S Corporation Tax Issues Due to Convertible Debt

I.Can an S corporation issue convertible debt to a shareholder without violating the “one class of stock” rule either (i) the straight-debt safe harbor or (ii) the option safe harbor, or (iii) when the debt is convertible for to-be-issued preferred stock, if such stock is ever issued?

The S election only exists for corporations with one class of stock.  See Reg. §1.1361-1(b)(iv).  Convertible debt is explained at Reg. §1.1361-1(l)(4)(iv).  In general, according to BNA, convertible debt violates the “one class of stock” rule if it is “treated as equity under general principles of federal tax law and is used to contravene the rights to distribution or liquidation proceeds or to contravene the limitation on eligible shareholders.”  Reg. §1.1361-1(l)(4)(iv) (referring to §1.1361-1(l)(4)(ii).  Convertible debt instruments are also considered as a second class of stock if they meet the failed loan standard.[1]  If both of these standards are satisfied, the convertible debt should be tested under the three situations posed.

Situation (i):  The Straight-Debt Safe Harbor

Summary: Never permitted. Convertible debt fails this test.

Lending money to an S corporation can constitute a second class of stock. The Code provides a safe harbor for “straight debt” of an S corporation. Code §1361(c)(5). Convertible debt is never “straight debt.” Code §1361(c)(5)(B)(ii).

Situation (ii):  The Option Safe Harbor

Summary:  Sometimes permitted.  Convertible debt terminates an S election if it fails the “call options test,” which would occur if the conversion exercise price is less than 90% of its fair market value or is substantially certain to be exercised.  Various events described below, including issuance and some transfers, trigger the call options test.

Convertible debt is considered a second class of stock if it “embodies rights equivalent to those of a call option that would be treated as a second class of stock under .”  Reg. § 1.1361-1(l)(4)(iv)(B), referencing Reg. §1.1361-1(l)(4)(iii).  The call options test states that call options (and similar instruments, such as warrants), are considered a second class of stock if the following two prongs are met:

1.Taking into account all the facts and circumstances the call option is substantially certain to be exercised, and

2.The stock has a strike price of less than 90% of its fair market value.

An option must pass the above test when the option is used, if and when it is transferred to a non-eligible shareholder (see Situation (iii), below), and if and when it is materially modified. Regs. §1.1361-1(l)(4)(iii)(A)–(C).

Note. Convertible debt issued without an exercise price creates a second class of stock and terminate the S election immediately (not requiring exercise). PLR 200724010.

Situation (iii):  The Contingent Conversion-to-Preferred Situation

Summary: Sometimes permitted. The analysis is very similar to Situation (ii).

The IRS’s treatment of convertible debt for to-be-issued preferred stock can be deduced by its approach to options for common stock, since the authority indicates the IRS would treat convertible debt for unissued preferred stock under the same analysis. Reg. § 1.1361-1(l)(4)(iv). As BNA points out,

In Rev. Rul. 67-269, the IRS ruled that options, warrants, and debentures that have none of the attributes of immediate stock ownership (e.g., the right to vote in the capacity of a shareholder or the right to receive dividends) are not a second class of stock. As a result, S corporations have been permitted almost without restriction to offer options, warrants, and other convertible instruments, including by issuing options to persons who could be ineligible shareholders. PLR 8811061 (a bank’s holding of an S corporation’s stock warrant did not violate the one class of stock rule, even though banks are ineligible shareholders of S corporations).

As BNA notes, in applying the “one class of stock” rule, “only stock which is outstanding is considered.  Treasury stock and unissued stock of a different class than that held by the shareholders does not disqualify a corporation.”  (BNA alludes to a situation where a C corporation with more than one class of stock converts to an S corporation but has not yet filed revised articles of incorporation; thus the new stock is outstanding but not authorized.)

However, call options for to-be-issued preferred stock must probably still pass the call options test—in other words, the “one class of stock” rule is probably violated if, ‘taking into account all the facts and circumstances, the call option is substantially certain to be exercised.’ Reg. §1.1361-1(l)(4)(iii).

Secondary authority appears to agree with this memo’s conclusion. One commentator places this answer in context:

It’s because a convertible turns into pref shares, or at least some pref shares, at the company’s next financing event, usually a Series A round. As soon as those pref shares come into existence, S-Corp status is gone. It is theoretically possible to have a convertible that converts to common stock, but that means the valuation event that triggers the conversion can’t create a new share class, which is rare. Nonetheless, you’re free to be an S-Corp and do a convertible (the new share class won’t come into existence because of the convertible). Just know that you’ll probably change to a C-Corp at your next round, which isn’t usually a big deal. The change to C-Corp (either from LLC or S-Corp) is actually really common at a Series A round (though it’s easier to go from S to C than from LLC to C). http://answers.onstartups.com/questions/19181/can-s-corporations-issue-convertible-notes-debt.

As in Situation (ii), convertible debt for to-be-issued preferred stock without an exercise price probably terminates the S election at issuance. PLR 200724010.

II.Is an S election terminated when one investor buys S corporation stock at $1/share, and another investor buys the same stock at $10/share?

Summary: The authority is unclear. The best argument for the proposed structure terminating the S election is that, when stock is simultaneously issued to two different shareholders at two different prices, either one shareholder receives stock “significantly in excess of or below the fair market value of the stock,” thus violating the purchase price test (below). The best arguments for the proposed structure not terminating the S election is that (i) the purchase price test does not extend to stock purchase agreements, or (ii) the first shareholder’s act of investing substantively separates the S corporation’s financial outlook from the moment before that investment occurred; thus the two stock issuances do not occur simultaneously but are separated by a meaningful event and the purchase price test is satisfied. Between the two arguments, the latter appears to be stronger, such that unless the stock purchases truly occur simultaneously—an avoidable event—this structure should be defensible against an S election termination argument.

The S election only exists for corporations with one class of stock.  See Reg. §1.1361-1(b)(iv).  Buy-sell agreements and redemption agreements trigger a two-pronged “one class of stock” test known as the “Purchase Price Test.”  Under the purchase price test, an agreement does not create a second class of stock unless:

1.a principal purpose of the agreement is to circumvent the one class of stock rule; or

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.

Reg. § 1.1361-1(l)(2)(iii)(A)(2); see also IRS Pub. 589 (1995) (in the context of buy-sell and redemption agreements, a stock price cannot be established that is “significantly above or below the fair market value of the stock”).

According to secondary authority, “this rationale appears to apply to a Shareholders Agreement.” See Am. College of Trust and Estate Counsel, Shareholders Agreements for Closely Held Corporations,

http://meetings.abanet.org/webupload/commupload/RP519000/relatedresources/2010_ACTEC_-_Shareholders_Agmt_Outline.pdf.  If that is true, then the simultaneous offer of two different prices to two different investors may violate the one class of stock rule.

The notion that different offering prices violate the S corporation view appears pervasive in relevant CPA forums.

“The S-corporation may not sell its own shares to shareholders with different nominations. The S-corporation is required to have one class of stock. If you do otherwise – the risk is that in case of audit – the S-corporation status could be revoked. . . . If shares are sold to shareholders at different prices – the S-corporation is deemed to have a second class of stock – as a result – your S election is terminated and will be converted to a C-corporation with all tax consequences triggered.”  JustAnswer:  Taxhttp://www.justanswer.com/tax/4wcfy-own-100-restaurant-corp-capital-investment.html#ixzz27bKvOrRzsee also Chicago Family Business Council, S Corporations and the Second Class of Stock Rulehttp://www.chicagofbc.com/s-corportations/.

However, the above rationale does not address additional paid in capital scenarios, which appear to dodge the above test because the capitalizations are not simultaneous.  A purchase price at book value or between book value and FMV is not considered to “establish a price that is significantly in excess of or below the fair market value of the stock.”  Reg. §1.1361-1(l)(2)(iii).  Thus, the passage of time adds defensibility to different paid in capital amounts.  As one commentator states, “As long as there’s some time separation between intial cap and later addition of money, I have no problem.”  TaxAlmanac Discussion:  Does S Corp APIC Change Ownership Percentage?,http://www.taxalmanac.org/index.php/Discussion:Does_S_Corp_APIC_Change_Ownership_Percentage%3F.

Folk does not answer the question. Folk states that “‘an arbitrary sale of the same issue of stock at different prices to different persons would not be sanctioned,’ different sale prices will be sustained by a court if they are ‘based on business and commercial facts which, in the existence of fair business judgment, lead directors to follow such course.’” Bodell v. Gen. Gas & Electric, 140 A. 264, 267 (Del. 1927) (quoting Atl. Ref. Co. v. Hodgman, 13 F.2d 781, 788 (3d. Cir.), cert. denied, 273 U.S. 731 (1926)). However, S corporations were developed in 1958; the above cases are not on point.

[1] The “failed loan standard” is met when “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 the maximum number of eligible shareholders.”  Chicago Family Business Council, S Corporations and the Second Class of Stock Rule,http://www.chicagofbc.com/s-corportations/.

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