Structuring corporate payments to shareholder-employees to avoid a second class of stock.

• Author: Ellentuck, Albert B.

Facts: John Thornberg, an inventor with an electrical engineering background, started a sole proprietorship three years ago in his garage to develop superior automobile audio systems. He recently negotiated a lucrative development contract with two different foreign luxury automobile manufacturers and has enticed several of his friends to join his business.

John previously met with his tax adviser and agreed to incorporate the business and elect S status. John will own the majority of the stock, while his key technical people will each own a small amount of stock. John meets again with his tax adviser to discuss the S election details. The tax adviser learns that John is interested in providing deferred compensation to his key employees to encourage them to stay and develop state-of-the-art audio components. John also states that his employees' previous employer reimbursed their business-related expenses; he wants the new S corporation to continue this practice.

As an example of John's willingness to keep his key employees satisfied, he casually mentions that a fire recently destroyed the lead technical engineer's home; the business loaned the employee $15,000 at no interest to help defray short-term living expenses. John is more than willing to extend a similar loan to other key employees who suffer unexpected or extraordinary losses in the future. Issue: How can various forms of corporate payments to employee-shareholders be structured to avoid the risk of S status termination?

Analysis

The tax adviser confirms that John does not want to change the company's proposed capitalization in the first few years. Thus, John is not interested in offering restricted stock or stock options to his key employees.

One employee incentive that does not involve stock issuance is some form of a deferred compensation plan. Because John wants to limit benefits to only key technical employees, he will use a non-qualified plan. Further, because of expected cashflow constraints during the corporation's formative years, John wants to delay funding the plan until his employees are eligible to receive the compensation. A common form of deferred compensation plan ties such compensation to the value of the company's stock (olden to the increase in the value of such stock over a particular period).

Outstanding shares are taken into account when determining whether the corporation has a second class of stock. Generally under Regs. Sec. 1.1361-1(1)(1), a corporation...