Avoiding S corporation debt obligations that are a second class of stock.

• Author: Ellentuck, Albert B.

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UNDER CERTAIN CIRCUMSTANCES, DEBT owed by an S corporation to one or more shareholders will be a second class of stock. An obligation (whether or not designated as debt) generally will be treated as a second class of stock if (1) it constitutes equity or otherwise results in the holder's being treated as a shareholder under general tax law and (2) a principal purpose of the obligation is to circumvent the distribution or liquidation rights conferred by the outstanding stock or to circumvent the maximum shareholder limitation (Regs. Sec. 1.1361-1(1)(4)(ii)).

Whether an obligation constitutes debt or equity can be important for the following practical reasons:

* The continued validity of the corporation's S election depends on having only one class of stock; and

* Payments on debt will reduce the corporate income available for distribution and likely will differ from amounts that would otherwise be distributed to the shareholders on equity.

For these reasons, and because the parameters of the "principal purpose" test are unclear, the practitioner should be aware of factors the courts consider in determining whether an obligation is debt or equity. The Tax Court has identified and applied various factors in concluding that the obligation under consideration was equity, including the intent of the parties, thin versus adequate capitalization, the source of repayment, and the right to enforce repayment (American Offshore, Inc., 97 T.C. 579 (1991); Gray, T.C. Memo. 1997-67). For additional assurance that the obligation will not jeopardize the corporation's S status, the planner can structure the obligation to meet the straight debt safe harbor described below.

Observation: The one-class-of-stock rules provided in Regs. Sec. 1.1361-1(1) do not apply to obligations issued before May 28, 1992, and not materially modified after that date. However, S corporations and their shareholders can apply the regulations to prior tax years (Regs. Sec. 1.1361-1(1)(7)).

Relying on the Straight Debt Safe Harbor

Debt that meets the definition of "straight debt" is not a second class of stock, regardless of whether such debt is classified as equity under general tax law principles. A straight debt instrument is a written unconditional promise to pay (whether or not embodied in a formal note) on demand or on a specific date a sum certain in money (Sec. 1361(c)(5)). In addition, straight debt must meet the following requirements:

1. The interest...