S CORPORATION BUY-SELL AGREEMENTS

DRAFTING S CORPORATION BUY/SELL AGREEMENTS Christopher K. Heuer Stoel Rives LLP Portland, Oregon I. Reasons for Entering into Buy-Sell Agreements. There are numerous reasons why some or all of the shareholders of a corporation will wish to enter into an agreement among themselves and with the corporation. The nature of a particular agreement can vary almost as widely as the reasons for initially entering into the business relationship. The scope and terms of an agreement between unrelated 50 percent shareholders will likely differ markedly from an agreement among multigenerational shareholders of a family business. A. Impose Restrictions on Transfer. 1. Protection of S Corporation Status. Buy-sell agreements can prohibit transfers of stock to persons who are ineligible to be shareholders of an S corporation or to an additional shareholder who would cause the corporation to exceed the 75-shareholder limit. Absolute protection of S corporation status, however, can be very difficult, if not impossible. See Part II, infra. Limit the Universe of Shareholders. Limitations on the number and type of shareholders can prevent the unilateral introduction of new shareholders, particularly by a minority owner. Such provisions are frequently used to keep ownership of a family business within the family. 2. B. Strategic Reacquisitions. Agreements can also provide for the surrender of stock by a person if the reason for originally making the person a shareholder is no longer applicable (e.g., termination of employment) or upon an event that would cause another person to become a shareholder (e.g., death, incompetence, divorce, or bankruptcy). Without the ability to repurchase stock upon termination of employment, for example, a corporation might be unwilling to issue stock to a key employee for whom stock will provide the appropriate incentive to maximize the enterprise value of the company to the benefit of all shareholders. Provide for Smooth Transfer of Control. Orderly transfers of corporate control of the corporation can be effected by limiting transfers to certain specified transferees or requiring sales and purchases upon certain triggering events. An agreement might provide, for example, for a purchase by the corporation (or a pro rata purchase by the remaining shareholders) upon the death of one of the shareholders. C. Mr. Heuer would like to acknowledge the contribution of Joel D. Kuntz, General Counsel, ENTEK International LLC, Lebanon, Oregon, for his comments on an earlier draft of this outline.  Portlnd1-2117140.3 0099870- 00001 D. Provide Liquidity for Interests in Closely Held Businesses. 1. Terminal Liquidity/Exit Strategy. An agreement can serve to create a market for an otherwise illiquid interest in a closely held corporation. Establishing a market can have a variety of positive benefits to shareholders, including allowing an employee shareholder to participate in the long-term appreciation in the value of a business at favorable capital gain rates or providing a deceased shareholder’s estate the liquidity to satisfy estate taxes. Operational Liquidity/Current Distributions. The amount and timing of distributions can be fixed to provide shareholders the cash needed to satisfy their personal tax liability on pass-through income from the corporation. See Part IV, infra. 2. E. Establish Advance Agreement on Other Important Issues. Agreements can also be used to establish advance agreement on a host of issues important to the corporation and its shareholders. 1. Stock Price. Having a stock purchase price mechanism in place can allow for orderly planning and help reduce the potential for shareholder disputes at the time a purchase is allowed or required under the agreement. The price established by the agreement may, in certain circumstances, also fix the value of the stock for estate planning purposes. Common approaches to establishing a price include: a. Multiple of corporate earnings. Defining “earnings” for this purpose requires careful consideration of the particular financial situation of a business. In some circumstances, earnings might need to be adjusted to arrive at an acceptable price (e.g., to neutralize the impact of excessive salaries or extraordinary income or expenses). Selecting the baseline for measurement and the appropriate capitalization rate can often be difficult. Book value (or adjusted book value) of the corporation’s assets. Book value is a commonly used valuation methodology but one that is unlikely to produce a fair market value price without adjustment. In some cases the corporation’s book value might be adjusted to take into account fair market value of certain assets. For example, the value of stock of a business with significant real estate holdings might be established by using the corporation’s book value at the close of the most recent month end, as adjusted by backing out the book value of the corporation’s real property and adding back the fair market value of that real property as established by appraisal. b. Portlnd1-2117140.3 0099870- 00001 2 c. Agreed-upon price. Agreements sometimes provide that the parties will agree upon a price and update that price periodically (e.g., annually by a majority of the shareholders). Such agreements often provide for alternative mechanisms, such as appraisal, if the agreed price has become “stale” because the shareholders have not in fact agreed to a price within a certain period (e.g., 15 months) before the event giving rise to the purchase. Appraisal. Agreements often provide for an independent, outside appraisal of the value of the stock to be purchased. Such provisions usually specify the mechanics of choosing one or more appraisers and may provide a methodology for conducting the valuation (e.g., ignoring minority discounts, assuming the corporation continues as a going concern, and averaging multiple appraisals). Shotgun. Under the so-called “shotgun” approach, one party specifies a purchase price and the other party elects either to buy from or to sell to the first party at that price. d. e. 2. Allocation of Pass-Through Income. Subchapter S provides some flexibility in determining the manner in which S corporation income will be passed through to shareholders in circumstances in which shareholders’ interests in the corporation change during a taxable year. The ability to select between alternatives occasionally provides for favorable tax planning opportunities but more often creates the potential for unintended pass-through results. Advance agreement can reduce the likelihood of pass-through windfalls and traps. See Part V, infra. Vote Thresholds. It is often important to fix in advance the vote level that will be required to terminate S corporation status or otherwise amend the agreement. Although the holders of more than 50 percent of the corporation’s issued and outstanding stock (including nonvoting stock) must consent to any revocation of S corporation status, Treas Reg § 1.1362-2(a)(1), agreements frequently fix a higher threshold for approval of termination of S status. Section 338(h)(10) Election. a. Preference for asset sale. In connection with the sale of an S corporation’s entire business, asset sale treatment often results in the most favorable overall income tax treatment. An S corporation shareholder generally is subject to only one level of tax upon an asset sale because the corporate-level gain that passes through to the shareholder increases the shareholder’s stock basis. That increased basis often means that the shareholder will realize no 3. 4. Portlnd1-2117140.3 0099870- 00001 3 gain upon a post-asset-sale liquidation of the corporation. Accordingly, an S corporation shareholder may pay no more net income tax upon an asset sale than if the shareholder had sold the stock itself (although the character of pass-through income is critical to the analysis and can in certain circumstances create significant disparity in the amount of net income tax). The acquirer of the business, by contrast, generally prefers to purchase assets rather than stock. If the acquirer buys stock, the corporation’s basis in its assets generally continues unchanged. If the acquirer buys assets, however, the purchaser will receive a purchase price basis, which is often higher than the basis of the assets in the hands of the target corporation. b. Deemed asset sale treatment. Regulations promulgated pursuant to IRC § 338(h)(10) allow the parties to a purchase and sale of at least 80 percent of the stock of an S corporation to treat the acquisition for tax purposes as a purchase of all the target corporation’s assets. Treas Reg § 1.338(h)(10)-1. Consent. The consent of all the shareholders of an S corporation (even those who do not sell their stock) is required for a valid IRC § 338(h)(10) election. Treas Reg § 1.338(h)(10)-1(c)(2). Thus it may be advisable to provide for the advance agreement among the shareholders that they will each consent to an IRC § 338(h)(10) election if the election is otherwise approvable by a specified percentage (usually a relatively high supermajority) of the corporation’s shareholders. c. II. Protection of S Corporation Status. A. Definition of S Corporation. The term “S corporation” means a small business corporation for which an election to be an S corporation is in effect for the taxable year. IRC § 1361(a)(1). For taxable years beginning after 1997, a “small business corporation” is a domestic corporation that is not an “ineligible corporation” and that does not have (1) more than 75 shareholders, (2) shareholders other than individuals, estates, certain trusts, and certain taxexempt entities, (3) a nonresident alien shareholder, or (4) more than one class of stock. IRC § 1361(b)(1). Termination upon Failure to Meet Definition; Re-election. Failure to continue to meet any of the above requirements will generally result in termination of the corporation’s election to be an S corporation effective on and after the day the requirement ceases to be met. IRC § 1362(d)(2). If an S corporation election terminates, the corporation is generally not eligible to reelect S status before the fifth taxable year beginning after the first year for which the termination is effective. IRC § 1362(g). B. Portlnd1-2117140.3 0099870- 00001 4 C. Restrictions on Transfer. 1. Need for Agreement. To help prevent a termination of a corporation’s S election, virtually all S corporation shareholder agreements contain some form of outright prohibition on transfers to ineligible shareholders. Usually, this overriding prohibition is in addition to the limitations on transfers that the shareholders and the corporation agree to for other business reasons. Relationship with Mandatory Distribution Provision. A minority shareholder should not agree to an S corporation termination transfer restriction unless the corporation is obligated to make distributions to allow shareholders to satisfy pass-through tax liability. See Part IV, infra. Otherwise the shareholder might be trapped with continual unfunded tax liability. Effect of Restriction upon Purported Prohibited Transfer. a. Retroactivity generally. Several cases and rulings have concluded that rescissions and reformations do not have retroactive effect for purposes of preserving S corporation status. See James S. Eustice & Joel D. Kuntz, Federal Income Taxation of S Corporations ¶ 5.08[2] (4th ed 2001). But see Rev Rul 80-58, 1980-1 CB 181 (allowing rescission of land sale because within same taxable year parties placed in same positions occupied before sale). Effect of shareholders agreement. In at least one private ruling, however, the Internal Revenue Service (the “Service”) concluded that a transfer of stock to a trust did not terminate the corporation’s S election because a state court later declared the transfer void ab initio. Ltr Rul 7748034 (Aug. 31, 1977). The ruling appears to have involved a transfer to a trust in violation of corporate resolutions granting the corporation a right of first refusal. See Ltr Rul 7716014 (Jan. 24, 1977). On the other hand, the Service concluded in another letter ruling that a termination occurred upon a transfer to a constructive trust even though the corporation subsequently obtained a state court order consenting to an agreement terminating the trust ab initio in accordance with a shareholders agreement providing that prohibited transfers were void ab initio. Ltr Rul 9042031 (July 23, 1990). Interaction with inadvertent termination relief provisions. Even if a corporation is unable to obtain assurance that a purported transfer to an ineligible shareholder was void from the outset, the Service nevertheless may be willing to waive the termination under the inadvertent-termination relief provisions of subchapter S. See Ltr Rul 9042031 (granting termination relief after concluding that 2. 3. b. c. Portlnd1-2117140.3 0099870- 00001 5 termination had occurred); see also Part II.E, infra (discussing inadvertent-termination relief). 4. Enforceability. To help ensure that the prohibition on transfers to ineligible shareholders is enforceable, the agreement should include several provisions. a. Legends. ORS 78.2040 provides that a restriction on transfer of a certificated investment security that is imposed by the issuer is ineffective--even if the restriction otherwise is lawful--against a person without knowledge of the restriction, unless the restriction is noted conspicuously on the security certificate. Accordingly, all stock certificates representing shares subject to an S corporation protection provision should be endorsed with a legend stating that the shares represented by the certificate are transferable only in compliance with the terms of an agreement among the corporation and its shareholders. Specific performance. The agreement should have the parties acknowledge that they will be irreparably damaged if the terms of the agreement are not adhered to and that equitable relief, including an injunction, is an appropriate remedy. Penalties for failure to maintain S corporation election. Drafters should consider including provisions that will impose personal liability on persons who transfer shares in violation of the agreement or establish liquidated damages for such failures. b. c. 5. Conditions on Transfer; Opportunity for Advance Review. Agreements frequently provide that the company and its counsel will have the opportunity to review transfer documentation before a transfer will be allowed. Sometimes receipt of an opinion from the company’s or the proposed transferee’s lawyers or a letter ruling from the Service is a prerequisite to transfer. An opinion is particularly useful in the case of transfers to trusts, because trusts eligible to be S corporation shareholders are subject to detailed qualification rules that will require careful analysis. See IRC §§ 1361(c)(2)(A), 671-679 (grantor trusts), 1361(d) (qualified subchapter S trusts), 1361(e) (electing small business trusts). Similarly, transfers to exempt organizations may raise qualification issues since the status of the corporation’s S election will turn on the organization’s taxexempt status. See IRC §§ 1361(b)(1)(B), 1361(c)(6). Post-transfer Activities. The subchapter S shareholder eligibility requirements can make it very difficult to establish with certainty that all of a corporation’s shareholders are eligible S corporation shareholders, especially with respect to actions that occur separate from any transfer of shares. Actions that can involve a transfer of stock ownership for tax 6. Portlnd1-2117140.3 0099870- 00001 6 purposes independent of transfers involving delivery of shares include, among others: (a) a change in beneficial owners of stock (e.g., upon foreclosure), (b) the failure of a new income beneficiary of a qualified subchapter S trust (“QSST”) to consent to the QSST election (c) the failure of a QSST to distribute all of its income currently, (d) an individual shareholder becoming a nonresident alien, (e) a change in status of a disregarded entity that is interposed between the corporation and an eligible shareholder, and (f) expiration of two-year grace period for qualification of a trust to which stock is transferred pursuant to a will. Because there is little clear authority regarding the ability of a corporation to protect its status as an S corporation in the face of changes in the nature of a previously eligible shareholder, it is advisable for the corporation to police the continued eligibility of its shareholders. Drafters should consider including purchase options that are triggered upon such changes (or even upon facts suggesting that a shareholder might become an ineligible shareholder). Care must be taken to allow for any such options to be triggered even in situations in which the corporation is not aware of the events causing ineligibility. D. Late Elections. The Service is authorized to treat certain S corporation elections as timely even if the election was made late (or not made at all) if it determines that there was reasonable cause for the failure to elect timely. IRC § 1362(b)(5). In certain cases the relief is automatic, but only if all shareholders attest that they have reported their income consistent with S corporation status for all relevant years (among other requirements). See Rev Proc 97-48, 1997-2 CB 521. A shareholders agreement should require all shareholders to take all actions required by the Service as a condition to obtaining relief. Invalid Elections. The Service is also authorized to treat a corporation as an S corporation even though the corporation did not meet the requirements of a small business corporation at the time of the election or did not obtain required shareholder consents to the election. IRC § 1362(f)(1)(A). In general, the Service will issue a ruling granting inadvertent-invalid-election relief only if it makes a determination that the failure properly to elect was inadvertent, the corporation takes steps to correct the situation within a reasonable time after discovery, and the corporation and its shareholders agree to make any adjustments the Service requires. IRC § 1362(f). At a minimum, the Service is likely to insist that all shareholders include their pro rata share of pass-though income from the corporation. As with late-election relief, the agreement should require all shareholders to take all actions required by the Service as a condition to obtaining a favorable determination that the corporation’s S election was valid. Inadvertent Termination. If a corporation’s S election terminates because the corporation ceased to qualify as an S corporation or because it violated the restriction on passive investment income, the Service is authorized to waive the termination. IRC § 1362(f)(1)(B). As with invalid-election relief, the Service will issue a ruling granting relief only if it makes a determination that the E. F. Portlnd1-2117140.3 0099870- 00001 7 termination was inadvertent, the corporation takes steps to correct the situation within a reasonable time after discovery, and the corporation and its shareholders agree to make any adjustments the Service requires. IRC § 1362(f). At a minimum, the Service is likely to insist that all shareholders include their pro rata share of pass-though income from the corporation. If termination occurred solely because the beneficiary of a QSST failed to timely file a QSST election or the trustee of an electing small business trust (“ESBT”) failed to timely file a ESBT election, the termination relief is automatic in certain circumstances. Rev Proc 98-55, 1998-2 CB 643. As a condition to QSST or ESBT automatic relief, the corporation must submit, among other things, affidavits from all shareholders that they have reported their income consistent with the S corporation election. Again, the agreement should require all shareholders to take all actions required by the Service as a condition to obtaining inadvertent-termination relief. III. Second Class of Stock Considerations. A. B. Multiple Classes Prohibited. By definition, a small business corporation may not have more than one class of stock. IRC § 1361(b)(1)(D). Voting Rights. A corporation does not have more than one class of stock merely because of differences in voting rights among shares of common stock. IRC § 1361(c)(4). Thus an S corporation may have issued and outstanding shares of voting and nonvoting common stock. The fact that the voting stock and nonvoting stock are different “classes” of common stock for state corporate law purposes will not affect this analysis, provided that the economic rights of each share of stock are the same. Economic Rights. 1. Identical Rights to Distribution and Liquidation Proceeds. a. General rule. Regulations provide that a corporation will be treated as having only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. Treas Reg § 1.1361-1(l)(l). Stock taken into account. Except with respect to certain restricted stock, deferred compensation plans, and so called “straight debt,” all shares of stock of the corporation are taken into account. Treas Reg § 1.1361-1(l)(3). For example, substantially nonvested stock with respect to which an election has been made under IRC § 83(b) is taken into account. Treas Reg § 1.1361-1(l)(3). Governing provisions. In general, the determination of whether all outstanding shares of a corporation’s stock confer identical rights to distribution and liquidation proceeds is made based on the corporation’s corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to 8 C. b. c. Portlnd1-2117140.3 0099870- 00001 distribution and liquidation proceeds. Treas Reg § 1.1361-1(l)(2)(i). These agreements are referred to collectively in the S corporation regulations as “governing provisions.” Id. A commercial contractual arrangement, such as a lease, employment agreement, or loan agreement, is not a binding agreement relating 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. Id. d. Actual distributions. 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. Id. For example, an excess distribution paid to an employee may be treated as additional compensation. Buy-sell and redemption agreements. (i) Generally. Buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights unless (1) a principal purpose of the agreement is to circumvent the one class of stock requirement and (2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock. Treas Reg § 1.1361-1(l)(2)(iii)(A). For the Service’s published position before adoption of the regulations, see Rev Rul 85-161, 1985-2 CB 191, declared obsolete by Rev Rul 95-71, 1995-2 CB 323. Establishing fair market value. (a) Good-faith safe harbor. A good-faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of value was not performed with reasonable diligence. Treas Reg § 1.13611(l)(2)(iii)(A). Book-value safe harbor. Agreements that provide for purchases or redemptions of stock at book value or at a price between fair market value and book e. (ii) (b) Portlnd1-2117140.3 0099870- 00001 9 value are not considered to establish a price that is significantly in excess of or below the fair market value of the stock and, thus, are disregarded in determining whether the outstanding shares of stock confer identical rights. Id. (c) GAAP or nontax use. A determination of book value will be respected if (1) the book value is determined in accordance with generally accepted accounting principles (including permitted optional adjustments) or (2) the book value is used for any substantial nontax purpose. Treas Reg § 1.1361-1(l)(2)(iii)(C). Other consequences. Although an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have other income or transfer tax consequences to the extent all shares are not treated identically. Treas Reg § 1.1361-1(l)(2)(iii)(A). (d) (iii) Special rules for death, divorce, disability, or termination of employment. Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are also disregarded in determining whether a corporation’s shares of stock confer identical rights. Treas Reg § 1.1361-1(l)(2)(iii)(B); see also Treas Reg § 1.1361-1(l)(2)(vi), ex 8 (agreement to redeem employee shareholder upon termination of employment disregarded in determining whether shares confer identical rights). This exception appears to apply regardless of the price established for the stock (subject, of course, to the “bona fide” qualification). Note the absence of incompetency, insolvency, bankruptcy, and termination of a nonemployee service arrangement. Bifurcation. A regulation example provides that portions of a redemption agreement will be analyzed separately. Treas Reg § 1.1361-1(l)(2)(vi), ex 9. In the example, the corporation is to redeem an employee-shareholder’s stock at significantly less than fair market value upon termination of employment or if the corporation’s sales fall below certain levels. The example states that the portion of the agreement providing for redemption upon termination of employment is simply disregarded. The portion of the agreement providing for redemption if the sales target is (iv) Portlnd1-2117140.3 0099870- 00001 10 not reached will be disregarded unless a principal purpose of the agreement is to circumvent the one class of stock requirement. f. Distributions That Take into Account Varying Stock Interests During Taxable Year. A governing provision does not alter the rights to liquidation and distribution proceeds conferred by an S corporation’s stock merely because the governing provision provides that, as a result of a change in stock ownership, distributions in a taxable year are to be made on the basis of shareholders’ varying interests in the S corporation’s income in the current or immediately preceding taxable year. Treas Reg § 1.1361-1(l)(2)(iv). If distributions pursuant to the provision are not made within a reasonable time after the close of the taxable year in which the varying interests occur, the distributions may be recharacterized depending on the facts and circumstances but generally will not result in a second class of stock. Id. 2. Other Arrangements. In general, any instrument, obligation, or arrangement issued by a corporation--regardless of whether designated as debt--is treated as a second class of stock of the corporation if (1) the instrument, obligation, or arrangement constitutes equity or otherwise results in the holder being treated as the owner of stock under general principles of federal tax law and (2) a principal purpose of issuing or entering into the instrument, obligation, or arrangement is to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock or to circumvent the limitation on eligible shareholders. Treas Reg § 1.1361-1(l)(4)(ii). Regulations contain several amplifications of and exceptions to this general rule, including special rules for options and warrants and for convertible debt. See Treas Reg § 1.1361-1(l)(4). Straight-Debt Safe Harbor. Straight debt is also not treated as a second class of stock. IRC § 1361(c)(5); Treas Reg § 1.1361-1(l)(5)(i). a. Definition. The term “straight debt” means a written unconditional obligation--regardless of whether embodied in a formal note--to pay a sum certain on demand, or on a specified due date, that (1) does not provide for an interest rate or payment dates that are contingent on profits, the borrower’s discretion, the payment of dividends with respect to common stock, or similar factors, (2) is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation, and (3) is held by an individual (other than a nonresident alien), an estate, an eligible S corporation trust, or a person who is actively and regularly engaged in the business of lending money. Id. 3. Portlnd1-2117140.3 0099870- 00001 11 b. Subordination. The fact that an obligation is subordinated to other debt of the corporation does not prevent the obligation from qualifying as a straight debt. Treas Reg § 1.1361-1(l)(5)(ii). Ceasing to qualify. An obligation that originally qualifies as straight debt ceases so to qualify if the obligation is materially modified so that it no longer satisfies the definition of straight debt or is transferred to a third party who is not an eligible S corporation shareholder. See Treas Reg § 1.1361-1(l)(5)(iii). c. IV. Distributions to Pay Tax. A. Pass-Through Income. An S corporation’s tax items “pass through” to its shareholders regardless of whether the S corporation actually makes distributions to its shareholders. IRC § 1366(a). If no distribution is made by an S corporation with net taxable income, its shareholders will have tax liability attributable to their ownership interest in the corporation with no cash from the corporation with which to satisfy the tax. To prevent this situation, many S corporation shareholder agreements require the corporation to make cash distributions in amounts and at times sufficient to allow the shareholders to pay their respective tax liabilities (including estimated tax payments) arising as a result of the passthrough income. Need for Pro Rata Distributions. To comply with the S corporation one class of stock requirement, an S corporation will generally need to make identical distributions with respect to each outstanding share of its stock. See Part III, supra; see also Treas Reg § 1.1361-1(l)(2)(vi), ex 6 (agreement to adjust distributions to shareholders to account for heavier state tax burdens gave rise to second class of stock). Accordingly, if the corporation agrees to make cash distributions to provide shareholders with funds to pay tax liability attributable to the corporation, the agreed-to dividend amount should be a percentage of taxable income high enough to ensure that shareholders in the highest applicable rate bracket receive distributions sufficient to satisfy their income tax liabilities arising as a result of their ownership of stock in the corporation. In computing this percentage, the corporation should factor in the amount of any state income tax liability, recognizing that state income tax generally is deductible for federal income tax purposes and that the deduction may be subject to phase-out. Special Considerations in Year of Sale. Note the different dynamic that may apply in the year in which a shareholder sells his or her stock. In general, any pass-through income in the year of sale will increase the shareholder’s basis in his or her shares, thereby reducing the gain (or increasing the loss) he or she will recognize upon sale. Conversely, any distribution in the year of sale will reduce the shareholder’s basis in his or her shares, thereby increasing the gain (or reducing the loss) he or she will recognize upon sale. The amount of any tax distribution needed may be limited to the difference in the character of the B. C. Portlnd1-2117140.3 0099870- 00001 12 income, gain, or loss to the shareholder (e.g., ordinary pass-through income but capital gain upon sale). V. Allocation of Tax Items in Year of Stock Transfer. Because S corporations are passthrough entities, whenever shares of stock are transferred during a taxable year it is necessary to determine how the corporation’s income and loss during that year are to be allocated among the shareholders. A relatively complex set of rules determines how those allocations are to be made. A. General Pro Rata Rule. In general, each shareholder’s pro rata share of any S corporation income (including tax-exempt income), loss, deductions or credit (each a “tax item”) for any taxable year is the sum of the amounts determined with respect to the shareholder by assigning an equal portion of the item to each day of the S corporation’s taxable year and then dividing that portion pro rata among the shares outstanding on that day. IRC § 1377(a)(1); Treas Reg § 1.1377-1(a)(1). Thus under the general “pro rata” or “per-share, per-day” rule, a shareholder who owns stock in an S corporation for only a portion of a year will take into account that portion of the S corporation income attributable to his or her shares for the year multiplied by a fraction, the numerator of which is the number of days the shareholder held the shares and the denominator of which is the total number of days in the year. Alternative Closing of the Books Rule. Because a corporation’s tax items in one portion of a year can significantly differ from the tax items in the rest of the year, S corporation rules require a corporation in certain circumstances to treat the separate portions of a year as separate taxable years and to assign tax items to each separate taxable year using the corporation’s normal method of accounting. Under this “closing of the books” rule, the amount of income and loss with respect to a portion of a year is allocated only to the shareholders owning stock during that portion of the year. In certain other circumstances, S corporations and their shareholders are allowed to elect to close the corporation’s books, even though closing the books is not required. Specific Situations. 1. Termination of S Corporation Status. Any termination that is effective on a day other than the first day of a taxable year will create an “S termination year.” IRC § 1362(e)(4). For example, if the S election of an S corporation using a calendar taxable year terminates on September 1, 2002, calendar year 2002 will be the S termination year. The portion of the S termination year ending on the day before the effective date of the termination is an “S short year.” IRC § 1362(e)(1)(A). The portion of the S termination year beginning on the first day on which the termination is effective is a “C short year.” IRC § 1362(e)(1)(B). Because the corporation will be a S corporation for part of the S termination year and a C corporation for the remainder of the S termination year, the corporation’s separately stated tax items, and the amount of the non- B. C. Portlnd1-2117140.3 0099870- 00001 13 separately stated income or loss, must be divided between the S short year and the C short year. a. Pro rata allocation method. Unless an election is made to close the books, the amount of each tax item is determined for the entire S termination year and allocated throughout the year on a daily basis. A pro rata allocation is made by first determining for the entire S termination year the amount of each separately stated tax item and the amount of the non-separately stated income or loss and then dividing each amount by the number of days in the S termination year. IRC § 1362(e)(2). The per-day amount must then be multiplied by the number of days in the S short year (with the resulting amount to be passed through to and taxed to the S corporation shareholders) and by the number of days in the C short year (with the resulting amount to be taxed to the C corporation). Generally, a pro rata allocation must be used unless the shareholders and S corporation specifically elect to use the closing of the books method. See IRC § 1362(e)(3). The pro rata allocation may not be used, however, with respect to any item that results from a corporation’s election to treat a stock purchase as an asset purchase pursuant to IRC § 338(h)(10) or if 50 percent or more of the corporation’s stock is sold or exchanged during the S termination year. IRC § 1362(e)(6)(C), (D). Closing of the books allocation method. A terminated S corporation may in some circumstances, and must in other circumstances, use the closing of the books method to allocate tax items between the S short year and the C short year. Under the closing of the books method, the corporation’s tax items are split between the S short year and the C short year in accordance with the date on which the items were actually realized or incurred based on the corporation’s books and records. The closing of the books election may be made only with the consent of each person who is a shareholder in the corporation at any time during the S short year and of each person who is a shareholder in the corporation on the first day of the C short year. IRC § 1362(e)(3)(B). The closing of the books method must be used with respect to any item that results from a corporation’s election to treat a stock purchase as an asset purchase pursuant to IRC § 338(h)(10) or if 50 percent or more of the corporation’s stock is sold or exchanged during the S termination year. IRC § 1362(e)(6)(C), (D). b. 2. Complete Termination of Shareholder’s Interest in the Corporation. If an S corporation shareholder’s entire interest in the corporation is terminated and the corporation and all affected shareholders agree, the S corporation may elect to treat the affected shareholders as if the corporation’s taxable Portlnd1-2117140.3 0099870- 00001 14 year consisted of two separate taxable years, the first of which ends at the close of the day on which the shareholder’s entire interest in the S corporation is terminated. IRC § 1377(a)(2)(A). The term “affected shareholders” means the shareholder whose interest is terminated and all shareholders to whom such shareholder has transferred shares during the taxable year. IRC § 1377(a)(2)(B). If the shareholder has transferred shares to the corporation, the term “affected shareholders” includes all persons who are shareholders during the taxable year. Id. 3. Qualifying Dispositions. In the event of a qualifying disposition, an S corporation may elect to treat the year as if it consisted of separate taxable years, the first of which ends at the close of the day on which the qualifying disposition occurs. Treas Reg § 1.1368-1(g). A “qualifying disposition” occurs if a shareholder disposes of, or the corporation redeems from the shareholder, 20 percent or more of the S corporation’s issued and outstanding stock in one or more transactions during any 30-day period during the taxable year. Treas Reg § 1.1368-1(g)(2)(i)(A), (B). A qualifying disposition also occurs if the corporation issues to one or more new shareholders an amount of stock equal to 25 percent or more of the previously outstanding stock during any 30-day period during the taxable year. Treas Reg § 1.1368-1(g)(2)(i)(C). Overlap. Ordering rules address overlap among the three rules that allow elections to close the books. Under the ordering rules, the election available in connection with a termination of S corporation status has the highest priority, followed by the election upon a complete termination of a shareholder’s interest. See Treas Reg §§ 1.1377-1(b)(1), 1.13681(g)(2)(iv). Thus an S corporation may not elect to close the books under the complete termination of a shareholder’s interest rules if the cessation of the shareholder’s interest occurs in a transaction that results in a termination of the corporation’s S election. Instead, the closing of the books election may be made only pursuant to the termination of S status election rules. Similarly, a S corporation may not make an election to close the books under the qualifying disposition election provisions if the event also constitutes a complete termination of the shareholder’s interest in the corporation or if the cessation of the shareholder’s interest occurs in a transaction that results in a termination of the corporation’s S election. Instead, the election may be made only pursuant to the complete termination of a shareholder’s interest rules or the termination of S corporation election rules, as applicable. 4. D. Tension Between Planning Opportunity and Unexpected Results. 1. Planning Opportunity. The ability to elect or refrain from electing to close the books sometimes presents taxpayers with tax planning opportunities, particularly in the family context. For example, a parent completely terminating his or her interest in an S corporation may not object to a pro Portlnd1-2117140.3 0099870- 00001 15 rata allocation of income that is higher to him or her than it would be under the closing of the books method if the only other shareholder is his or her daughter. 2. Potential for Unexpected Results. Nevertheless, the potential for unfavorable--and often unexpected--consequences is also present. For example, a shareholder who sells all of his or her stock early in a taxable year may find that, absent an election to close the books, the amount of the corporation’s income that passes through to him or her on a pro rata basis is much higher than he or she anticipated. This result can arise simply as a result of increased profitability during the later part of the year. The result is perhaps even more likely to occur if, after the sale, the corporation acquires additional income-producing assets (by capital contribution from shareholders, for example) or the corporation sells substantial assets. The reverse will apply if the income is less than anticipated. If, for example, the corporation suffers an unexpected loss after the stock sale, the income passed through to the selling shareholder could be reduced or eliminated. Advance Agreement to Close Books. Because of this potential for substantial swings in taxable income, shareholder agreement drafters should consider including a provision that the corporation agrees to make, and all the shareholders agree to consent to, any available closing of the books election. Alternatively, because the second class of stock rules generally allow distributions that are made on the basis of shareholders’ varying interests in the S corporation’s income in the current or immediately preceding taxable year, the agreement may be able to address the disparities arising from pro rata allocations by using pro rata passthrough income and loss as the basis for determining varying interests. 3. VI. Tax Consequences of Stock Purchases. A. Cross-Purchase. Because the source of funds for a cross-purchase form of stock purchase does not come from the corporation, the income tax consequences are often less complex and problematic than the consequences encountered in the redemption form of purchase. As the number of purchasing shareholders increases, the complexity of the cross-purchase form often increases and the feasibility often decreases, sometimes exponentially. 1. Consequences to the Seller. a. Capital gain. Stock in an S corporation is generally held as a capital asset, so except in rare cases (e.g., if the shareholder is a dealer in stock), any gain recognized in connection with the sale will be capital gain. Favorable long-term capital gain rates will apply if the seller has held the stock for more than one year. IRC §§ 1222, 1(h). Portlnd1-2117140.3 0099870- 00001 16 b. Installment sale treatment. Because the sale of stock to another shareholder will normally qualify as a sale or exchange (rather than a dividend), the installment sale rules will be available if the purchase price for the stock is paid over time. See IRC § 453. Stock basis. As with stock in a C corporation, a shareholder’s basis in stock of an S corporation generally equals the amount paid for the stock, increased by the amount of cash and adjusted basis of property contributed to the corporation. See IRC §§ 1012, 358(a). Basis is generally increased by the amount of income and gain that passes through to the shareholder and is generally decreased by the amount of loss and deduction that passes through to the shareholder and by the amount of distributions made to the shareholder. See IRC §1367(a). If an S corporation shareholder disposes of stock during a taxable year, the basis adjustments with respect to the stock are effective immediately before the disposition. Treas Reg § 1.1367-1(d). The basis in the hands of a person acquiring S corporation stock from a decedent or to whom the property passed from a decedent generally equals the fair market value of the stock on the date of death. IRC § 1014(a). That basis is reduced, however, by the portion of the value of the stock attributable to items constituting income in respect of a decedent. See IRC §§ 1367(b)(4), 691. c. 2. Consequences to the Buyer. a. Outside basis. A principal advantage to the buyer of corporate stock in a cross purchase arrangement is that the buyer receives a purchase price basis in the purchased stock. Obtaining basis in the stock as a result of a purchase can be favorable because a higher basis will generally reduce the gain (or increase the loss) realized upon ultimate disposition of the stock. Moreover, in the case of an S corporation, the additional basis may allow the purchasing shareholder to utilize losses that otherwise might not be allowed as a result of insufficient basis in the stock. In certain circumstances, the acquisition of additional basis might even allow recognition of losses previously suspended due to insufficient basis in stock and debt. See IRC §1366(d). No inside basis adjustment. Despite many similarities in the taxation of partnerships and S corporations, the buyer is not able to adjust his or her allocable portion of the corporation’s inside basis in its assets to correspond with the buying shareholder’s outside basis in the purchased stock. See IRC §§ 754, 743(b). This inability to “step up” the inside basis of the S corporation’s assets is a major disadvantage of subchapter S relative to subchapter K. b. Portlnd1-2117140.3 0099870- 00001 17 3. Consequences to the Corporation. a. Earnings and profits; accumulated adjustments account. The cross-purchase does not result in a change to the corporation’s accumulated earnings and profits or accumulated adjustments account (“AAA”). Thus, unlike the consequences that often apply under the redemption form of purchase, those amounts continue unchanged in a cross-purchase. See Part VI.B.5.b, infra. Sufficient surplus. Because the cross-purchase form of purchase does not involve a distribution of corporate funds, the question of whether the corporation has sufficient surplus to effect a redemption distribution is generally not applicable. See ORS 60.181. b. B. Redemption. The tax considerations applicable in a redemption form of stock purchase are considerably more complex for both parties. A good deal of that complexity arises due to the interaction between two sets of rules: (1) the exchange vs. distribution rules of IRC §§ 302, 303, and 301 and (2) the S corporation distributions rules of IRC § 1368. 1. Section 302(b) or Section 303 Exchange vs. Section 301(a) Distribution. If a corporation redeems its stock in a transaction described in IRC § 302(b), the redemption will be treated as a distribution in part or full payment in exchange for the stock. IRC § 302(a). A similar rule applies in the case of certain redemptions of stock of a decedent. See IRC § 303. A distribution will be treated as a sale or exchange subject to IRC § 302(a) if one of the following four circumstances applies: a. Not essentially equivalent to a dividend. Whether a redemption is “not essentially equivalent to a dividend” depends on all the facts and circumstances surrounding the redemption. Usually, a redemption will not meet the requirements of IRC § 302(b)(1) unless the shareholder’s right to control the corporation’s affairs is materially reduced. Given the subjective nature of the inquiry, IRC § 302(b)(1) rarely provides certainty of exchange treatment. Substantially disproportionate. A redemption of stock from a shareholder will be “substantially disproportionate” if (1) the shareholder owns less than 50 percent of the corporation’s voting stock immediately after the redemption and (2) the shareholder’s ownership percentage in the corporation immediately after the redemption is less than 80 percent of the shareholder’s ownership percentage in the corporation immediately before the redemption. IRC § 302(b)(2). The 80 percent test must be satisfied with respect to the shareholder’s percentage ownership of both the b. Portlnd1-2117140.3 0099870- 00001 18 corporation’s voting stock and the corporation’s common stock (whether voting or nonvoting). Id. c. Termination of entire interest. IRC § 302(b)(3) applies if the redemption is in complete redemption of all the stock of the corporation owned by the shareholder. Partial liquidation. IRC § 302(b)(4) applies to redemptions of stock held by noncorporate shareholders in partial liquidation of the distributing corporation. d. 2. Attribution Rules. For purposes of determining a shareholder’s ownership interest, the attribution rules of IRC § 318 apply. See IRC § 302(c)(1). These rules are designed to prevent taxpayers from circumventing dividend treatment by structuring redemption transactions that, while technically qualifying for exchange treatment, are the economic equivalent of a dividend. For example, a shareholder generally is treated, both before and after the redemption, as owning stock owned by his or her spouse, children, grandchildren, and parents. IRC § 318(a)(1). Special attribution rules apply in the case of a complete termination of interest under IRC § 302(b)(3). See IRC § 302(c)(2). Section 1368 Distribution Rules. The tax treatment accorded distributions from an S corporation to its shareholders with respect to stock that are not treated as payment in exchange for the stock is governed by IRC § 1368. Under that section, the tax consequences of the distribution are determined principally by three factors: (1) the presence or absence of accumulated earnings and profits for a corporation with a C corporation history, (2) the balance of the S corporation’s AAA, and (3) the shareholder’s adjusted basis in his or her S corporation stock. a. S corporations without accumulated earnings and profits. For S corporations without accumulated earnings and profits, a distribution to a shareholder is tax-free to the shareholder to the extent of the shareholder’s stock basis. IRC § 1368(b)(1). Any excess is treated as gain from the sale or exchange of property. IRC § 1368(b)(2). S corporations with accumulated earnings and profits. (i) AAA. Broadly speaking, a corporation’s AAA tracks the amount of the corporation’s previously taxed but undistributed income. Its principal function is to allow an S corporation with accumulated earnings and profits to distribute to shareholders, tax-free, earnings on which the shareholders have already been taxed. It is an account of 3. b. Portlnd1-2117140.3 0099870- 00001 19 the S corporation and is not apportioned among shareholders. Treas Reg § 1.1368-2(a)(1). (ii) Treatment of current distributions. If an S corporation has accumulated earnings and profits, distributions to shareholders are governed by a five-tier system: (a) First, the portion of the distribution that does not exceed the corporation’s AAA is tax-free to the shareholders to the extent it does not exceed the shareholder’s stock basis. IRC §§ 1368(c)(1), 1368(b)(1). Second, to the extent the distribution does not exceed the AAA but does exceed the shareholder’s stock basis, the excess over the basis is treated as gain from the sale or exchange of property. IRC §§ 1368(c)(1), 1368(b)(2). Third, the amount by which the distribution exceeds the S corporation’s AAA balance is treated as a dividend to the extent of the S corporation’s accumulated earnings and profits. IRC § 1368(c)(1). Fourth, if the distribution exceeds both the AAA and the accumulated earnings and profits, the excess is tax-free to the shareholder in an amount up to the shareholder’s remaining stock basis. IRC §§ 1368(c)(3), 1368(b)(1). Fifth, if the amount of the distribution exceeds all four of the preceding tiers, the shareholder’s stock basis has necessarily been reduced to zero and any excess of that amount is treated as gain from the sale or exchange of property. IRC §§ 1368(c)(3), 1368(b)(2). (b) (c) (d) (e) 4. Consequences to Redeemed Shareholder. a. Distributions qualifying for exchange treatment. If a distribution in redemption of stock qualifies for exchange treatment under IRC § 302(b) or 303, the shareholder receiving the distribution generally recognizes capital gain in an amount equal to the excess of the amount received in the distribution over the shareholder’s adjusted basis in the shares redeemed. IRC §§ 1371(a), 302(a), 303(a), 1001(a). Portlnd1-2117140.3 0099870- 00001 20 b. Distributions not qualifying for exchange treatment. (i) Adequate AAA. If a redemption does not qualify as an exchange under IRC § 302(b) or 303, the tax effects of the distribution are determined under normal S corporation current distribution rules described above. Under those rules, the redeeming shareholder will not recognize gain so long as the redemption payments do not exceed the corporation’s AAA and the shareholder’s aggregate basis in his or her S corporation stock. To the extent the distribution exceeds the shareholder’s basis but does not exceed the corporation’s AAA, the distribution results in gain from the sale or exchange of property. Thus, from the shareholder’s perspective, provided the corporation has a sufficient AAA to cover the entire distribution, the tax consequences of a distribution qualifying for exchange treatment can be essentially identical to tax consequences of a distribution not qualifying for exchange treatment. Distribution in excess of AAA. (a) If the corporation does not have accumulated earnings and profits, then the consequences of not qualifying for exchange treatment can be largely irrelevant. Absent accumulated earnings and profits, no portion of the distribution will be a dividend and the general IRC § 1368(b) distribution rules (i.e., tax-free recovery of basis followed by gain from the sale of exchange of property) will apply. If the corporation has accumulated earnings and profits, failure to qualify for exchange treatment is likely to have adverse consequences to the shareholder. The portion in excess of the corporation’s AAA will be a dividend to the redeeming shareholder, not to exceed the amount of the accumulated earnings and profits. (ii) (b) (iii) Installment sale treatment. An important consequence of failure to qualify for exchange treatment under IRC § 302(b) or 303 is the inability to qualify for installment sale treatment. See, e.g., Coates Trust v. Commissioner, 55 TC 501 (1970), acq 1972-2 CB 1, aff’d 480 F2d 468 (9th Cir 1973), cert den 414 US 1045 (1974). Portlnd1-2117140.3 0099870- 00001 21 5. Consequences to Redeeming Corporation and Other Shareholders. a. Distributions qualifying for exchange treatment. If a redemption is treated as an exchange, the corporation’s AAA and accumulated earnings and profits will be decreased in proportion to the number of shares redeemed relative to the total number of shares outstanding. See IRC §§ 1368(e)(1)(B), 312(n)(7); Treas Reg § 1.1368-2(d)(ii). Distributions not qualifying for exchange treatment. If a redemption is not treated as an exchange, the distribution will reduce the corporation’s AAA on a dollar-for-dollar basis. Treas Reg § 1.1368-2(a)(3)(iii); Rev Rul 95-14, 1995-1 CB 169. b. C. Hybrid. Many shareholder agreements combine the cross-purchase and redemption forms. 1. First Offer to Corporation; Second Offer to Shareholders. Shareholders agreements often provide that the corporation has the right to buy shares upon a triggering event and, if the corporation does not elect to purchase the shares, the shareholders will have the right to purchase. The purchase rights are typically held proportionately by the other shareholders. This right can be particularly important when the corporation does not have adequate surplus to legally consummate the redemption. Obligation of Shareholders; Purchase by Corporation. Note the potential for dividend treatment if a shareholder has the obligation to purchase shares under a cross-purchase or hybrid agreement but the shares are actually purchased by the corporation. See Rev Rul 69-608, 1969-2 CB 42; Schroeder v. Commissioner, 831 F2d 856 (9th Cir 1987). 2. D. Special Considerations. 1. Corporate Distribution of Property Other Than Money. a. Gain but not loss under section 311(b). In general, no gain or loss is recognized by an S corporation when it distributes money to its shareholders. As with a C corporation, however, gain (but not loss) is recognized by the S corporation on a distribution of appreciated property. IRC §§ 1371(a), 311(b). In accordance with general pass-through rules for recognition of income by S corporations, gain attributable to the distribution of appreciated property is passed through to the corporation’s shareholders. IRC § 1366. Disadvantage of distribution of loss property. Since no loss is recognized by a corporation on a nonliquidating distribution of property, no loss passes through to an S corporation’s shareholders 22 b. Portlnd1-2117140.3 0099870- 00001 as a result of a distribution of property in which the corporation has a basis higher than fair market value. IRC § 311(a). Furthermore, because a shareholder takes a basis in the distributed property equal to the fair market value of the property (resulting in a stepdown), IRC § 301(d), no immediate benefit is received from the distribution. In such circumstances it may be beneficial to have the S corporation sell the property to a third party so as to pass through the loss to its shareholders. 2. Use of life insurance to fund acquisition. a. Treatment of proceeds. Life insurance proceeds are generally excluded from the income of the recipient. IRC § 101(a). In the case of C corporations, however, death benefits under a life insurance contract may be subject to the alternative minimum tax (“AMT”). See IRC §§ 55, 56(g). S corporations, on the other hand, are not subject to AMT. See IRC § 1363(a). Thus, an S corporation can receive the proceeds of a corporate-owned policy without adverse AMT consequences. Increase in basis. Tax-exempt income, including life insurance proceeds, generally passes through to the corporation’s shareholders and serves to increase stock basis. IRC § 1367(a)(1); Treas Reg § 1.1366-1(a)(2)(viii). Two problems can arise in connection with the basis increase. First, because of transfers in ownership during the year in which insurance proceeds are taken into income, the tax-exempt life insurance income may not be allocated among the shareholders as might be expected. See Part V, supra. Second, an allocation of insurance proceeds income to a particular shareholder might lead to unexpected results. For example, insurance proceeds income might pass through to the decedent’s estate, further increasing basis that has already been increased to fair market value on the date of death under IRC § 1014. Effect on AAA. Although excluded life insurance proceeds income passes through to shareholders and increases basis, it does not increase the corporation’s AAA. IRC § 1368(e)(1)(A). The mismatch between basis and AAA can cause problems for corporations with accumulated earnings and profits, particularly if the insurance proceeds are to be used in a redemption that does not qualify for exchange treatment under IRC § 302(b) or 303. b. c. VII. Special Considerations for Stock Issued to Service Providers. A. Section 83 Considerations. Portlnd1-2117140.3 0099870- 00001 23 1. Section 83. IRC § 83 generally provides that if property is transferred in connection with the performance of services, the person who performed the services must include in income the excess of (1) the fair market value of the property (determined without regard to any nonlapse restriction) at the time the property is first transferable or not subject to a substantial risk of forfeiture over (2) the amount, if any, paid for the property. IRC § 83(a). Regulations define property that is subject to a substantial risk of forfeiture and nontransferable as being “substantially nonvested.” See Treas Reg § 1.83-3(b). The person performing the services can elect to include in income the fair market value of the property (determined without regard to any nonlapse restriction) at the time of transfer, over the amount, if any, paid for the property. IRC § 83(b). If such an election is made, IRC § 83(a) will not apply with respect to the transfer. IRC § 83(b)(1). Treatment of Nonvested Stock of S Corporation. Stock of an S corporation that is issued in connection with the performance of services and that is substantially nonvested is not treated as outstanding for purposes of subchapter S, and the holder of the stock is not treated as a shareholder solely by reason of holding the stock, unless the holder makes an election under IRC § 83(b). Treas Reg § 1.1361-1(b)(3); see also Treas Reg § 1.83-1(a)(1). As a result, a person who holds substantially nonvested stock (and no other stock) (1) should not have to consent to the corporation’s S election, (2) should be able to be a person not eligible to be an S shareholder, such as a nonresident alien, without affecting the corporation’s S election or S corporation status, (3) should not count toward the 75-shareholder limit, and (4) should not receive any allocation of income or loss under the S corporation pass-through provisions. In addition, substantially nonvested stock should not count as a second class of stock, even if the stock is entitled to distribution and liquidation rights that differ from those of other outstanding stock of the corporation. See Treas Reg § 1.1361-1(l)(3). Effect of Section 83(b) Election. If the holder of substantially nonvested stock makes an election under IRC § 83(b), the stock will be treated as outstanding and the holder will be treated as a shareholder for S corporation purposes. Treas Reg § 1.1361-1(b)(3). If stock subject to an IRC § 83(b) election is held by an ineligible shareholder, the corporation will lose its S corporation status (subject to any available inadvertent-termination relief). Similarly, if such restricted stock carries rights to distribution and liquidation proceeds different from those of outstanding unrestricted stock, such as the absence of the right to receive dividends during the restriction period, the one class of stock limitation would be violated and S corporation status would be lost (again, subject to inadvertent-termination relief). 2. 3. Portlnd1-2117140.3 0099870- 00001 24 4. State Law Treatment. Under state law, by contrast, a person who holds substantially nonvested stock will be treated as a shareholder. Thus, if dividends are declared on the stock, the restricted shareholder will be entitled to dividend distributions. For federal income tax purposes, state law dividends on substantially nonvested stock will be treated as additional compensation. See Treas Reg § 1.83-1(a)(1). B. Alternatives to Issuing Stock to Service Providers. 1. Phantom Stock, Stock Appreciation Right, or Sale Bonus Agreements. a. Deferred compensation generally. For S corporation purposes, an arrangement under a deferred compensation plan generally does not constitute outstanding stock. Specifically, an instrument, obligation, or arrangement is not outstanding stock if it (1) does not convey the right to vote, (2) is an unfunded and unsecured promise to pay money or property in the future, (3) is issued to an individual who is an employee in connection with the performance of services for the corporation or to an individual who is an independent contractor in connection with the performance of services for the corporation (and is not excessive by reference to the services performed), and (4) is issued pursuant to a plan with respect to which the employee or independent contractor is not currently taxed on income. Treas Reg § 1.1361-1(b)(4). Current payment feature. A deferred compensation plan will not be excluded from the foregoing description merely because it has a current payment feature (for example, payment of dividend equivalent amounts that are currently taxed as compensation). Id. Effect of plan. A person who holds phantom stock or a stock appreciation right or who is entitled to a bonus upon the sale of all or substantially all of the corporation’s business (and who holds no other stock) generally (1) should not need to consent to the corporation’s S election, (2) should be able to be a person not eligible to be an S shareholder, such as a nonresident alien, without affecting the corporation’s S election or S corporation status, (3) should not count toward the 75-shareholder limit, and (4) should not receive any allocation of pass-through income or loss under the S corporation provisions. b. c. 2. Deduction Issues. Note the potential for increased tax liability to the service provider because all the income is taxed to him or her as compensation upon vesting or payment. Often the overall tax consequences to the parties are offset to a great extent by the availability of a compensation deduction to the corporation. Sometimes the service provider, now as a shareholder, may be able to realize a significant portion Portlnd1-2117140.3 0099870- 00001 25 of the pass-through benefits of the deduction. Timing is important, however. If the deduction arises in connection with a sale of all or substantially all of the corporation’s business, the absence of a substantial amount of ordinary income in the year of sale may result in the deduction effectively offsetting capital gain, thus reducing the value of the deduction. Portlnd1-2117140.3 0099870- 00001 26