Introduction: A Second Class of Stock Isn’t Kosher

If you’ve already read S corporations: Advantages and Disadvantages,” you may be wondering why we’re talking about S-corporations and classes of stock. As you may recall, the requirements determining eligibility for S-corporation status are rather strict.

One of the requirements that can cause negative consequences for the unwary taxpayer is the requirement that S- corporations solely distribute a single class of stock.[1]

If an S-corporation distributes a second class of stock, the corporation loses its S- election and faces the consequences described below. 

Any violation of these requirements may cause the business to lose its prized S-election status. The S- election status is valuable because it allows the corporation to be taxed as a partnership.

Without the S- election, the corporation’s income no longer passes directly to shareholders, and the corporation no longer avoids the double layer of taxation imposed on its C- corporation cousins.

Stripped of its S corporation status, both the company and its shareholders will be subject to corporate taxes on its net income.

The M&A Minefield: What to Watch Out For

Keeping in mind the negative consequences described above, buyers in a merger or acquisition should take care during due diligence to verify that the target company’s S- election is valid by closely examining the shareholders’ agreement.

Both buyers and sellers should also be aware that a target company’s failure to qualify as an S- corporation also has the following adverse consequences:

  1. A buyer will be liable for the prior year’s taxes and will be taxed as a C- corporation instead of as an S- corporation; and
  2. The buyer will not receive a step up in basis if a 338(h)(10) election is pursued. For more on 338(h)(10) elections, read “The Unicorn of M&A: 338(h)(10) Elections.

A knowledgeable tax adviser can help buyers and sellers conducting due diligence to determine whether the S- corporation involved risks losing its S- election as a result of the transaction.

Threats to S Elections

Here are two threats to S- elections that tax advisers look out for:

  1. Unauthorized shareholders; and
  2. All shares distributed should have equal rights to proceeds from distributions and liquidations.

Trusts (with some exceptions) and foreign shareholders without residence in the United States are two examples of unauthorized shareholders that can cause an S- corporation to lose their S- election status.[2]

Unauthorized Shareholders

Sometimes the issue of unauthorized shareholders is not immediately obvious in the due diligence process. Consider the following example:

Company X finds out during due diligence that one of Company Y’s shareholders is married. The shareholder, Grace, lives in California with her husband Jonathan. The shares of stock are only in Grace’s name, but not Jonathan’s. Jonathan never consented to Company Y’s S- election. In most other states, that wouldn’t be a problem. However, California is a community property state, which means that both Jonathan and Grace are Company Y shareholders in the eyes of the law.

All shareholders are required to consent in order for the S- election. Spouses of shareholders residing in community property states must also consent to the S- election.[3]

Since Jonathan never consented, then Company Y will lose its S- election status. As this example illustrates, the issue of unauthorized shareholders may be a thorny one that some buyers may encounter.

The second point mentioned above (whether shareholders have equal rights) is important because if the shareholders’ rights are deemed unequal, then the S- corporation is determined to have more than one class of stock.[4]

In order to prove that shareholders have equal rights, the shareholders’ agreement and distributions of stock must hold the following characteristics: 

  1. Equity compensation plans should not be created to circumvent the one class of stock requirement; and
  2. The stock’s purchase price cannot be significantly greater or less than the fair market value of the stock at the time of the agreement; and
  3. The timing and amounts of distributions must be equal.[5]

The last point regarding disproportionate distributions may be remedied in some cases. A tax adviser can help “cure” the disproportionate distributions by giving “appropriate tax effect” to differences in the timing or amount of distributions.[6]

This means that the S- corporation makes proportional payments to each of the shareholders based on their respective interests in the S- corporation in order to reconcile the differences between the prior distributions.

This is done in order to illustrate that the disproportionate distributions were not made with the intention of circumventing the requirement that S- corporations may only distribute one class of stock.

Conclusions: Why Classes of Stock Are Important in M&A

Both buyers and sellers in a merger or acquisition involving S- corporations should keep this issue in mind as they approach the due diligence process.

A knowledgeable tax adviser can help both sides identify potential threats to S- election status, from unauthorized shareholders to unequal shareholder rights.

From the seller’s standpoint, losing an S- election during a transaction results in the recognition of both corporate and shareholder level gain, instead of just the latter.[7]

If the ineligibility of S- election status is not caught during due diligence by the buyer, this may result in a double-layer of taxation for the new owner, who had bought the company expecting only a single layer of taxation.

Furthermore, if the target company loses its S- election but has marketed it as an S- corporation to the buyer, then the target company risks receiving a lower purchase price.

Therefore, safeguarding against the inadvertent distribution of a second class of stock is an important step for all participants in a transaction involving S- corporations is an important step to take.

[1] 26 CFR §1.1361-1(b)(1).

[2] 26 CFR  §§1.1361-1(f), 1.1361-1(g).

[3] §1.1362-6(2)(i).

[4] 26 CFR §1.1361-1(l)(1).

[5] 26 CFR §1.1361-1(l).

[6] 26 CFR §1.1361-1(l)(2).

[7] IRC §1362(e)(1).