United States

S corp's buy-sell agreement did not create second class of stock

TAX ALERT  | 

The IRS recently ruled that it would ignore certain provisions of a stock repurchase agreement between an S corporation and its shareholders when determining whether the S corporation had more than one class of stock outstanding. The ruling provides welcome assurance for S corporations with buy-sell agreements whose provisions mirror those in the ruling, but it also serves as a useful reminder that S corporations should scrutinize their buy-sell agreements to be sure they conform with safe harbors outlined in the relevant regulations. Failure to do so can put the company’s subchapter S status at risk.

The facts

The ruling involved an S corporation that had adopted an equity compensation plan, under which the company was authorized to issue shares to certain key employees. Shares issued under that plan were subject to transfer restrictions and repurchase provisions outlined in a buy-sell agreement. The agreement provided, in the event of the employee’s termination of employment for cause, that the company could repurchase the shares at the, “forfeiture repurchase price,” defined as the lesser of fair market value or the price paid for the shares. Depending on the circumstances, the forfeiture repurchase price could be as low as zero.

The relevant guidance

A corporation with more than one class of stock cannot qualify as an S corporation. The determination of whether a corporation has more than one class of stock is based on the company’s governing documents, and ultimately rests on whether all shares have equal rights to distribution and liquidation proceeds.

When determining whether its shares have equal rights, a company would generally need to consider provisions within buy-sell and redemption agreements that might affect shareholders’ economic rights. However, Treasury regulations provide that these agreements will be disregarded for this purpose unless:

  1. A principal purpose of the agreement is to circumvent the single class of stock requirement, and
  2. The agreement establishes a purchase price that is significantly in excess of or below the fair market value of the stock at the time the parties enter the agreement.

Furthermore, bona fide agreements to redeem or repurchase stock in the event of death, divorce, disability, or termination of employment are always disregarded when determining whether shares confer identical economic rights – no matter the agreed upon purchase price.

The ruling

The IRS concluded that the repurchase provisions outlined in the buy-sell agreement would be disregarded because they applied in the case of an employee’s termination of employment, one of the categories for which that the regulations provide blanket immunity.

The takeaway

Buy-sell agreements between an S corporation and its shareholders can significantly affect the shareholders’ rights with respect to the shares. For this reason, S corporations need to be diligent about ensuring that existing agreements and future amendments do not include provisions that might be construed as providing differing distribution or liquidation rights among the shareholders. S corporations and their shareholders can take some comfort in knowing that agreements covering redemptions and purchases in the event of death, divorce, disability, or termination of employment are typically protected without regard to the agreed upon purchase price, but agreements that cover additional circumstances may require additional scrutiny.

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