Many small businesses choose to operate as a corporation to take advantage of the limited liability protections. However, federal income tax law generally imposes two levels of tax on corporate profits: a corporate-level income tax and a tax on the dividends paid to the corporation’s shareholders.
The Internal Revenue Code allows some “small business corporations” to be so-called “S corporations,” which generally are not subject to corporate-level income tax. S corporation status is available only if the corporation meets specific criteria, including have only one class of stock.
The Single Class Stock Requirement for S Corporations
The regulations governing S corporations state that a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. These regulations also state determining if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to the distribution and liquidation proceeds. The regulations, however, also state bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment do not change whether a corporation’s shares of stock confer identical rights.
Employee Stock Compensation and the Single Class Stock Requirement
In Private Letter Ruling 201918013 released on May 3, 2019, the IRS [PDF] was asked to rule whether shares of stock in an S corporation acquired under an employee stock compensation plan (that authorized the corporation to sell shares of its stock to key employees or to grant shares or options to purchase shares to such employees, subject to certain restrictions) would create an impermissible second class of stock.
The specific restrictions in the employee stock compensation plan included making the shares non-transferable without the prior written consent of the corporation’s chairman of the board and giving the corporation the right to repurchase the shares under certain circumstances (for example, upon termination of employment and at fair market value or the forfeiture repurchase price).
The IRS Issues New Guidance
The IRS determined the transfer restrictions and repurchase provisions do not change whether the shares issued pursuant to the employee stock compensation plan conferred identical rights to other stock issued by the S corporation. The transfer restrictions and repurchase provisions were found to be bona fide agreements to redeem or repurchase stock allowable under the regulations governing the single class of stock requirement for S corporations.
How Does the Guidance Affect My Small Business?
Equity-based compensation plans and shareholder agreements for S corporations should be carefully reviewed to determine if the plan or agreement potentially creates a second class of stock. A compensation plan that does not meet the specific restrictions outlined above will adversely affect the status of the corporation as an S corporation. The recent Private Letter Ruling provides further guidance to make such determinations.
If you have any questions concerning the second class of stock restriction on S corporations or the impact of equity-based compensation plans or shareholder agreements on your S corporation’s tax status, please contact the attorneys in the Woods Rogers Tax Group.
