Employee-share repurchase terms did not create second stock class

Plain-English summary

An S corporation's equity compensation plan allowed employees to acquire shares, while restricting transfers and permitting the corporation to repurchase shares after employment ended. The repurchase price generally was fair market value, but could be lower when an employee committed theft or fraud that materially harmed the corporation. Employees also could hold shares through trusts that qualified as eligible S corporation shareholders. The IRS ruled that the transfer restrictions and repurchase provisions would be disregarded when determining whether all shares had identical distribution and liquidation rights under IRC § 1361. The ruling did not decide whether the corporation otherwise qualified as an S corporation.

Ruling snapshot

• Question: Did the employee-share transfer restrictions and repurchase provisions affect the S corporation's one-class-of-stock status?
• Outcome: Approved. The restrictions and provisions were disregarded when testing whether the shares conferred identical rights.
• 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: 201918013 Third Party Communication: None
Release Date: 5/3/2019 Date of Communication: Not Applicable
Index Number: 1361.00-00, 1361.01-00,
1361.01-04 Person To Contact:
---------------------, ID No. ----------------
-------------------------------- Telephone Number:
------------------------ --------------------
-------------------------------- Refer Reply To:
------------------------------------------------------ CC:PSI:B01
PLR-123691-18
Date:
November 16, 2018

LEGEND:

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

State = -----------

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

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

Agreement = -------------------------------------------------------------------------------------------------------------

Plan = -----------------------------------------------------------------------------------------------------------------
---------------------------

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

This letter responds to a letter dated August 2, 2018, and subsequent correspondence,
submitted on behalf of X requesting a ruling under § 1361(b)(1)(D) of the Internal
Revenue Code.

Facts

The information submitted states that X was incorporated under the laws of State on
Date 1, and elected to be treated as an S corporation effective Date 2. X has one class
of voting common stock outstanding.
PLR-123691-18 2

Under an agreement entered into by X and its shareholders, the Agreement, shares
generally may not be transferred without the prior written consent of the Chairman of the
Board of Directors of X.

X has adopted an equity compensation plan, the Plan, which authorizes X to sell shares
of X’s stock to key employees of X or to grant shares or options to purchase shares to
such employees. Shares acquired under the Plan are subject to the same transfer
restrictions set forth in the Agreement. In addition, shares held by employees may be
repurchased under certain circumstances by X (generally, upon termination of
employment) at either the “non-forfeiture repurchase price,” which equals the fair market
value of the shares, or the “forfeiture repurchase price,” which is the lesser of: (i) the fair
market value of the shares or (ii) the price paid, if any, to acquire the shares. Depending
on the circumstances, the forfeiture repurchase price could be as low as zero. The
repurchase price of the shares will only be the forfeiture repurchase price if the
employee has engaged in activity meeting the definition of “cause” in the Plan, which
generally only includes theft or fraud by the employee that materially harms X.

Some employees of X have requested (i) permission to transfer their shares of X to a
trust for the benefit of themselves and/or their family members, or (ii) that the shares of
X that would otherwise be issued to them pursuant to the Plan instead be issued to
such a trust. X will confirm that the trusts are eligible S corporation shareholders.
Shares held in such trusts will be subject to the same restrictions under the Agreement
and the Plan as shares directly held by employees.

X represents that the Agreement and the Plan were not created as a plan to circumvent
the one class of stock requirement for S corporations.

Law and Analysis

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) defines a “small business corporation” as a domestic corporation
which is not an ineligible corporation and which does not (A) have more than 100
shareholders, (B) have as a shareholder a person (other than an estate, a trust
described in § 1361(c)(2), or an organization described in § 1361(c)(6)) who is not an
individual, (C) have a nonresident alien as a shareholder, and (D) have more than one
class of stock.

Section 1.1361-1(l)(1) of the Income Tax Regulations provides 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
PLR-123691-18 3

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 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).

Section 1.1361-1(l)(2)(iii)(B) provides that bona fide agreements to redeem or purchase
stock at the time of death, divorce, disability, or termination of employment are
disregarded in determining whether a corporation's shares of stock confer identical
rights.

Conclusion

Based solely on the facts submitted and representations made, we conclude that the
transfer restrictions and repurchase provisions in the Agreement and the Plan will be
disregarded in determining whether X’s shares of stock confer identical rights.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. In particular, no opinion is expressed on whether X otherwise qualifies as an
S corporation.

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

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representatives.

                                   Sincerely,


                                   David R. Haglund
                                   David R. Haglund
                                   Branch Chief, Branch 1
                                   (Passthroughs & Special Industries)

Enclosures (2):
Copy of this letter
Copy for 6110 purposes