Affiliated Groups and Subsidiaries of S corporation

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One Class of Stock

An S corporation may (Quote from Quizlet) have only one class of stock. One class of stock means that the outstanding shares of the corporation must be identical as to the rights of the holders in the profits and the assets of the corporation.

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Note: Authorized but un-issued stock and treasury stock are not considered in determining if a corporation has more than one class of stock. Nor is special stock issued to the Federal Housing Administration considered when making this determination.

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However, a stock may have differences in voting rights and still be considered one class of stock. For example, 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 concerning rights to choose members of the board of directors.

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Recently issued final regulations emphasize that the one class of stock requirement is not to be taken lightly. The new one-class-of-stock regulations apply to corporate tax years beginning after May 27, 1992. Under these regulations, the determination of whether the stock has identical rights to distribution and liquidation proceeds is made based on the governing provisions of the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds.

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The regulations adopt some important positions:

1. A commercial contractual agreement, such as a lease or loan agreement is not a binding agreement relating to distribution and liquidation proceeds, and thus(Quoted from IRS), not a governing provision unless a principal purpose of the agreement is to get around this one-class-of-stock provision.

2. State laws may require a corporation to pay or withhold state income taxes on behalf of some or all of the corporation’s shareholders. These laws are disregarded in finding whether all outstanding shares have identical rights to distribution and liquidation proceeds if, when the constructive distributions resulting from the payment or withholding of taxes by the corporation are taken into account, the shares have identical rights.

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3. Bona fide agreements to redeem or purchase the stock at the time of death, divorce, disability, or termination of employment are disregarded for the one-class-of-stock rules. Also disregarded are buy-sell agreements, redemption agreements, and agreements restricting the transferability of stock unless:

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An agreements restricting the transferability of stock unless:

(a) The main reason for the agreement is to get around the one-class-of-stock rules, and

(b) The agreement establishes a purchase price that, at the time of the agreement, is significantly above or less than the correct market value of the stock.

a) A principal purpose of the agreement is to get around the one-

class-of-stock rules, and

(b) The agreement establishes a purchase price that, at the time of the deal is significantly above or less than the market value of the stock.

4. Debt obligations of a corporation that are contributions of equity capital may be treated as a second class of stock. However, an instrument or obligation that is straight debt is not treated as a second class of stock. The term “straight debt” means any written unconditional promise to pay a fixed amount on-demand or a specified date if:

(a) The interest rate and interest payment dates are not contingent on benefit, the borrower’s discretion, or similar factors,

(b) The debt cannot be converted directly or indirectly into stock, and

(c) The creditor is an individual (other than a nonresident alien), an estate, or a trust eligible to hold stock in an S corporation. (Quotes from IRS)

Note: An obligation that is subordinated (placed in a lower position) to other debt of the corporation does not prevent the obligation from qualifying as straight debt.

An obligation that originally qualifies as straight debt ceases to qualify if:

(a) The obligation is materially modified so that it no longer satisfies the definition of straight debt, or

(b) It is transferred to a third party who is not an eligible shareholder in the S corporation.

5. An instrument, obligation, or another arrangement, regardless of whether it is called debt, is treated as a second class of stock if:

(a) It is permanent equity or otherwise results in the holder being the owner of stock under federal tax law principles, and

(b) A principal purpose of the transaction is to get around the one-class-of-stock rules or the limitations on eligible shareholders.

6. A call option, warrant, or similar instrument is treated as a second class of stock if, taking into account all facts and circumstances:

(a) It is substantially certain to be executed, and

(b) It has a strike price substantially minor to the fair market value of the underlying stock on the date the call option is issued.

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7. A stock that is issued in connection with the performance of services, and that is substantially non-invested, is not treated as outstanding stock. The holder of that stock is not treated as a shareholder unless he or she makes an election to include in income the fair market value of the stock at the time of the transfer minus the amount paid for the stock.

Whether that non-vested stock is treated as a second class of stock depends on the facts and circumstances.

8. An instrument, obligation, or arrangement is not treated as outstanding stock if it:

(a) Does not convey the right to vote,

(b) Is an unfunded and unsecured promise to pay money or property in the future,

(c) Is issued to an employee or independent contractor in connection with the performance of services for the corporation, (Quotes from Bradford tax institute)

(d) Is issued under a plan under which the employee or independent contractor is not taxed currently on income.

Affiliated Groups & Subsidiaries   Affiliated Group Investopedia 

Prior to Law

Before December 31, 1996, an S corporation could not be a member of an affiliated group (i.e., it could not own 80% or more of the stock of another corporation). It could only own such stock if the other corporation had not begun a business and had no gross income at any time during the taxable year of the S corporation (old §§1361(b)(2)(A), (c)(6)). However, an S corporation could own less than 80% of another corporation, thereby allowing it to retain investments in multiple businesses. There are no attribution rules under §1504. Thus, an S corporation could own 79% of another corporation, and the S corporation shareholders could own the other 21%. An S corporation could also be a partner in a partnership.

Note: An affiliated group is not the same as a controlled group. An S corporation can be part of a controlled group where its shareholders own the majority interest of other corporations creating an allowable brother-sister control group under §1563(a).

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Current Law

Effective for the years beginning after December 31, 1996, an S corporation is allowed to own 80% or more of the stock in a C corporation. However, while a C corporation subsidiary can elect to join in the filing of a consolidated return with its affiliated C corporation, an S corporation may not join in such an election.

Note: Dividends received by an S corporation from a C corporation in which the S corporation has an 80% or greater ownership is not passive investment income for purposes of §1362 and §1375 to the extent such dividends are. Attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business (IRS).9-13

 

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