S Corp Second Class of Stock and Ineligible Shareholder Problems

Most S corporation owners assume their election is permanent once the IRS accepts Form 2553. It is not. An S election lasts only as long as the corporation keeps meeting the eligibility rules, and the moment it stops, the election ends. Nobody sends you a letter. You usually find out years later, in an exam, or when a buyer's lawyer starts asking questions in due diligence.

Two of the most common ways an S corporation loses its status are a second class of stock and an ineligible shareholder. Both are easy to trip over. Both can often be fixed, if you catch them and act.

The eligibility rules you have to keep meeting

Under IRC Section 1361(b)(1), a "small business corporation" is a domestic corporation that is not an ineligible corporation and that does not:

• have more than 100 shareholders,
• have a shareholder who is not an individual (other than an estate, certain trusts described in IRC 1361(c)(2), or certain exempt organizations described in IRC 1361(c)(6)),
• have a nonresident alien as a shareholder, or
• have more than one class of stock.

IRC 1362(d)(2) then says the election terminates whenever the corporation ceases to be a small business corporation, and the termination is effective on and after the date of cessation. Not at year end. On the day it happens.

Ineligible shareholders: how they sneak in

The shareholder rules sound simple. In practice, ineligible owners usually arrive by accident:

• A partnership or corporation buys in. A business partner decides to hold the shares through his own LLC taxed as a partnership, or through a C corporation. That entity is not an individual, and it is not one of the permitted estates, trusts, or exempt organizations.
• A shareholder moves abroad or was never a resident. IRC 1361(b)(1)(C) bars nonresident alien shareholders. A foreign investor or a relative who is not a U.S. citizen or resident can break the election.
• Stock goes into the wrong kind of trust. IRC 1361(c)(2) allows only specific trusts, such as grantor trusts, certain testamentary trusts for a limited period, qualified subchapter S trusts, and electing small business trusts. A trust that does not fit one of those categories, or a QSST or ESBT whose election was never filed, is a problem.
• A shareholder dies and the estate plan was not built for S stock. The estate itself is a permitted shareholder, but the stock may later pass to a trust that does not qualify.

On the 100 shareholder limit, IRC 1361(c)(1) treats a husband and wife (and their estates), and all members of a family, as one shareholder. Few closely held companies get anywhere near 100 owners, so the ineligible shareholder issue is far more common than the headcount issue.

Second class of stock: it is about economic rights, not paper

Here is where owners get confused. You can have voting and nonvoting shares. IRC 1361(c)(4) says differences in voting rights among shares of common stock are disregarded. What you cannot have is shares with different rights to distributions and liquidation proceeds.

Treas. Reg. 1.1361-1(l)(1) states the test: a corporation is treated as having one class of stock if all outstanding shares confer identical rights to distribution and liquidation proceeds. Treas. Reg. 1.1361-1(l)(2)(i) says that determination is made based on the "governing provisions," meaning the corporate charter, articles, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds.

What usually does not create a second class

• Distributions that are out of sync. If the governing provisions give everyone identical rights, the regulation says distributions that differ in timing or amount are given appropriate tax effect under the facts and circumstances. Example 2 in the regulation describes one shareholder being paid a year after the other, without a second class of stock.
• Ordinary commercial contracts. Employment agreements, leases, and loan agreements are not governing provisions unless a principal purpose is to get around the one class of stock rule. Example 3 in the regulation involves excessive compensation paid to one shareholder: the deduction is denied, but no second class of stock results.
• Buy-sell and redemption agreements, unless a principal purpose is to circumvent the rule and the agreement sets a price significantly above or below fair market value. Agreements at book value, or between book value and fair market value, are disregarded under Treas. Reg. 1.1361-1(l)(2)(iii)(A).
• Straight debt. IRC 1361(c)(5) and Treas. Reg. 1.1361-1(l)(5) provide a safe harbor for a written unconditional promise to pay a sum certain, with interest not contingent on profits or the borrower's discretion, not convertible into stock, and held by an eligible creditor.

What can create a second class

• Articles, bylaws, or a shareholder agreement that give one owner a preferred return, a larger share of liquidation proceeds, or a priority on distributions.
• An LLC that elected S status but kept an operating agreement written for a partnership, with capital accounts, special allocations, or a liquidation waterfall that does not match ownership percentages.
• An instrument labeled as debt that is really equity, where a principal purpose is to circumvent the distribution rights of the stock or the eligible shareholder rules. Treas. Reg. 1.1361-1(l)(4)(ii)(A) treats that as a second class of stock.
• Certain call options that are substantially certain to be exercised and carry a strike price substantially below fair market value, under Treas. Reg. 1.1361-1(l)(4)(iii).

The LLC operating agreement problem deserves its own warning. If your LLC files Form 1120-S and the operating agreement still reads like a partnership agreement, have it reviewed. That document is a governing provision.

What happens when the election terminates

When the election ends mid-year, IRC 1362(e) splits the year into an S short year and a C short year. The C short year is taxed at the corporate level, and income is generally allocated between the two short years pro rata by day unless an election is made under IRC 1362(e)(3).

Going forward, the company is a C corporation. Distributions can become taxable dividends. And IRC 1362(g) generally bars a new S election before the fifth taxable year beginning after the first taxable year the termination was effective, unless the IRS consents.

If the problem existed from day one, the election may never have been valid. That is the same mess, just starting earlier.

The fix: inadvertent termination relief under IRC 1362(f)

Congress built a safety valve. Under IRC 1362(f), the IRS can treat the corporation as continuing to be an S corporation if:

1. the election was ineffective or terminated because of a failure to meet the IRC 1361(b) requirements (or to obtain shareholder consents),
2. the IRS determines the circumstances were inadvertent,
3. within a reasonable period after discovery, steps were taken so the corporation again qualifies, and
4. the corporation and every person who was a shareholder during the relevant period agree to make the adjustments the IRS requires.

Treas. Reg. 1.1362-4 fills in the details. The request is made as a private letter ruling request. The corporation carries the burden of showing inadvertence, and the regulation says it helps if the terminating event was not reasonably within the corporation's control, was not part of a plan to terminate, or happened without the corporation's knowledge despite due diligence. Treas. Reg. 1.1362-4(e) requires consent statements signed by the corporation and each affected shareholder.

The adjustments can be real. Under Treas. Reg. 1.1362-4(d), where an ineligible shareholder caused the problem, the IRS may require that shareholder to be treated as a shareholder for the period it held stock, and may require protective adjustments to prevent revenue loss.

The details of the relief process are covered in our guide to inadvertent S corporation termination. If the problem is an election that was filed late or never filed, see late S corporation election relief.

A practical checklist

• Pull every governing document: articles, bylaws, operating agreement, shareholder agreements, buy-sell agreements. Read the distribution and liquidation provisions.
• Build a stock ledger showing every owner on every date since the election. Note who is an individual, what kind of trust or entity holds shares, and each owner's residency.
• Check whether any trust shareholder needed a QSST or ESBT election and whether it was made.
• Look at how shareholder loans are documented. Our page on S corp shareholder loans covers the straight debt safe harbor and the basis issues.
• Fix the defect quickly once you find it. IRC 1362(f)(3) requires corrective steps within a reasonable period after discovery. Delay hurts the request.

And keep filing. A corporation that thinks it might have lost its S status still has filing obligations, and a missed Form 1120-S brings its own penalty under IRC 6699, discussed in our page on the Form 1120-S late filing penalty.

The one class of stock rule rewards boring, consistent paperwork. If yours is anything but boring, call the Law Offices of Darrin T. Mish, P.A. in Tampa at 813-229-7100 and get it reviewed before the IRS reviews it for you.