Different redemption rights did not create second class of stock.

• Author: Gould, Michael R.
• Position: In S corporation taxation

Generally under Sec. 1361 (b)(1)(D) and Regs. Sec. 1.1361-1(1)(1), S corporations are allowed to have only a single class of stock (SCOS); all shares must participate equally in distribution and liquidation rights. This has its foundation in the policy rationale that S corporations should be confined to simple capital structures; see U.S. Treasury Dep't, "Technical Explanation of Tax Reform Proposals," 91st Cong., 1st Sess. (1969), p. 5232 and GCM 38419. Although the SCOS rules appear clear (i.e., simply ensure that the S corporation's articles of incorporation authorize only one class of stock), there are several traps that could give rise to a prohibited second class of stock and terminate S status. Two recent Letter Rulings, 200329011 and 200329012, address whether differences in shareholder rights that do not specifically affect distribution or liquidation rights cause the termination of S status.

Letter Ruling 200329011

Facts: In Letter Ruling 200329011, a cash basis personal injury law firm sought guidance on a stock arrangement that remained after the firm's S election. Although the firm had only one class of stock outstanding, there were two different arrangements as to redemption rights that potentially challenged the SCOS requirement.

The first type of agreement, the "Incentive Shareholder Agreement," tailored for younger firm members, required each contracting shareholder to sell his or her shares on death, disability, retirement or termination of employment (terminating event) at a price determined through complex formulas engineered to reward long-term employment. The second type of agreement, the "Old Redemption Agreement" only applied to two senior firm members and required them to sell their shares back to the firm at book value on a terminating event, determined as of the last day of the firm's prior tax year. The two agreements created different redemption rights on the occurrence of a terminating event.

Ruling: Citing Kegs. Sec. 1.1361-1(1)(2)(iii)(A), the Service concluded that, in general, buy sell agreements among shareholders, agreements restricting stock transferability and redemption agreements are...