S Corporations—Selected Topics

• Pages: 437-459
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

437

Chapter 14

S CORPORATIONS—

SELECTED TOPICS

This chapter first examines the “one class of stock” requirement,

in particular considering how shareholder agreements and debt

affect that requirement. It next surveys rules relating to qualified

subchapter S subsidiaries, discussing how they are treated, some

consequences of their formation and termination, and their use in

planning. The chapter then considers limitations on the use of an S

corporation’s allocable losses under § 1366(d), § 465, and § 469. Next,

it explores how § 1366(e) addresses a possible assignment of income

between family members be fore describing how § 336(e) and

§ 338(h)(10) apply to S corporation targets. It concludes by briefly

reviewing how S corporations compute employment taxes for their

shareholder-employees. That computation may sometimes favor

choosing an S corporation over a partnership, although changes

made by the 2017 tax act may weigh against that choice.

14.01 One Class of Stock

Every system of pass-thru taxation needs a mechanism for

allocating the entity’s income and loss among its owners. For

partnerships, that mechanism is § 704. Most partnership income can

be allocated among the partners as they see fit, subject only to the

“substantial economic effect” test of § 704(b). However, to address

concerns with assignment of income, under § 704(c), the partnership

must specially allocate gain or loss on contributed property if the

property, when contributed, had a basis-value disparity. Much of the

flexibility and complexity of Subchapter K can be traced to those two

provisions.

Because an S corporation must have “one class of stock”

(§ 1361(b)(1)(D)), its income and loss must be allocated in proportion

to stock ownership. Thus, this “one class of stock” rule avoids the

complexity of § 704(b)–(c) but lacks its flexibility.

An S corporation is treated as having one class of stock if “all

outstanding shares of stock [of the corporation] confer identical

rights to distribution and liquidation proceeds.” Regs. § 1.1361–

1(l)(1). In particular, different shares may have different voting

rights without violating the one class of stock requirement.

§ 1361(c)(4).

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S CORPORATIONS—SELECTED TOPICS

Ch. 14

(a) Shareholder Agreements

Especially in closely held corporations, shareholders often sign

agreements restricting their rights to transfer their stock. For

example, an employee may be required to sell her stock to another

shareholder or back to the corporation if she terminates her

employment. Sale and redemption agreements triggered by death,

bankruptcy and divorce also are common. If a shareholder signs such

an agreement, do the restrictions transform the shareholder’s stock

into a second, impermissible class of stock?

In general, the answer is no. Under the regulations, “[t]he

determination of whether all outstanding shares of stock confer

identical rights to distribution and liquidation proceeds is made

based on the corporate charter, . . . applicable state law, and binding

agreements relating to distribution and liquidation proceeds.” Regs.

§ 1.1361–1(l)(2)(i). The regulations specify that these “governing

instruments” do not include buy-sell agreements, agreements

restricting the transferability of shares, and similar arrangements

unless (1) a principal purpose of the agreement is to circumvent the

one class of stock requirement and (2) the agreement establishes a

purchase price that, at the time the agreement is entered into, is

significantly in excess of or significantly below the fair market value

of the stock. Regs. § 1.1361–1(l)(2)(iii)(A).

1

Further, bona fide

agreements to redeem or purchase shares at death, divorce, disability

or termination of employment are disregarded in determining

whether a corporation’s shares confer identical rights. Regs.

§ 1.1361–1(l)(2)(iii)(B).

The regulations offer several examples applying these rules. For

example, suppose an S corporation enters into an agreement

providing that distributions to its shareholders will be made in such

proportions as to ensure that each shareholder will receive the same

amount after taking into account state tax burdens. Thus,

shareholders residing in a state that imposes no state income tax will

receive $100 per share, while shareholders in a state that imposes a

state income tax, say at 6%, will receive $106.38 per share.

2

In this example, the corporation will be treated as having more

than one class of stock outstanding because a binding agreement

relating to distribution proceeds is a “governing instrument” and this

governing instrument alters distribution rights such that those

1

These regulations also state that agreements that provide for the purchase

or redemption of stock at book value or at a price between book value and fair market

value will not be considered as establishing a price significantly in excess of or below

the fair market value of the stock. Id.

2

A 6% tax impos ed on $106.38 equals $6.38, so that the after-tax amount

equals $100.00.