Voting and nonvoting S corporation stock

No, and the answer is written into the statute rather than left to interpretation. Internal Revenue Code section 1361(b)(1)(D) says an S corporation may have only one class of stock, which is why owners get nervous about a two class structure. Section 1361(c)(4) then says a corporation is not treated as having more than one class of stock solely because of differences in voting rights among shares of common stock. Those two sentences are what make voting and nonvoting S corporation stock a normal planning tool rather than a hazard. The regulations fill in the test. A corporation has one class of stock if all outstanding shares confer identical rights to distribution proceeds and to liquidation proceeds. Voting power is deliberately left out of that test. Nonvoting shares are still common stock, and the people who hold them still count toward the 100 shareholder ceiling. The Internal Revenue Service describes the basic entity rules on its business structures page, and the company continues to file Form 1120-S exactly as before.

What the regulations do police is the set of governing provisions. That phrase covers the articles of incorporation, the bylaws, applicable state law, and any binding agreement that touches distribution or liquidation rights. The list is broader than most owners expect. A side agreement among shareholders counts even if it never reaches the articles, and so does a provision of state law the corporation has not opted out of. Routine commercial arrangements are left alone, so a lease between the company and an owner, or a loan on ordinary terms, does not create a class of stock merely because one shareholder sits on the other side of it. If the governing documents give one block of shares a better economic deal than another, the corporation has two classes and the S election is gone. If they give one block more votes and nothing else, the corporation is fine.

Numbers make it concrete. Say a company recapitalizes into 1,000 voting shares and 99,000 nonvoting shares, 100,000 shares in total. The board declares a 100,000 dollar distribution. Every share, voting or not, receives 1 dollar. The voting block collects 1,000 dollars and the nonvoting block collects 99,000 dollars. Nobody may take a preference, a catch-up, or a larger slice because they hold the votes. If the founder holding the voting block took 20,000 dollars while the nonvoting holders split the remaining 80,000 dollars, an examiner has a strong argument that the shares carry different economic rights. The same discipline applies on a wind up. If the company sold everything and liquidated, the cash would be divided per share across both blocks with no preference for the voting holders.

The mistake that ends S elections is dressing up the voting shares with a return. An owner asks for a 6 percent annual preference on the voting block as compensation for staying in charge, the attorney writes it into the articles because it sounds reasonable, and the corporation now has preferred stock. The S election terminates on the effective date and the company becomes a C corporation. At 21 percent on 800,000 dollars of income that is 168,000 dollars of tax nobody planned for. The Reed Corporation is a certified public accounting and tax firm. We do not practice law and we do not draft charters or shareholder agreements, so those documents belong to your attorney while we read them for tax effect. Companies that have the governing documents reviewed before the amendment is filed almost never meet this problem, and our tax strategy consulting group runs that review as a standing item.

The usual mechanics are simple. The corporation amends its articles to authorize a nonvoting common class with rights to distributions and liquidation proceeds identical to the existing shares. Each shareholder then exchanges old shares for a small number of new voting shares plus a larger number of new nonvoting shares. That exchange is a recapitalization, which is a reorganization described in section 368(a)(1)(E). Where a shareholder receives only stock in exchange for stock, section 354 says no gain or loss is recognized. Basis carries over into the new shares under section 358 and the holding period tacks under section 1223. At the corporate level section 1032 keeps the company from recognizing anything. The S election continues without interruption, no new Form 2553 is filed, and the employer identification number stays the same.

State corporate law drives the sequence. The board approves the amendment, the shareholders approve it where the statute requires that, and the amendment is filed with the secretary of state before any certificates change hands. Doing the exchange first and the filing later leaves a period when the nonvoting shares do not legally exist, which is the kind of gap that surfaces in due diligence years later. A recapitalization can also be carried out by authorizing the new class and converting only part of each holder’s position, rather than surrendering and reissuing everything. Which route the attorney takes is a state law question, and the federal tax analysis is generally the same either way.

Two details can change the tax answer. If a shareholder receives cash or other property along with the new shares, gain is recognized to the extent of that boot. And because the exchange rearranges who holds what inside a family, the values have to be respected. Where both classes carry identical distribution rights, the special valuation rules that trip up preferred stock freezes generally do not reach a common for common recapitalization, but that analysis belongs with counsel and with a qualified appraiser rather than with an assumption. Splitting voting and nonvoting S corporation stock among family members in unequal proportions during the exchange can create a gift on the spot, which is a separate question from whether the exchange itself was taxable.

Here is a typical set of facts. A founder owns 1,000 shares of a company worth 10,000,000 dollars with a stock basis of 250,000 dollars. The company recapitalizes and the founder exchanges those 1,000 shares for 100 voting shares and 9,900 nonvoting shares. No tax is due on the exchange. The 250,000 dollar basis spreads across the 10,000 new shares at 25 dollars per share, and the holding period runs from the original purchase date rather than restarting. Nothing on the corporate return reports the recapitalization as income, though the share counts behind each Schedule K-1 change. Basis tracking of this kind follows the rules described in Publication 551, and a later sale is reported on Form 8949.

The common mistake is administrative rather than technical. The recapitalization gets approved, the amendment gets filed, and nobody updates the stock ledger or the certificates. Three years later a buyer’s counsel asks which shares are voting and the company cannot prove it, which stalls a closing and costs more in fees than the original planning did. We ask for the amended articles, the board consent, and the updated ledger for the permanent file the same month the recapitalization happens. We also confirm the accumulated adjustments account and the stock basis records carried across the exchange rather than restarting, because a reorganization resets neither one. Companies that keep share records current find the next transaction moves at the pace the deal needs, and steady bookkeeping on the equity accounts is the least expensive part of the exercise.

This is where the structure earns its keep. A founder who wants to move value to the next generation without giving up control gifts or sells nonvoting shares while keeping the voting block. Because voting power is not part of the one class test, the transfer does not disturb the S election on its own. The recipient can be a child directly, but more often it is a trust, and that is where a second rule set arrives. Only certain trusts may own S corporation shares. An electing small business trust and a qualified subchapter S trust both work, each with its own election, its own signer, and its own filing deadline of two months and sixteen days after the shares are transferred. A trust that is not a permitted holder ends the S election the day it receives a share. The eligible shareholder rules live in the same part of the code that governs the election itself, and the general framework sits on the Service’s small business and self-employed hub, with each holder’s share reported on Form 1120-S. Naming the trust as the record holder on the ledger matters as much as the assignment itself.

Valuation is the other half. Nonvoting shares in a closely held company are worth less than a control block, and a qualified appraiser supports discounts for lack of control and lack of marketability. Those discounts are real and they are also the most examined figure on a gift tax return, so the appraisal has to be defensible and the return has to make adequate disclosure of the transfer, which starts the three year limitations clock. The appraisal should be dated close to the transfer and should value the specific block being given rather than the whole company divided by share count. Section 2704 limits certain lapsing rights and restrictions that would otherwise inflate a discount. A founder who keeps too much benefit from the transferred shares can also see them pulled back into the taxable estate under section 2036, which is a drafting question for your attorney rather than an accounting entry.

Run the arithmetic. The company is worth 10,000,000 dollars. The founder gifts 30 percent of the nonvoting shares to a trust for two children. Before discounts that slice is 3,000,000 dollars. With a supportable combined discount of 25 percent the reported gift is 2,250,000 dollars, so the transfer uses 750,000 dollars less lifetime exemption than the undiscounted figure. Every dollar of future growth on those shares then accrues outside the founder’s estate. If the company doubles over the next decade, roughly 3,000,000 dollars of appreciation sits with the children rather than in a taxable estate. The receiving trust also needs cash to pay whatever tax falls on it, which is why the shareholder agreement should address tax distributions before the gift is made.

The mistake we see is a gift made to the family’s existing revocable trust with no election filed. The shares land in an ineligible holder and the S election terminates back to that date, which turns a planning win into a corporate tax bill. A sale of nonvoting shares to a trust in exchange for a note is a different structure with its own rules, and it should never be papered from a template. We check the receiving trust before the assignment is signed, not after. As families move more of their voting and nonvoting S corporation stock down a generation over the coming years, a short annual review of who holds which shares and which elections are on file keeps the plan intact. Recipients report their share of income on their own returns, prepared by our individual tax return group so the corporate and personal filings agree.

Four situations account for nearly all real cases. The regulations look at whether the governing provisions confer identical rights, so the analysis starts by reading documents rather than by counting dollars. The first situation is a governing provision that gives different distribution or liquidation rights, which is the direct hit already described. The second is a pattern of distributions that does not follow ownership. The regulations test the governing provisions rather than the checkbook, so an isolated timing difference is usually survivable, but a consistent practice of paying one owner more can be used as evidence that an unwritten agreement exists. The third is debt that behaves like equity. Section 1361(c)(5) provides a straight debt safe harbor for a written unconditional promise to pay a fixed amount, where the interest rate and payment dates are not contingent on profits, the debt is not convertible into stock, and the creditor is a person eligible to hold shares. Loans outside that safe harbor invite an argument that the lender holds a second class.

The fourth is options and similar rights. A call option is treated as a second class of stock only if it is substantially certain to be exercised and has an exercise price substantially below the fair market value of the underlying shares. There are safe harbors, including one for options priced at or above 90 percent of fair market value on the issue date, and a separate carve out for options issued to employees in connection with services. Deferred compensation arrangements are generally carved out as well, provided they are not convertible into stock and carry no voting rights. Ordinary buy-sell and redemption agreements are usually disregarded unless a principal purpose is to get around the one class rule and the price is significantly off market. State law can supply a right the articles never mention, which is why the analysis is not finished when the charter looks clean.

Consider a company with a 60 percent owner and a 40 percent owner earning 500,000 dollars. The majority owner draws 60,000 dollars from the account in December and the minority owner draws nothing. Standing alone this is fixable by a true-up distribution of 40,000 dollars to the minority owner in the same year or the next. Repeated for four years without correction, it starts to look like an agreement that the two blocks carry different rights. The cleanest repair is a corrective distribution recorded in the minutes rather than a silent adjustment on the books. Meanwhile, if the 60,000 dollars was really pay for services, it should have run through payroll, and the Service treats owner compensation seriously, as its employment taxes material and Form W-2 reporting rules make clear.

The common mistake is the owner who treats the company account as a personal one and reasons that it all evens out at year end. It usually does not, and the record it leaves is exactly the record an examiner wants. Relief for an inadvertent second class exists under section 1362(f), but it runs through a private letter ruling request with a user fee and a wait measured in months, so prevention costs far less than repair. Deductibility questions for the underlying costs are covered in Publication 535, and the yearly picture lands on Form 1120-S. We reconcile owner draws against ownership percentages every quarter so a true-up happens while it is still a bookkeeping entry. Companies holding voting and nonvoting S corporation stock carry more moving parts than a single class company, and that quarterly check keeps the extra structure from creating extra exposure later.

The division of labor is clear and we hold to it. The Reed Corporation is a certified public accounting and tax firm. We do not practice law. We do not draft the charter amendment, the shareholder agreement, or the assignment that moves the shares, and we do not opine on whether a document accomplishes what the family intends. Your attorney owns those documents. A qualified appraiser owns the valuation that supports any discount, and we do not perform that appraisal ourselves. Where the family has a business attorney and an estate attorney who are different people, we make sure both are working from the same set of numbers. Our work is the tax layer. We read the governing documents for anything that changes distribution or liquidation rights, we confirm the S election and any trust elections are on file, and we price the outcome in dollars before the family commits. We do not promise a specific estate or income tax result, because the facts and the law both keep moving.

Once the structure is in place the annual work is where errors show up. Income is allocated among shareholders on a per share per day basis under section 1377(a)(1) unless the owners make an election tied to a complete termination of an interest. That means the exact date of a gift changes everyone’s Schedule K-1. Distributions have to be checked against the accumulated adjustments account so they are not accidentally reported as dividends. Stock basis has to be rolled forward every year for income and for distributions, since a later sale depends on it. We also watch for a mid year change in the number of holders, because adding a trust with several potential current beneficiaries can push a company toward the 100 shareholder ceiling. Records are kept along the lines the Service sets out in its recordkeeping guidance, and shareholders newly receiving flow-through income without withholding usually need quarterly payments under the framework on the Service’s estimated taxes page. No return is beyond an audit, so the file has to stand on its own.

Timing drives real dollars. A company earns 1,200,000 dollars for the year and the founder gifts 30 percent of the nonvoting shares on July 1. Under the per share per day rule the recipients are allocated roughly 180,000 dollars, half of the 360,000 dollars a full year of that ownership would have carried. Move the same gift to January 2 of the following year and the allocation shifts by about 180,000 dollars between two generations of taxpayers. The election tied to a complete termination of a shareholder’s interest can change that split, but it needs consent from the affected owners and has to be made with the return. Neither answer is wrong. The wrong answer is learning in March that the gift happened in July. If you are weighing a transfer this year, you can request a consultation and we will map the allocation with your attorney before the assignment is signed.

The common mistake is a December gift disclosed to the accountant in April. By then the corporate return is in progress with the old ownership percentages, the Schedule K-1 figures are wrong, and amended returns follow for the company and for every shareholder. We ask clients to tell us before a share moves rather than after, even if the transfer never happens. We also keep a one page ownership summary current so anyone joining the team later can read the history without working through a decade of minutes. Families who keep the attorney, the appraiser, and the accountant working from one calendar move value down a generation with far less friction, and that habit matters more each year the company grows.