New Proposed One-Class-of-Stock Regulations

By Oliva, Robert R. | The CPA Journal, February 1992 | Go to article overview

New Proposed One-Class-of-Stock Regulations

Oliva, Robert R., The CPA Journal

What do five of the Big Six, the AICPA, the National Conference of CPAs, the National Society of Public Accountants, the Small Business Administration, a number of U.S. Senators and Congressmen, state CPA societies, many individual CPAs, firms in 18 states, and a dentist in Georgia have in common? All participated in writing more than 200 letters and making more than 200 telephone calls to the IRS requesting changes or repeal of the proposed regulations on S corporations' one-class-of-stock requirements within the first 150 days of its announcement on October 5, 1990.

In response, on August 8, 1991, the IRS announced new proposed regulations to replace the October proposal. Although the new proposal reiterates that an S corporation will be treated as having more than one class of stock when the "outstanding" stock does not provide "identical rights" to distributions and liquidations proceeds, the new version provides numerous examples, safe harbors, and exceptions. It also states that reclassification or other arrangements of debt as equity under general federal tax principles will result in a second class of stock only when the action was taken to contravene the "second-class" status or the type and number of shareholder requirements of subchapter S.

The importance of these regulations cannot be understated. Pursuant to IRC Sec. 1361(b)(1)(D), an S corporation can have only one class of stock. If an S corporation is deemed to have more than one class at its inception or at any time thereafter, Sec. 1362(d)(2) states that the S election is invalid or terminates on the date the second class of stock was created.


Criticisms of the original proposal were directed to:

* Application retroactive to January 1, 1983;

* Possibility that informal advances, constructive distributions, or fringe benefits such as automobiles, excessive compensation and even medical insurance would be considered nonconforming distributions and thus give rise to a second class of stock;

* Lack of any de minimis exceptions;

* Broadness and apparent lack of legislative mandate to automatically conclude that any debt reclassified as equity is automatically a second class of stock;

* Requirement of a reasonable interest rate for straight debt;

* Cursory treatment of options and warrants; and

* Proposed regulations that were unnecessarily broad.

Some letters urged, and the IRS eventually agreed, that termination should occur only when the transgressions form a deliberate and abusive pattern of nonconforming distributions or prohibited use of debt in order to avoid the second-class requirements. Similarly, others argued, and the IRS eventually agreed, that recharacterization of any tainted payment as compensation or as a constructive dividend is a more adequate remedy than termination. Some critics simply asked for, and eventually received, more examples.


However, a more direct attack on the proposed regulations came from four Senate Finance Committee members. First, David Boren (D-Okla.) introduced S. 532 on February 28, 1991. Co-sponsored by David Pryor (D-Ark.) and Max Baucus (D-Mont.), S. 532, billed as The Taxpayer Regulatory Relief Act of 1991, was aimed to prevent the Treasury and the IRS from writing and applying retro-active regulations.

Second, Sen. William V. Roth (R-Del.) revealed the makings of a possible bipartisan coalition when he introduced S. 722 on March 21, 1991. His bill and the original IRS proposal would have been applied retroactively to December 31, 1982, and required that all outstanding shares of an S corporation confer identical rights as to distribution and liquidation proceeds. However, unlike the original IRS proposal, his bill a) would not consider options and warrants as outstanding stock unless they are exercised but b) would provide a cure of a terminating event within a reasonable time after its discovery. …

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