Is your company an S corporation or thinking of becoming one? S corporation status is the usual choice for most closely held businesses. But here's a rule that most S corporation stockholders do not know even exists: A corporation cannot qualify as an S corporation if it has more than one class of stock. Any firm violating this rule immediately loses its S corporation status and becomes a C (tax-paying) corporation, like it or not.
An dangerous situation exists when some shareholders have different rights to distribution and liquidation proceeds than other shareholders. Such shareholders may be treated as owning a different class of stock. Result:
Immediate termination of your S corporation status.
If you follow the rules set out in a new IRS letter ruling, however, you can rest easy. Here is an example to elucidate the facts in this ruling:
Success Co., an S Corporation, has 11 shareholders; one shareholder owns 65% of the stock and 10 shareholders own the other 35%. Under a stock redemption agreement, the minority shareholders will receive the fair market value price of their shares less a minority discount. However, in no case will their price be less than the book value of their shares.
For this type of situation, the IRS said that a redemption agreement providing for a redemption price significantly above or below the stock's fair market value will be considered a second class of stock. So the key question revolves around the definition of 'significantly.' The IRS went on to say that if the price equals book value or an amount between book and fair market value, it will not be treated as 'significantly below' market value. Thus Success Co.'s redemption agreement will not affect its S corporation status. (See Ltr. Rul. 9433024.)