17 Dec How to Preserve an S election while using Convertible Debt
Convertible Debt in an S Corporation
Because S corporations cannot issue preferred stock, they will often give investors convertible debt that attempts to mimic the preferences they might obtain through preferred stock. However, unless carefully structured, the issuance of convertible debt may terminate a corporation’s S election.
An S corporation may only issue one class of stock. Treasury Regulations Section (Regs. §) 1.1361-1(b)(1)(iv). In general, an instrument violates the “one class of stock” rule if it “constitutes equity or otherwise results in the holder being treated as the owner of stock under general principles of Federal tax law; and . . . 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”. Regs. §1.1361-1(l)(4)(iv) (referring to Regs. §1.1361-1(l)(4)(ii)).
Under a regulatory safe harbor, a call option is not considered a second class of stock unless (i) taking into account all the facts and circumstances the call option is substantially certain to be exercised, and (ii) the stock has a strike price substantially below (less than 90% of) its fair market value. Regs. §1.1361-1(l)(4)(iii). An option must pass the above test when the option is used, if and when it is transferred to a non-eligible shareholder, and if and when it is materially modified. Regs. §1.1361-1(l)(4)(iii)(A)–(C). Convertible debt and other convertible securities such as warrants and options are eligible for the call option safe harbor. See Regs. § 1.1361-1(l)(4)(iv)(B) (referring to Regs. §1.1361-1(l)(4)(iii)). See PLR 201119017 (May 31, 2011); see also PLR 201115016 (Apr. 15, 2011); PLR 201126023 (July 1, 2011) (IRS treatment of convertible securities under the call option safe harbor).
To meet the safe harbor, convertibles should contain a strike price in excess of 90% of the stock’s fair market value at the date of issuance to meet the safe harbor. Valuations and appraisals are prudent to support the analysis. Outside of the safe harbor, the IRS would scrutinize the convertible securities’ features to determine whether it is equity under principles of tax law. The safest course is to specify sufficient strike price. As stated above, the strike price valuation must be tested when the convertible securities are issued, if and when they are negotiated to a non-eligible shareholder, and if and when they are materially modified.
Taxpayers dealing in convertible securities should understand that uncertainty surrounds the IRS’s treatment of convertible securities in the S election context. If convertible securities are to be issued, the most conservative approach would be to ensure it is not issued, subsequently negotiated to a non-eligible stockholder, or materially modified any time it has a strike price at or below 90% of its fair market value.