May 21, 2019

by Gregory S. Dowell

A corporation may make an election under Internal Revenue Code Section 1361 to be taxed as an S corporation for Federal income tax purposes. One of the restrictions of being an S corporation is that the S corporation can only have one class of stock. That one class of stock must confer identical rights to all shareholders. However, bona fide agreements to redeem or repurchase stock when a shareholder dies, is divorced, becomes disabled or ends employment are disregarded when determining whether the shares issued to the plan confer identical rights to shares issued outside the plan. (Reg. §1.1361-1(l)(2)(iii)). In a recent Private Letter Ruling (PLR 201918013), the IRS determined that an S corporation’s employee stock compensation plan did not create a second class of stock.

In the situation addressed by the PLR, the S corporation adopted an employee stock compensation plan. The plan authorized the corporation to sell shares of stock to certain employees or grant shares or options to purchase shares to such employees. As is the case with many employee stock compensation plans, the shares acquired under the plan were subject to certain restrictions. Those shares could not be transferred without the prior written consent of the taxpayer’s chairman of the board, and the corporation could repurchase the shares under certain circumstances, including upon the termination of employment, either at fair market value or the forfeiture repurchase price.

The restrictions on transfer and repurchase in this situation were determined by the IRS to be bona fide agreements to redeem or repurchase stock

under Reg. §1.1361-1(l)(2)(iii)(B). Thus, those restrictions were disregarded when determining whether the shares so awarded under the employee stock compensation plan conferred identical rights to other stock issued by the S corporation. Because those restrictions were disregarded and the shares were identical, it was deemed that only one class of stock existed.