In response, on August 8, 1991, the IRS announced new proposed regulations to replace the October proposal. Although the new proposal reiterates that an S corporation will be treated as having more than one class of stock when the "outstanding" stock does not provide "identical rights" to distributions and liquidations proceeds, the new version provides numerous examples, safe harbors, and exceptions. It also states that reclassification or other arrangements of debt as equity under general federal tax principles will result in a second class of stock only when the action was taken to contravene the "second-class" status or the type and number of shareholder requirements of subchapter S.

The importance of these regulations cannot be understated. Pursuant to IRC Sec. 1361(b)(1)(D), an S corporation can have only one class of stock. If an S corporation is deemed to have more than one class at its inception or at any time thereafter, Sec. 1362(d)(2) states that the S election is invalid or terminates on the date the second class of stock was created.

CRITICISMS OF THE

ORIGINAL PROPOSAL

Criticisms of the original proposal were directed to:

* Application retroactive to January 1, 1983;

* Possibility that informal advances, constructive distributions, or fringe benefits such as automobiles, excessive compensation and even medical insurance would be considered nonconforming distributions and thus give rise to a second class of stock;

* Lack of any de minimis exceptions;

* Broadness and apparent lack of legislative mandate to automatically conclude that any debt reclassified as equity is automatically a second class of stock;

* Requirement of a reasonable interest rate for straight debt;

* Cursory treatment of options and warrants; and

* Proposed regulations that were unnecessarily broad.

Some letters urged, and the IRS eventually agreed, that termination should occur only when the transgressions form a deliberate and abusive pattern of non-conforming distributions or prohibited use of debt in order to avoid the second-class requirements. Similarly, others argued, and the IRS eventually agreed, that recharacterization of any tainted payment as compensation or as a constructive dividend is a more adequate remedy than termination. Some critics simply asked for, and eventually received, more examples.

CONGRESS FLEXES IT'S

MUSCLES

However, a more direct attack on the proposed regulations came from four Senate Finance Committee members. First, David Boren (D-Okla.) introduced S. 532 on February 28, 1991. Co-sponsored by David Pryor (D- Ark) and Max Baucus (D-Mont.), S. 532, billed as The Taxpayer Regulatory Relief Act of 1991, was aimed to prevent the Treasury and the IRS from writing and applying retroactive regulations.

Second, Sen. William V. Roth (R-Del.) revealed the makings of a possible bipartisan coalition when he introduced S. 722 on March 21, 1991. His bill and the original IRS proposal would have been applied retroactively to December 31, 1982, and required that all outstanding shares of an S corporation confer identical rights as to distribution and liquidation proceeds. However, unlike the original IRS proposal, his bill a) would not consider options and warrants as outstanding stock unless they are exercised but b) would provide a cure of a terminating event within a reasonable time after its discovery.

IRS RESPONSE: A KINDER

AND GENTLER PROPOSAL--NO

RETROACTIVITY, MORE

SAFE HARBORS, FEWER

SUMMARY TERMINATIONS

In February 1991, in response to this overwhelming reaction the IRS announced that it would apply the new regulations prospectively. Then, on August 8, 1991, it released a kinder and gentler proposal amending the original version.

Only Consider Stock

"Outstanding"

The new proposal contains two sections, (b) and (1). The first two subsections in section (b) define an S corporation as in Sec. 1361(b)(1) and (3). The remainder of section (b) generally follows the original proposal--the only change being the inclusion of independent contractors in connection with deferred compensation plans. It states that the following three interests are not considered "outstanding" and therefore not subject to reclassification as a second class of stock:

1. Substantially non-vested stock issued for services (as defined in Sec.83). If the shareholder makes a Sec.83(b) election, the stock is treated as "outstanding." However, Prop. Reg. 1.1361(1)(3) states that even if considered "outstanding," such stock will not be considered a second class of stock if it confers "identical rights" to distribution and liquidation proceeds.

2. Stock to be issued to employees and (added in the new proposal) to independent contractors pursuant to a deferred compensation plan in connection with the performance of services. There is an exception: a right to stock must not be Sec. 83 property nor convey the right to vote.

3. "Straight debt," even if it could be reclassified as "equity;" see also Prop. Reg. 1.1361(1)(5)(iv).

While generally this section becomes effective on January 1, 1992, some parts of the "effective date" provisions in Prop. Reg. 1.1361(b)(6) may be confusing. Essentially, the new proposal "grandfathers" stock that has been treated as outstanding even though it is substantially non-vested stock and no Sec. 83(b) election has been made. Then, effective with taxable years beginning on January 1, 1992, substantially non-vested stock would be considered as a second class of stock only when 1) the Sec. 83(b) election is made and 2) it fails to confer rights identical to those of the other outstanding stock.

"Outstanding" Stock Must

Convey "Identical Rights" to

Distribution and Liquidation

Proceeds

Similar to the language of the original, the new proposal states that a corporation will not be deemed to have a second class of stock where all "outstanding" shares of stock confer "identical rigths" to distribution and liquidation proceeds, and that differences in voting rights among the shares of stock do not create a second class of stock.

Previous Proposal Did Not Allow Any Differences. In determining whether all outstanding stock conveys identical economic rights, the original Prop. Reg. 1.1361(1)(2)(i) required that any and all differences were to be considered, regardless of reasons. This provision was criticized because it provided no de minimis exceptions, e.g., any differences in rights due to any agreement would have meant a finding of a second class of stock and thus termination of the S election.

Furthermore, under the original version, even if such differences in rights were to have triggered a constructive distribution, the additional income tax to be exacted from the tainted shareholder would not have been deemed a sufficient remedy, as the original proposed regulations still demanded termination of the S election.

Under the original proposal any non-pro rata distribution that differed in time or amount, e.g., a business related expense incurred by one shareholder but not by others, or the finding of unreasonable compensation, or differences in distribution to account for differences in state tax laws, would have been considered a non-conforming distibution and would have triggered a finding of a second class of stock. Had the original proposal prevailed, a shareholder could not have obtained even an advance from the S corporation unless all other shareholders also received an advance proportional to their individual holdings. This part of the previous proposal was heavily and rightfully criticized.

New Proposal Contains "Safe Harbors" for Timing Differences, Fringe Benefits and Below-Market Loans. While the new proposal, at first, also states that identity of rights will be determined based on a review of the "governing provisions," applicable state law and binding agreements relating to distribution and liquidation proceeds, it provides four circumstances that may appear to violate the "identical rights" requirement, but do not do so.

1. Prop. Reg. 1.1361(1)(2)(i) specifically excludes differences in rights due to routine commercial agreements, e.g., leases, employment contracts, or loan agreements. Such differences are to be considered only when used to circumvent the one class of stock requirements.

For instance, under the new proposal a difference in the timing of the distributions must be analyzed to determine whether such distributions confer identical rights to shareholders. Example 2 under the new Prop. Reg. 1.1361(10(2)(v) clearly indicates in an example describing a timing difference of one year, that, as long as the governing documents provide for equal distributions and that the difference in the timing of the distribution is not caused by a "binding agreement," such a difference in the timing of the distributions would not create a second class of stock. However, other sections of the IRC, e.g., Sec. 7872, may come into play to characterize the differences as constructive income.

Similarly, example 4 clearly indicates the fact that an S corporation may pay different accident and health insurance premiums, or other similar fringe benefits, on behalf of some (e.g., shareholders who are employees) but not all shareholders (e.g., shareholders who are not employees) and not fail the "identical rights" requirements. Likewise, example 5 states than an S corporation may provide a below-market loan to some of its shareholders without violating the "identical rights" standard. While the latter may result in a constructive distribution under Sec. 7872, it would not be considered a termination event.

2. Prop. Reg. 1.1361(1)(2)(ii) provides that differences in actual distributions due to some state income tax withholding requirements are not necessarily tainted as it requires that any amounts so withheld, e.g., the constructive distributions, be added to the actual distributions in order to determine whether "identical rights" are extended to all shareholders.

To clarify the effect of state law, example 1 in Prop. Reg. 1.1361(1)(2)(v) indicates that equality of rights does not exist and the organization fails to qualify as an S corporation where a state law requires that shareholders who do not pay cash for their stock waive their rigths to receive distributions until those who paid cash for their stock receive distributions in the amount of their cash contributions.

However, example 7 is clear regarding the exception provided in Prop. Reg. 1.1361(1)(2)(ii). It indicates that identical rights do exist where pursuant to state law, and the S corporation provides reduced distributions to nonresident shareholders. Both the actual distribution and the withheld portion will be considered to determine whether identical rigths exist. While the payment by the corporation of said state income taxes may result in constructive distributions to the nonresident shareholders, they do not result in termination.

3. Prop. Reg. 1.1361(1)(2)(iii) specifically states that any redemption or purchase agreements (apparently by corporation or among shareholders) in connection with death, disability or termination of employment are disregarded in determining the equality of rights requirement (see example 8). Similarly, it ignores "general" redemption agreements (a new clause), buy-sell agreements among shareholders, and restrictions on transferability unless entered into to circumvent the one-class-of-stock requirements.

4. Finally, Prop. Reg. 1.1361(1)(2)(iv) permits agreed distributions on the basis of a shareholder's varying ownership interest during the preceding taxable year.

RECLASSIFICATION OF DEBT

INTO EQUITY

Originally any Reclassified Debt

was a Second Class of Stock

This area involves one of the most criticized provisions in the original version. Under the 1990 proposals, with the exception of two "safe harbors," any debt reclassified as equity under general principles of federal tax law automatically would have been deemed a second class of stock. The two "safe harbors" were a) any stock excluded as "outstanding" under the previously discussed provision on deferred compensation plans and b) debt within the "straight debt" safe harbor provided in Sec. 1361(c)(5) and described in then Prop. Reg. 1.1361(1)(4).

The criticism of this provision centered around allegations that the IRS misinterpreted the intent of Congress and was trying to reinstate a pre-1966 regulation, amend a post-1966 regulation and overrule a large body of case law. That body of case law provides:

1. A proportionality safe harbor: debt held in substantially the same proportion as common stock would not be subject to reclassification unless it provides additional rights to shareholders: and

2. Additional inquiry into the equity rights provided by reclassified debt so as to prevent automatic classification as a second class of stock, even if not proportionally held to stockholdings.

The New Two-Pronged Test:

"Equity" Plus "Contravention"

The new proposal attempts to follow that case law. For instance, Prop. Reg. 1.1361(1)(4)(ii) outlines the new general rule of debt reclassification: unless within one of the four "safe harbors" described later, "any instrument, obligation or arrangement . . . regardless of whether designated as debt is treated as a second class of stock . . . if . . . (it) . . . (1) constitutes equity . . . and (2) is used to contravene the . . . (identical). . . rights (provision) . . . or . . . the limitation on eligible shareholders. . . . "

The New "Safe Harbors"

Today, the new version still contains two "safe harbors" from the original proposal in connection with deferred compensation plans and with "straight debt." In addition, two new "safe harbors" have been included:

1. The short-term unwritten advance safe harbor in Prop. Reg. 1.1361(1)(4)(ii)(B) (1) states that, even if reclassified as equity, short-term unwritten shareholder advances up to $10,000 that are treated as debt by all parties and expected to be repaid within a reasonable time will not be considered a second class of stock; and

2. The proportionality safe harbor in Prop. Reg. 1.1361(1)(4)(ii)(B)(2), which states that, even if reclassified as equity, debt owned a) solely by shareholders and b) proportionately to the number of shares held by the shareholders, will not be treated as a second class of stock.

It should be noted that a version of this "safe harbor" appeared under the original Prop. Reg. 1.1361(1)(7) explaining the effective date of the original proposal. There it said that this "safe harbor" was to apply only prospectively, e.g., 90 days after the regulations were adopted in its final form. This meant that under the original proposal, the old general rule--if debt, than automatically a second class of stock--was to be applied retroactively to January 1, 1983. As indicated below, under the new proposal, the "safe harbor," as well as the general rule, will be applied prospectively.

In the explanation of provisions accompanying the release of the proposed regulations, the IRS claims that ". . . this rule is consistent with case law holding that purported debt which would ordinarily, be recharacterized as equity does not always constitute a second class of stock . . . ." However, it should be noted that, as only the debt owned entirely by shareholders is eligible for this exclusion, this "safe harbor" is not available to any corporation that obtains credit from anyone who is not a shareholder.

The amended proposal further states that debt held by a sole shareholder will be considered as held proportionally to the corporation's outstanding stock.

Yet, under the new proposal, if debt fails the numerical proportionality test, or for that matter any of the new "safe harbors," it does not mean automatic reclassification as a second class of stock. Instead, it means that the instrument would have to be considered under the two-pronged general rule of equity/contravention outlined previously.

While not an unconditional acceptance of prior case law, this new set of rules is certainly a far cry from the IRS's original position when in its original Prop. Reg. 1.1361(1)(3(i) and (ii) stated that ". . . any . . . obligation . . . is treated as a second class of stock . . . if the . . . obligation . . . constitutes equity . . . under principles of federal tax law . . . although held proportionately by the shareholders. . . ." (See also original Prop. Reg. 1.1361(1)(5), example 3.)

The Straight Debt Safe Harbor

Similar to, but not as thorough as, the original 1990 version, Prop. Reg. 1.1361 (1)(5) outlines the "straight debt safe harbor." This subsection is further divided into five subparts, 1.1361(1)(5)(i)-(v). While the first subpart, (i), is merely a restatement of Sec. 1361(c)(5)(A) and (B), the other four subparts follow the mandate of Congress in Sec.1361(c)(5) (C) ". . . to provide for the proper treatment of straight debt under this subchapter. . . ." For that reason, these four subparts, 1.1361(1)(5)(ii)-(v), if adopted as final regulations, will be considered quasi-legislative regulations and will receive a great degree of judicial deference.

Specifically, the four subparts state:

* Subordination to other debt does not affect classification as "straight debt;"

* "Straight devt" status is lost if modification of terms or transfer to a third party contravene the "straight debt" definition;

* "Straight debt" will ". . . not be treated as a second class of stock even if it is considered equity under general principles of federal tax law . . . ;" and

* A C corporation's "straight debt" status is not lost merely because the shareholders elect to convert to S status.

Noted for its absence is the highly criticized original provision requiring reasonable interest rates for "straight debt."

THE NEW "EFFECTIVE DATE"

FOR DEBT/EQUITY

PROVISIONS

Finally, removing altogether probably the most criticized part of the original proposed regulations, e.g., that dealing with any debt (outside the "straight debt" safe harbor) that may exist at the time the regulations become effective, the current version states that " . . . paragraph (1)(4) of this section does not apply to instruments, obligations or arrangements issued or entered into on or before August 8, 1991 . . . ."

This means that the new general rule involving the two-pronged "debt/equity" and "contravention" tests is to be applied only to debt issued after the announcement of the amended proposed regulations. Thus, unlike the original proposal which had intended only to apply the proportionality and the straight debt safe harbors prospectively, the current proposal's general rule, as well as the new "safe harbors," will not apply to debt issued prior to August 9, 1991.

RECLASSIFICATION OF

OPTIONS INTO EQUITY

In connection with options, the original and the current proposed regulations both generally state that call options would be considered a second class of stock if, at the time of issuance, subsequent substantial modification or transfer to a third party 1) the call option is "substantially certain" to be exercised and 2) the strike price is "substantially below" fair market value at the time of issuance, substantial modification, or transfer to an ineligible third party. The original version required reconsideration of this test upon transfer of the option to any third party. The new proposals limits reconsideration only when the option is transferred to an ineligible shareholder see example 1 under Prop. Reg. 1.1361(1)(4)(v).

The current proposal contains three exceptions which were also in the original version:

1. Options issued to an institutional lender in connection with a commercially reasonable loan. Options issued in connection with loan agreements may be extended when the terms of the loan are extended. Absent in the current proposal are the original verion's requirements that the lender not be a Sec. 465(b)(3)(C) related person and that the option could be exercised only in the event of loan default.

2. Options with strike prices at least 90% of the fair market value of the underlying stock at the time of issuance, transfer to an ineligible shareholder, or a material modification, would not be considered substantially certain to be exercised.

A major concern in the letters to the IRS were the difficulties in establishing the fair market value of a closely held S corporation. The new proposal states in Prop. Reg. 1.1361(1)(iii)(C) that a good faith estimate of fair market value will be respected unless 1) substantially in error or 2) the corporation failed to exercise due diligence in its determination of fair market value. However, the new proposal also states that failure to meet the 90% fair market value test does not mean that the option automatically would be classified as a second class of stock.

3. As before, a safe harbor exists to protect options issued to employees or independent contractors in connection with the performance of services when the option is nontransferable as defined under Reg. 1.83-3(d) and has not readily ascertainable fair market value, as defined in Reg. 1.83-7(b) at the time of issuance. As previously indicated, the current version added independent contractors to this "safe harbor." Example 2 in Prop. Reg. 1.1361(1)(4)(v) explains the mechanics of this safe harbor.

RECLASSIFICATION OF

CONVERTIBLE DEBT INTO

EQUITY

Because of its debt and option-type qualities, Prop. Reg. 1.1361(1)(4)(iv) states that convertible debt may be considered a second class of stock under the test applicable to non-straight debt or the test applicable to options.

EFFECTIVE DATES

Finally, Prop. Regs. 1.1361(1)(6) and (7) refer to inadvertent provisions in Sec. 1362(f) and announce the effective date of the amended provisions. As mentioned earlier, with the exception of Prop. Reg. 1.1361(1)(4) which will not be applied to any debt, instrument or arrangement issued or entered into on or before August 8, 1991, the recent proposal applies to taxable years beginning on or after January 1, 1992.

WHAT DID WE GET?

In summary, the new proposal:

* Defines what interests are not "outstanding" and thus outside the reach of the one-class-of-stock regulations;

* Requires that all "outstanding" stock must confer identical economic rights, but adopts a series of "safe harbors" indicating the circumstances when differential economic treatment will be permitted;

* Provides four "safe harbors" protecting debt, obligations, or other instruments from being reclassified as equity and then possibly as a second class of stock;

* Adopts a new two-pronged test, to reclassify debt or other interests as a second class of stock, requiring a positive answer to the following two questions:

a. Can the debt, or the interest in question, be reclassified as "equity" under general principles of tax law?

b. If so, was such interest used to contravene the eligible shareholders' requirements of Subchapter S?

* Eliminates the previous requirement that "straight debt" carry a reasonable rate of interest;

* Outlines under what conditions call options and convertible debt may be reclassified as second class of stock;

* Provides new assurances that a reasonable determination of fair market value evaluation will be respected; and

* Adopts prospective application in all cases, e.g., effective on January 1, 1992, grandfathering various interests that may be subject to reclassification under the new proposal.

Robert R. Oliva, JD, LLM, CPA, is an Associate Professor of Accounting in the College of Business Administration, Florida International University.