An S corporation must be a small business corporation, which can have only one class of stock. If an S corporation issues a second class of stock, it ceases to meet the definition of a small business corporation, and its S corporation status is automatically terminated triggering significant adverse tax ramifications for its owners.  A corporation that has issued only one class of stock may conduct its business or enter into agreements that treat certain shareholders or creditors in a manner that causes the company’s actions/agreements to be considered a second class of stock.

The one-class-of-stock rule prevents the corporation from having the complexity related to  allocating earnings to multiple classes of owners.  A corporation has only one class of stock if all outstanding shares provide for identical rights to stockholders regarding distribution and liquidation proceeds.  However, differences in voting rights among shares of stock of a corporation do not automatically indicate that there is more than one class of stock.

A corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.  Relevant to a determination of whether all outstanding shares of stock are of the same class requires that the stock confer identical rights to distribution and liquidation proceeds (versus voting rights) and is based on the terms of the articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds.

An Interesting Case.

A shareholder used the second-class-of-stock rule in a court case when the shareholder’s parents had a janitorial and paper-supply company that elected S status.  As the shareholder’s parents aged, the shareholder and her brother took control of the company, each owning half of the stock.  The corporation retained most of its earnings, but did distribute enough dividends to enable shareholders to pay their personal income tax on their shares of corporate income.  The corporation suddenly stopped making the tax-payment dividends, leaving the shareholder with substantial income tax liabilities and no company distributions to cover the taxes. The shareholder knew this was part of an effort by the father and brother to squeeze the shareholder  out of the business.

As a stockholder, the shareholder took a very unusual position: that the S election had been lost, and the tax on corporate earnings be imposed on the corporation rather than on the shareholders. According to the shareholder, certain extra payments made to the parents from the S corporation indicated that the parents had preference as to dividends.  This preference meant there was a second class of stock.  If the shareholder won, then the S election had been lost and no taxes would be owed.
The court found little evidence on which to base a conclusion regarding the nature of the extra corporate payments to the parents. The shareholder was unable to meet the burden of proof needed to show that there was a second class of stock and was liable for the income taxes.  Too bad for the shareholder, but an interesting legal argument since shareholders rarely try to terminate an S election as they usually fight to maintain it.

Situations that create a second class of stock.

1.  S Corporation has a binding agreement with its shareholders to modify its normal distribution policy by making upward adjustments of its distributions to those shareholders who bear heavier state tax burdens. The adjustments are based on a formula that will give the shareholders equal after-tax (i.e. after state tax) distributions. The agreement relates to distribution or liquidation proceeds and is a governing provision that alters the rights conferred by the outstanding stock of S to distribution proceeds therefore, those rights are not identical thereby treating the company as having more than one class of stock.

2. Interest on debt is paid only if the corporation has earnings, or is interest payments are tied in some way to dividend policy. The corporation may be treated as having more than one class of stock.

Cases that typically do not create a second class of stock.

The IRS regulations list the following situations that do not involve a second class of stock.   Caution is advised, because the result may be different if the circumstances indicate there is an attempt to avoid the one-class-of-stock requirement, etc. When in doubt seek appropriate counsel.

1. Straight Debt. Debt is not treated as a second class of stock if: it is 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; it 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; It is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation; it is held by an individual (other than a nonresident alien), an estate, or certain trusts.

2. Debt held proportionately. Obligations of the same class that are considered equity under general principles of federal tax law, but are owned solely by the owners of, and in the same proportion as, the outstanding stock of the corporation, are not treated as a second class of stock.

3. Buy-sell agreements. Agreements among shareholders restricting the transferability of stock, are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation.

4. Redemption Agreements. Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation’s shares of stock confer identical rights.

5. Fringe Benefits. S Corporation is required under binding agreements to pay accident and health insurance premiums on behalf of certain of its employees who are also shareholders. Different premium amounts are paid by S Corporation for each employee-shareholder. S Corporation is not treated as having more than one class of stock.

6. Employment Agreements. A and B are shareholders of S Corporation. A is also an employee of the company. By agreement, the company will redeem A’s shares on the termination of employment. The agreement is disregarded in determining whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds.

7. Change in Stock Ownership. An S corporation governing instrument provides that the amount of distribution will be adjusted to take into account the fact that a stockholder owned stock for less than the full year. The corporation is not treated as having more than one class of stock.

Voting Rights

The Subchapter S Revision Act of 1982 added the flexibility of allowing a company to issue voting and non-voting stock without running afoul of the one-class-of-stock requirement. Voting stock may be given to those family members who are most qualified to run the business, with non-voting stock given to other family members. However, the stock must have the same rights to distributions, or the S election will be lost.

Given the impact that losing an S election can have on a company and its shareholders, one is well advised to seek counsel before undertaking matters that could cause the loss of the election.

In response to corporate abuses at Enron, Tyco and other companies, militant shareholders in both public and private companies are increasingly trying to hold management and directors accountable for their actions (not a bad thing at all).  The bottom line of any of this type of activism is that directors and officers are held to elevated expectations and greater scrutiny of their performance.

In making decisions on behalf of the company, directors (and officers) are held to two duties: one of care and the other of loyalty.  If directors and/or officers comply with these duties, the decision is protected by “the business judgment rule,” a standard of court review where courts will defer to a decision unless there is palpable evidence that the parties have ignored or breached their duty of care or loyalty.  Directors may also breach their duty of oversight by failing to make a decision at all; that is, by not acting to hold management accountable for their actions.

Key board decisions, such as whether to sell the company or issue or redeem stock present the possibility that the board may not be acting in the best interests of the shareholders but instead to entrench itself in power.  The Delaware Courts sent a message in In re The Walt Disney Co. Derivative Litigation case by not dismissing claims that the board members were grossly negligent in approving key executive compensation agreements.  While the directors were eventually exonerated the series of decisions in the Disney litigation highlighted the importance of corporate minutes.

The Necessity of Maintaining Accurate Minutes

Corporations are required by law to keep accurate books and records, and specifically to prepare and maintain minutes recording the proceedings of any meetings of directors and shareholders.  Regularly maintaining corporate minutes is also a key component of observing corporate formalities, which is essential to recognition of the corporate form.  Failure to observe these formalities can result in creditors “piercing the corporate veil” and imposing liability on the shareholders for corporate obligations.

Minutes are prepared not just for internal use but also for review by third parties such as shareholders.  In addition to shareholders, those who may seek to review corporate minutes include underwriters in connection with due diligence reviews for capital raising transactions and buy-side counsel in connection with sale, merger or acquisition.

In re NetSmart Technologies, Inc. Shareholders Litigation is a poster child for poor minutes preparation practices in connection with a critical decision such as the sale of the company.  The case illustrates how courts focus on relevant minutes to determine whether the board complied with the heightened standards that apply to significant corporate transactions, such as a merger, the need for consistency between the minutes and the disclosure documents describing background events in such transactions, and the importance of preparing and approving minutes promptly (and properly) while events are still fresh in the minds of the directors who were present.

Responding to overtures from private equity buyers, the NetSmart board formed a special committee to oversee a rapid auction process among identified private equity bidders that led to execution of a cash merger agreement with the winning bidder.  Shareholders complained that the agreement was the result of a defective sales process because it excluded strategic buyers and that the proxy statement omitted material information.  The Court noted that once the board determined to sell the company for cash, it had a duty under Revlon to secure the highest price realistically achievable given the market for the company.  Concluding that the plaintiff’s had established a reasonable probability of success on the merits of two of their claims that the board had failed this standard, and the court preliminarily enjoined the shareholder vote on the merger to provide time for the defendants to amend the proxy statement to respond to the plaintiff’s disclosure claims.

The court was highly critical of the company’s minute-taking practices.  It pointed to a May 19 meeting, described in the proxy statement as an informal board meeting because no minutes were taken, where a determination was made to attempt to sell the company and to focus on private equity buyers without an active canvass of strategic buyers.  The court noted that no minutes were taken at a July 13 meeting to consider an acquisition proposal, also referenced in the proxy statement, held by a special committee created by the board.  Thus, if the board had, in fact, considered carefully and rejected the option of opening the sale process to strategic bidders, the absence of minutes clearly recording such deliberations greatly impaired the directors’ ability to make that argument.

As you can see properly drafted minutes are an important part of owning or running a corporation and should not be dismissed as merely a lawyer’s fetish.  Ask yourself a question; are the potential consequences of failing to keep accurate, well drafted minutes worth taking a chance on?  Would you bet your company on it?

The next form is a “limited liability company.  An LLC is an entity separate from its owners, so ownership can involve one, two or more owners. As a separate entity, the LLC (not its owners) is responsible for the liabilities of the business.  If the business fails you may lose your investment, but your assets are not at risk. Corporations are the oldest form of business entity and as a result, people are generally at ease with a corporation.

Corporations provide the strongest protection against personal liability but may or may not have the same tax advantages of an LLC.   An “S-Corp.” is made for small business and can’t have more than 100 shareholders; however, it does feature pass-through tax treatment like an LLC.   A “C” corporation has a big disadvantage for start-ups; that is, that the income or loss of a C corporation only taxable to the corporation and does not pass through to shareholders.  Shareholders cannot use start-up or other losses to against income received by sources other than the corporation.  Neither an LLC nor a corporation is the best choice for all businesses.

The form of entity that is appropriate for your business will depend upon your situation.   One would be well advised to seek counsel before starting up a company because the tax and legal ramifications of the choice are significant.