7780 / What is the requirement that an S corporation have only one class of stock and how is it met?

Editor’s Note: Many violations of the one class of stock rule are inadvertent. The IRS has recently issued relief for S corporations to avoid termination of an S election for certain inadvertent violations without having to request a private letter ruling. Much of this relief deals with violations of the one class of stock rule. Under Revenue Procedure 2022-19, the IRS clarifies that in situations involving execution of buy-sell agreements, agreements restricting the transferability of stock or redemption agreements, the S election will not be invalid if the agreement did not have the principal purpose of circumventing the one class of stock rule. The IRS also provides that if the taxpayer identifies and fixes non-identical governing provisions before they are identified by the IRS, the S election will not be void due to violations of the one class of stock rule. The guidance also eliminates the risk that disproportionate distributions will violate the one class of stock rule if the governing documents provide identical rights to distributions and liquidation proceeds.

A corporation will be treated as having one class of stock if all of its outstanding shares confer identical rights to distribution and liquidation proceeds.¹ “Bona fide agreements to redeem or purchase stock at the time of death, disability or termination of employment” will be disregarded for purposes of the one-class rule unless a principal purpose of the arrangement is to circumvent the rule. Similarly, bona fide buy-sell agreements will be disregarded unless a principal purpose of the arrangement is to circumvent the one-class rule and they establish a purchase price that is not substantially above or below the fair market value of the stock. The IRS confirmed that this was the case, so that a buy-sell agreement could be disregarded, even when an equity compensation plan was involved that called for a forfeiture price for shares that could have been as low as $0.²

Agreements that provide for a purchase price or redemption of stock at book value or a price between book value and fair market value will not be considered to establish a price that is substantially above or below fair market value.³ Regulations provide that agreements triggered by divorce and forfeiture provisions that cause a share of stock to be substantially nonvested will be disregarded in determining whether a corporation’s shares confer identical rights to distribution and liquidation proceeds.⁴