S stock call options as a second class of stock.

• Author: Pitts, Jennings P.

An S corporation can have only one class of stock; if a second class of stock exists, a corporation's S election will terminate. The second-class-of-stock requirements are governed by the regulations under Sec. 1361, which states that generally call options, warrants, or similar instruments (collectively, "call options") are treated as a second class of stock if the call options are substantially certain to be exercised and have a strike price substantially below the FMV of the underlying stock on the date that the call options are issued or transferred by an eligible shareholder to a person who is not an eligible shareholder. The regulations require retesting if and when the call options are first transferred to an ineligible shareholder. A call option is not considered to have a strike price substantially below FMV if the price at the time of exercise, under terms of instrument, cannot be substantially below the FMV of the underlying stock at the time of the exercise. It is important that the stock's FMV be determined through a formal process, such as an independent appraisal.

There are three main exceptions to the general rule under Sec. 1361:

1. Call options issued to a person actively and regularly engaged in the business of lending and issued in connection with a commercially reasonable loan to the S corporation (Regs. Sec. 1.1361-1(1)(4)(iii)(B)(1)). This exception applies if the call option is transferred with the loan or if a portion of the call option is transferred with a corresponding portion of the loan. If the call option is transferred without a corresponding portion of the loan, this exception no longer applies. Upon such a transfer, if, but for this exception, the call option would have been treated as a second class of stock as of its date of issue, the option is retested under the general rule.

2. Call options issued to employees or independent contractors (Regs. Sec. 1.1361-1(1)(4)(iii)(B)(2)). Call options issued to employees or independent contractors in connection with the performance of services do not constitute a second class of stock if the call options are not transferable and do not have a readily ascertainable FMV at the time the option is issued under Sec. 83. This exception extends beyond the termination of employee or independent contractor status and applies whether the services are provided to a corporation itself or to a corporation controlled by the issuing corporation.

3. Safe-harbor exception: The strike...