualify as straight debt the obligation must bear a reasonable rate of interest. …

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