Letter ruling reaffirms the use of restricted stock by S corporations.

• Author: Bakale, Anthony

Although the use of restricted stock is a common component of the overall compensation strategy of most publicly traded C corporations, several issues arise when a closely held S corporation grants restricted stock to its employees. In Letter Ruling 200118046, the IRS determined that an S corporation's issuance of nonvoting common stock to key employees and the payment of bonuses to those employees would not cause it to have more than one class of stock.

The founders of an S corporation wanted to transfer nonvoting stock in the corporation to certain key employees. The stock grants were to vest at future specified dates, conditioned on the employees' continued employment by the corporation on the vesting date: The employees were required to execute an agreement that the stock's fair market value (FMV) was to be its book value. The agreement further required the key employees to offer their stock to the corporation and its shareholders at book value when the key employee's employment terminated or there was an attempted voluntary or involuntary transfer of the stock.

During the vesting period, the corporation was required to pay the key employees, annually and in arrears, bonuses equal to a percentage of the distributions paid to the founders with respect to their stock. The bonuses were to be treated as wages subject to withholding and deductible by the corporation. In addition, a key employee whose employment terminated during the vesting period was entitled to a payment equal to certain book appreciation in his respective restricted stock during the vesting period.

The ruling contains four characteristics common to S corporation restricted-stock programs:

1. The use of nonvoting stock to make grants to employees;

2. The existence of a buy-sell agreement requiring stock to be returned to the corporation or its shareholders or both on termination of employment;

3. The use of book value as an agreed-on FMV; and

4. The payment of "dividends" on the restricted stock during the vesting period.

In addition, to the extent employees are entitled to severance equal to certain book appreciation in their respective restricted stock shares, the fact pattern incorporated a modified stock appreciation right (SAR) plan.

Use of Nonvoting Stock and Existence of Buy-Sell Agreements

Sec. 1361(b)(1)(D) provides that an S corporation may not have more than one class of stock. This requirement can present several potential difficulties to closely held...