Agreement on How to Distribute Liquidation Proceeds Created Second Class of Stock

One of the major disadvantages of an S corporation involves the rather strict rules that must be followed to maintain it status.  One of the key rules involves the one class of stock requirement found at IRC §1361(b)(1)(D).  If an S corporation has outstanding more than one class of stock, as defined in Reg. §1.1361-1(l)(1), its S status is terminated as of the first day that second class of stock is found to exist.

In PLR 201605002 the taxpayers found that what they wanted to do ran afoul of these rules. While the taxpayers were able to persuade the National Office that this was inadvertent and they received the right to fix the issue and still be considered an S corporation, that only happened after the taxpayers went to the expense of obtaining their own private letter ruling.

What constitutes two classes of stock for purposes of this test is not the same as what makes for different classes of stock under corporate law.  For instance, if the only differences in rights between two classes of stock is that one has voting rights while the other doesn’t, both are considered part of one class of stock for S corporation purposes.

Rather, for these purposes, stock is considered to consist of different classes if the stocks differ, on a per share basis, either in terms of rights to distributions (dividends under state corporate law) or in liquidation of the entity.

In this case the letter ruling describes what the taxpayers did that managed to terminate the S status, necessitating a request to the IRS that this termination be deemed inadvertent: 

On Date 2, X amended its articles of incorporation to provide that X could issue M shares of stock in each of M classes. In general, there were no preferences, distinctions, or special rights with respect to any one class of stock, except that the articles provided that X and its shareholders could, by written agreement, specify the manner in which the assets of X would be distributed in the event of a liquidation, dissolution, or winding up of X. In conjunction with these amended articles of incorporation and on the same date, X and its shareholders entered into binding Agreement 1.

Agreement 1 permitted potentially different rights of the shareholders to liquidation proceeds. It provided that the net proceeds on liquidation would be distributed in accordance with a plan of distribution approved by N% of the shareholders or, if no plan was approved, the proceeds would be distributed in a way that could vary by class and by the length of a shareholder's employment with X.

Effective Date 3, X elected to be treated as an S corporation. The articles of incorporation and the provisions of Agreement 1 thus applied during the time X intended to be an S corporation.

Clearly that agreement presented a problem, since that created a situation where there would be different rights on liquidation. The fact that there has been no liquidation proceeds ever distributed is not the issue—the rights are what matter and those are different.

Since this is a private letter ruling request, someone associated with the taxpayer (perhaps a new CPA or attorney) discovered the problem.  The corporation therefore took the following steps before requesting the ruling:

On Date 4, X amended its articles of incorporation to provide for only one class of common stock of X. On Date 5, X and its shareholders amended Agreement 1 by entering into binding Agreement 2. Agreement 2 does not provide for any differing rights among the shareholders to proceeds from any liquidation of X.

Given the fact that the taxpayer had always intended to be an S corporation, had always filed as an S corporation, had removed the problematic agreement and no distributions had ever actually been made under that agreement, the IRS granted relief.

CPAs taking on a new S corporation client should consider reviewing the various corporate documents and agreements to insure that a problem such as this isn’t lurking in the background.  If caught immediately upon taking on the client the CPA can insure there won’t be a problem.