Excessive compensation does not create second stock class

Plain-English summary

An S corporation may have paid excessive compensation to a shareholder who worked as an at-will employee without a written compensation agreement. The corporation's governing documents gave every outstanding share identical rights to distributions and liquidation proceeds. It also represented that the compensation was not intended to bypass the one-class-of-stock requirement. The IRS ruled that the compensation did not create a second class of stock and therefore did not terminate the corporation's S election. The IRS did not decide whether the compensation was actually excessive or whether the corporation otherwise qualified for S status.

Ruling snapshot

• Question: Did possible excessive compensation to a shareholder-employee create a prohibited second class of stock?
• Outcome: No, the compensation did not terminate the corporation's S election.
• Key authorities: IRC §§ 1361 and 1362; Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201607001                                              Third Party Communication: None
Release Date: 2/12/2016                                        Date of Communication: Not Applicable
Index Number: 1361.01-04
                                                               Person To Contact:
------------------------------------------------------------   ------------------------, ID No. ------------------
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------------------------------------------------------------   Telephone Number:
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--------------------------------------------                   Refer Reply To:
------------------------------------                           CC:PSI:B3
                                                               PLR-110362-15
                                                               Date: September 17, 2015




LEGEND

X                 =        ----------------------------------------------------------------
                           -----------------------

A                 =        ---------------------------

State             =        --------

Date 1            =        -------------------------

Date 2            =        ----------------------

Period            =        -------------------------------------------------


Dear ----------------:

       This letter responds to a letter dated March 18, 2015, and subsequent
correspondence, submitted on behalf of X, requesting a ruling under § 1361(b)(1)(D) of
the Internal Revenue Code (Code).

FACTS

       The information submitted states that X was incorporated in State on Date 1 and
elected to be treated as an S corporation effective Date 2. From Period, X employed A,
who was also a shareholder of X. During that time, X may have paid excessive
compensation to A. A was an at will employee without a written compensation
agreement. X’s board reviewed and approved the compensation of all of X’s employees
annually. X represents that its governing provisions, including its Articles of
Association, its Bylaws and its Shareholder Agreements, confer identical rights to
PLR-110362-15                                2

distribution and liquidation proceeds with respect to X’s outstanding shares of stock. X
also represents that it was not a principal purpose to circumvent the one class of stock
requirement through compensation paid to A.

LAW

      Section 1362(a) provides that, except as provided in § 1362(g), a small business
corporation may elect, in accordance with the provisions of § 1362, to be an S
corporation.

        Section 1361(a)(1) provides that the term "S corporation" means, with respect to
any taxable year, a small business corporation for which an election under § 1362(a) is
in effect for such year.

       Section 1361(b)(1) provides that the term "small business corporation" means a
domestic corporation which is not an ineligible corporation and which, among other
prohibitions, does not have more than one class of stock.

       Section 1.1361-1(l)(1) of the Income Tax Regulations provides, in part, that a
corporation that has more than one class of stock does not qualify as a small business
corporation. Except as provided in § 1.1361-1(l)(4) (relating to instruments, obligations,
or arrangements treated as a second class of stock), a corporation is treated as having
only one class of stock if all outstanding shares of stock of the corporation confer
identical rights to distribution and liquidation proceeds.

       Section 1.1361-1(l)(2)(i) provides, in part, that the determination of whether all
outstanding shares of stock confer identical rights to distribution and liquidation
proceeds is made based on the corporate charter, articles of incorporation, bylaws,
applicable state law, and binding agreements relating to distribution and liquidation
proceeds (collectively, the governing provisions). A commercial contractual agreement,
such as a lease, employment agreement or loan agreement, is not a binding agreement
related to distribution and liquidation proceeds and thus is not a governing provision
unless a principal purpose of the agreement is to circumvent the one class of stock
requirement of § 1361(b)(1)(D) and § 1.1361-1(l). Although a corporation is not treated
as having more than one class of stock so long as the governing provisions provide for
identical distribution and liquidation rights, any distributions (including actual,
constructive, or deemed distributions) that differ in timing or amount are to be given
appropriate tax effect in accordance with the facts and circumstances.

      In § 1.1361-1(l)(2)(vi), Example 3 (treatment of excessive compensation), S, a
corporation, has two equal shareholders, C and D, who are each employed by S and
have binding employment agreements with S. The compensation paid by S to C under
C’s employment agreement is reasonable. The compensation paid by S to D under D’s
employment agreement, however, is found to be excessive. The facts and
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circumstances do not reflect that a principal purpose of D’s employment agreement is to
circumvent the one class of stock requirement of section § 1361(b)(1)(D) and § 1.1361-
1(l). Under § 1.1361-1(l)(2)(i), the employment agreements are not governing
provisions. Accordingly, S is not treated as having more than one class of stock by
reason of the employment agreements, even though S is not allowed a deduction for
the excessive compensation paid to D.

CONCLUSION

       Based solely on the facts submitted and representations made, we conclude that
because X’s governing provisions provide for identical distribution and liquidation rights
and because X represents that it was not a principal purpose to circumvent the one
class of stock requirement through compensation paid to A, any excessive
compensation paid to A does not cause X to be treated as having more than one class
of stock for purposes of § 1361(b)(1)(D). Under these circumstances, we conclude that
X's S corporation election did not terminate as a result of the compensation paid to A.

       Except as specifically ruled above, we express or imply no opinion concerning
the federal tax consequences of the facts described above under any other provisions
of the Code. Specifically, we express or imply no opinion regarding X's eligibility to be
an S corporation or whether X paid excessive compensation to A.

       The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the ruling request, it is subject to verification on examination.

       This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)
of the Code provides that it may not be used or cited as precedent.

      In accordance with a power of attorney on file with this office, we are sending a
copy of this letter to your authorized representative.


                                      Sincerely,


                                      Holly Porter
                                      Branch Chief, Branch 3
                                      Office of Associate Chief Counsel
                                      (Passthroughs & Special Industries)
Enclosures (2)
      Copy of this letter
      Copy for § 6110 purposes