The CPA Journal

By Linda Burilovich

Subchapter S of the IRC allows an eligible corporation to elect to be taxed as a conduit. Under this concept, a corporation’s income is taxed directly to shareholders in the same manner as a partnership. The legislative rationale is to promote small business by eliminating the financial burden of tax at the corporate level. It allows a company to have both the legal advantages of a corporation and the tax advantages of a partnership.

IRC section 1361 outlines specific technical requirements that must be met for an S election. These include restrictions on the number of shareholders (no more than 75) and the types of shareholders [only individuals; estates or certain trusts in IRC section 1361(c)(2) are treated as individuals]. S corporations can have no more than one class of stock, which requires careful structuring of agreements between the S corporation and its shareholders or other parties. An S corporation debt obligation that in substance resembles equity is at risk of being reclassified as equity by the IRS, potentially creating a second class of stock and inadvertently terminating the S election.

Reclassifying Debt as Equity

In 1969 Congress issued IRC section 385, which authorized the Treasury Department to write regulations identifying the criteria to be used in distinguishing debt from equity. The Treasury’s attempts in 1980 to finalize regulations failed, and it has issued no further formal response. The definition of what constitutes a second class of stock is complex. Prior to 1982, any difference in voting rights, distribution rights, or liquidation rights of outstanding shares would automatically result in a second class of stock. The Subchapter S Revision Act of 1982 (SSRA) revised the rules so that a mere difference in voting rights would not create a second class of stock. The SSRA also introduced IRC section 1361(c)(5) to provide a safe harbor for instruments meeting the definition of straight debt. Instruments that fall within this safe harbor will not be treated as a second class of stock under specific conditions. Treasury Regulations section 1.1361-1, issued in 1992, elaborates details of the safe harbor provision.

The risk of having debt reclassified as equity exists for all corporations. C corporations have the incentive to issue debt to receive the tax deduction for interest expense that is not available for dividends. A reclassification may convert interest and principal payments made from the corporation to a shareholder into nondeductible dividends, imposing an unexpected tax cost for disallowed interest expense. The shareholder may also bear an additional tax for converting nontaxable principal repayments into taxable dividend income.

S corporation debt may be used to circumvent the one-class rules. When interest or principal repayments are tied to income, debt may be substituting for shares of stock. This creates a variance in distribution or liquidation rights among shareholders. Debt instruments can also provide a vehicle for investors that are not qualified to be shareholders in an S corporation (e.g., corporations, nonresident aliens).

Reclassification typically occurs when the contractual terms of an obligation resemble equity more closely than debt. Two primary concerns exist: First, careless drafting of a debt instrument could inadvertently create a second class of stock and terminate the S election, causing unexpected tax costs. Second, corporate obligations to parties not eligible to be shareholders will automatically terminate the S election if reclassified as equity, regardless of whether this would create a new class of stock.

Distribution and Liquidation Rights

The rules established under IRC section 1361 indicate that two classes of common stock that differ only by voting rights are by definition a single class of stock under Subchapter S. The other components of equity that distinguish classes of stock are distribution rights and the right to liquidation proceeds. Any variation between shares with regard to these two components will constitute a second class of stock. Most debt obligations automatically create different liquidation rights since equity is subordinate to debt in the event of liquidation, except in cases where the debt was held by shareholders in exact proportion to their stock. The regulations under IRC section 1361 establish more specifically how differences in these rights will be determined, and when such differences will be recognized as creating a second class of stock.

Proof of identical distribution and liquidation rights is established by a review of the corporation’s governing provisions, including the corporate charter, articles of incorporation, bylaws, applicable state law, and related binding agreements. A commercial contract such as a loan agreement, a lease, or an employment contract is not a binding agreement with regard to distribution or liquidation rights and thus is not part of the governing provisions. These contracts will be classified as a second class of stock if they constitute equity under the general principles of tax law and if the principal purpose of the instrument is to alter the distribution or liquidation rights of outstanding shares or to circumvent the limitation on eligible shareholders.

In ascertaining whether a second class of stock exists, the liquidation and distribution rights of all outstanding stock are taken into account, except for certain shares subject to restriction under employment agreements or deferred compensation plans. Even if the governing provisions provide for identical distribution or liquidation rights, any variation in actual, constructive, or deemed distributions may cause reclassification. For example, if the corporation pays state income tax on behalf of a shareholder receiving a distribution, it makes a constructive distribution to the shareholder. In the event that shareholders are subject to varying state income tax rates, distribution rights will vary. If the corporation makes appropriate adjustments so that in total the constructive and actual distributions to each shareholder are proportional to stock holdings, distribution rights will be equal. Some state laws require the corporation to pay or withhold income tax on behalf of some or all shareholders. These payments are disregarded provided that when the constructive distributions resulting from the payments are taken into account, the outstanding shares confer identical rights to distribution.

Shareholder agreements can be binding agreements that are part of the governing provisions affecting distribution or liquidation rights.

Example. A and B are equal shareholders in S Inc. The shareholders wish to raise additional capital without creating additional debt. A second class of nonvoting common stock might be issued to raise the additional capital; however, neither shareholder is willing to make additional investment under the current agreement regarding distributions and liquidation rights.

Shareholder A is willing to contribute the additional capital if there is a liquidation preference and a preferential dividend payment when income permits. To avoid risk of termination, S Inc. borrows the necessary funds from A and creates a debt instrument which calls for an interest payment to A in years when income is at least equal to the annual interest. In other years, A does not receive an interest payment.

In this example, S Inc. has essentially issued a second class of stock. The IRS is likely to look past the form of the instrument and recognize that in substance the debt represents equity with different distribution and liquidation rights. In this event, the S election may be terminated under the one-class rules. This illustration suggests the need for constant scrutiny of shareholder contracts. If the terms of an agreement resemble equity, the risk of termination is present. Some relief may be found in the safe harbor provisions.

Safe Harbor Provisions

The safe harbor provisions ensure that certain shareholder debt will not be treated as a second class of stock even if such loans would be considered equity under general principles of federal tax law. This safety net is available for debt, buy-sell agreements, or redemption agreements that do not otherwise qualify as straight debt. The safe harbor governing S corporation debt is effective for instruments issued or materially modified in corporate tax years beginning on or after May 28, 1992. It applies only when the instrument is not convertible into stock and is held by a person eligible to hold subchapter S stock. In most situations, the safe harbor is lost if the principal purpose of issuing or entering into the arrangement is to circumvent the identical distribution or liquidation rights of the common stock or the limitation on types of shareholders.

The regulations discuss several specific instruments in detail. Straight debt, short-term advances, and proportionately held obligations are generally not treated as a second class of stock. With a few exceptions, call options and convertible debt are treated as a second class of stock.

Straight debt. In general, straight debt will not be treated as a second class of stock. To qualify as straight debt, the loan must be subject to a written unconditional obligation, regardless of whether embodied in a formal note. The agreement must call for a fixed sum payable on demand or on a specified due date. The fact that an instrument is subordinate to other debt or provides for excessive interest payments does not prevent its qualification as straight debt. An excessively high interest rate may cause a portion of the interest to be recharacterized as a distribution; however, this recharacterization alone does not result in a second class of stock.

Certain instruments are specifically excluded from the straight debt umbrella. An agreement in which the interest rate or payment date is contingent on profits, is at the discretion of the borrower, or is tied to payment of dividends on common stock, is disqualified. If the terms of the loan are such that interest or repayment is contingent on any other factor associated with the return or value of equity, the transaction might not qualify as straight debt. Debt instruments that are directly or indirectly convertible into stock (or any other equity interest) or are held by parties ineligible to be shareholders will also not meet the safe harbor. In addition to these specific exclusions, agreements that initially qualify as straight debt may fall out of the scope of its definition if there are modifications or transfers. Material modifications to a contract such that it no longer meets the definition of straight debt will cause the loan to no longer qualify. A transfer to an ineligible shareholder will also cause the loan to lose its straight debt status.

Short-term advances. Unwritten advances from shareholders will fall within the safe harbor when they are treated as debt by both parties and there is an expectation of repayment within a reasonable period of time. These advances may not exceed an aggregate of $10,000 for any single shareholder during the corporation’s taxable year. Falling outside the safe harbor does not mean automatic reclassification as a second class of stock, unless it is considered equity under general principles of tax law and the principal purpose of the advance is to circumvent the rights of the outstanding shares or to circumvent the rules on ineligible shareholders.

Proportionately held obligations. Obligations of the same class held by all shareholders in proportion to outstanding stock will meet the safe harbor even if the debt would otherwise be considered equity under federal tax law. The only circumstance in which such debt would be a second class of stock appears to be when its purpose is to circumvent the rights of outstanding shares or to disguise equity holdings by ineligible shareholders.

Call options, warrants, or similar instruments. In general, a call option, warrant, or other similar instrument issued by a corporation is treated as a second class of stock if the option is “substantially certain to be exercised” and has a strike price “substantially below the fair market value of the underlying stock.” These criteria are tested on the date it is issued, transferred by an eligible shareholder to an ineligible shareholder, or materially modified. If an option is passed from an eligible shareholder to an ineligible shareholder, the relative value of the option’s strike price to the underlying stock is retested on the date of the transfer. If the strike price falls substantially below market value, the option becomes a second class of stock. If the strike price is at least 90% of the fair market value of the underlying stock on the date the option is issued or retested, none of the above criteria will cause the option to be treated as a second class of stock.

Convertible debt. A convertible debt obligation will be treated as a second class of stock if it would be treated as equity under general principles of federal taxation and it is issued to circumvent the rights associated with common stock. If convertible debt embodies characteristics of a call option, it will be treated as a second class of stock.

Linda Burilovich, PhD, CPA, is a professor in the department of accounting at Eastern Michigan University, Ypsilanti, Mich. She was previously a field auditor for the IRS.