Avoiding S Corporation Debt Obligations That Are a Second Class of Stock

Under certain circumstances, debt owed by an S corporation to one or more shareholders will be a second class of stock. An obligation (whether or not designated as debt) generally will be treated as a second class of stock if (1) it constitutes equity or otherwise results in the holder’s being treated as a shareholder under general tax law and (2) a principal purpose of the obligation is to circumvent the distribution or liquidation rights conferred by the outstanding stock or to circumvent the maximum shareholder limitation (Regs. Sec. 1.1361-1(l)(4)(ii)).

Whether an obligation constitutes debt or equity can be important for the following practical reasons:

• The continued validity of the corporation’s S election depends on having only one class of stock; and
• Payments on debt will reduce the corporate income available for distribution and likely will differ from amounts that would otherwise be distributed to the shareholders on equity.

For these reasons, and because the parameters of the “principal purpose” test are unclear, the practitioner should be aware of factors the courts consider in determining whether an obligation is debt or equity. The Tax Court has identified and applied various factors in concluding that the obligation under consideration was equity, including the intent of the parties, thin versus adequate capitalization, the source of repayment, and the right to enforce repayment (American Offshore, Inc., 97 T.C. 579 (1991); Gray, T.C. Memo. 1997-67). For additional assurance that the obligation will not jeopardize the corporation’s S status, the planner can structure the obligation to meet the straight debt safe harbor described below.

Observation: The one-class-of-stock rules provided in Regs. Sec. 1.1361-1(l) do not apply to obligations issued before May 28, 1992, and not materially modified after that date. However, S corporations and their shareholders can apply the regulations to prior tax years (Regs. Sec. 1.1361-1(l)(7)).

Relying on the Straight Debt Safe Harbor

Debt that meets the definition of “straight debt” is not a second class of stock, regardless of whether such debt is classified as equity under general tax law principles. A straight debt instrument is a written unconditional promise to pay (whether or not embodied in a formal note) on demand or on a specific date a sum certain in money (Sec. 1361(c)(5)). In addition, straight debt must meet the following requirements:

1. The interest rate and payment dates are not contingent on profits, corporate discretion, etc.;
2. The instrument is not convertible into stock; and
3. The lender is an individual (other than a nonresident alien), an estate, a trust that is eligible to hold S corporation stock, or a person actively and regularly engaged in the business of lending money (e.g., a bank).

Example 1: STI is an S corporation owned by B. B is president of the company and devotes 100% of his time to its activities. He contributed $5,000 to the company when it was formed in exchange for the stock. Five years ago, when STI was a regular C corporation, B was required to inject an additional $100,000 into the corporation. His controller advised him to lend the money to the corporation so it could be withdrawn later without the risk of dividend treatment. B loaned $100,000 to the company and received a $100,000 written demand note bearing an interest rate of 10%. About two years ago, STI converted from C to S corporation status. In analyzing STI’s note to B, the tax practitioner confirmed that the note is not convertible into STI stock and verified that the other straight debt safeharbor requirements are met. Therefore, the note meets the statutory criteria for safe-harbor debt.

Thin versus adequate capitalization is a factor commonly used by the courts. Thus, in this example, an IRS contention that the company is inadequately capitalized is possible because STI’s outstanding debt is 20 times its outstanding capital stock. However, since STI’s obligation meets the straight debt safe-harbor rule, it will not be considered a second class of stock.

Even if an obligation is subordinated to other debt of the corporation, it can still qualify as straight debt. Straight debt ceases to qualify if it is transferred to an ineligible S corporation shareholder or is materially modified so the straight debt requirements are no longer met.

An obligation issued by a C corporation that satisfies the definition of straight debt is not treated as a second class of stock if the corporation elects S status, even if the debt is considered equity under general tax law principles. In addition, conversion to S status is not treated as an exchange of debt for stock with respect to such an obligation (see Regs. Sec. 1.1361-1(l)(5)(v)).

Short-Term Unwritten Advances and Proportionately Held Debt

In addition to the safe harbor for straight debt obligations, there are two additional safe harbors to prevent certain debt being treated as a second class of stock (Regs. Sec. 1.1361-1(l)(4)(ii)(B)). The safe harbors are for certain short-term unwritten advances and proportionately held debt.

Unwritten advances that (1) do not exceed $10,000 in the aggregate at any time, (2) are treated as debt by the parties, and (3) are expected to be repaid within a reasonable time are not treated as a second class of stock (even if considered equity under general tax law principles).

Proportionately held debt includes any class of obligations considered equity under general tax law principles and held by the shareholders in the same proportion as the S corporation’s outstanding stock. Note that debt held by a sole shareholder of an S corporation always meets the definition of proportionately held debt. Thus, debt held by shareholders in the same proportions as their stock ownership (including debt owed by the corporation to a sole shareholder) will not be considered a second class of stock.

Example 2: Assume the same facts as in Example 1 except the interest rate called for in the note was contingent upon the corporation’s profits.

While the loan no longer qualifies for the straight debt safe harbor (because interest is contingent on the corporation’s profits), it does qualify for the proportionately held safe harbor. The regulations explicitly state that obligations held by the sole shareholder of an S corporation are always considered proportionately held.

If the debt is disproportionately held, it will not create a second class of stock unless the debt has a principal purpose of circumventing the distribution or liquidation rights conferred by the outstanding shares of stock or circumventing the 100-shareholder limitation (Regs. Sec. 1.1361-1(l)(4)(ii)(B)(2)).

Example 3: Now assume that B is only a 50% shareholder (yet all loans have come from him).

If the debt owed to B by the corporation qualifies as straight debt, it does not result in a second class of stock. But even if the straight debt requirements are not met, the mere fact that the debt is disproportionately held will not create a second class of stock, unless it is considered to be equity and has a principal purpose of circumventing the distribution or liquidation rights conferred by the outstanding shares of stock, or circumventing the 100-shareholder limitation.

Loaning Distributions Back to the Corporation

Shareholders can lend back to the corporation all or some distributions to them without breaching the one-class-of-stock rules. However, the shareholders should not be under any obligation to recontribute the distributions, and the notes issued to the shareholders should meet the straight debt criteria (Letter Ruling 9746038).

Example 4: E Corp. is an S corporation that makes periodic distributions to its shareholders. It needs to fund its expansion but wants to minimize its commercial borrowing by obtaining loans from its shareholders. The corporation proposes that the shareholders recontribute to E all or a portion of their cash distributions in exchange for one or more promissory notes. The shareholders, however, would be under no obligation to lend the distributions back to the company. The promissory notes would carry interest at a rate equal to the applicable federal rate in effect at the time of each transaction. Interest payments would not be contingent on E’s profits, and the notes would not be directly or indirectly convertible into stock.

The IRS has ruled under similar facts that a second class of stock will not result when distributions are recontributed to the corporation in exchange for promissory notes (Letter Ruling 9746038). The IRS attached importance to the fact that the shareholders were under no obligation to loan their cash distributions to the corporation. The ruling concludes that the notes issued by the corporation to the shareholders would be considered straight debt. Thus, any cash distributions by E to its shareholders followed by a loan by the shareholders of part or all of their cash distributions back to E will not result in E’s being treated as having a second class of stock.

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 22d Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ((800) 323-8724; ppc.thomson.com).

EditorNotes

Albert Ellentuck is of counsel with King & Nordinger, L.L.P., in Arlington, VA.