PLR 200029050: Employee stock buyback terms do not create a second stock class

Plain-English summary

An S corporation gave a key employee nonvoting common stock under an employment agreement. The agreement required the company to buy that stock after specified events, with different prices for voluntary and involuntary departures. The IRS ruled that the buyback restrictions would be disregarded when testing whether the company's shares had identical rights, so the agreement did not by itself create a second class of stock. The ruling relied on the company's representations that dividends and liquidation proceeds were equal for all shareholders, the contract was negotiated at arm's length, and it was not designed to evade the one-class rule. The IRS did not decide whether the company met the other S corporation requirements.

Ruling snapshot

• Question: Do employment-agreement buyback terms create a second class of stock under section 1361?
• Outcome: Approved as to the stated buyback restrictions.
• Key authorities: IRC § 1361(b)(1)(D); Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

Internal Revenue Service                        Department of the Treasury

Index Number:       1361.01-04                  Washington, DC 20224



                                                Person to Contact:
Number: 200029050                               Telephone Number:
Release Date: 7/21/2000
                                                Refer Reply To:
                                                CC:DOM:P&SI:3 PLR-101056-00
                                                Date:
                                                April 26, 2000


       Company:

       State:

       M:

       N:

       P:

       Formula A:




       Formula B:

       a:

       b:

       c:

Dear

       This letter responds to a letter from M dated January 4, 2000, requesting a ruling
that the restrictions placed on Company’s nonvoting common stock by an employment
agreement (the “Agreement”) will not cause Company to have a second class of stock
under § 1361(b)(1)(D) of the Internal Revenue Code. Company represents the
following facts.

      Company, a State corporation, is owned by M, N, and P. Company elected
under § 1362(a) to be an S corporation effective a.

       P entered into the Agreement with Company effective b. As part of the

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Agreement, P was given Company common stock, consisting of nonvoting shares.

       The Agreement provides that Company is obligated to buy P’s stock if certain
events occur. By formula, a higher stock purchase price is provided for “nonvoluntary”
events than for “voluntary” ones. Nonvoluntary events include death or disability,
divorce, termination of employment by Company without just cause, or termination of
employment by P with just cause. Voluntary events include termination of employment
by P without just cause or termination of employment by Company with just cause.

       Upon the occurrence of a nonvoluntary event, Company must buy P’s stock for a
price that reflects the parties’ good faith determination of fair market value. This price is
determined by Formula A.

       Upon the occurrence of a voluntary event, P will receive a price that reflects only
the increase in shareholders’ equity since c. This price is determined by Formula B.

       The agreement does not affect the amount of dividend distributions or liquidation
proceeds, which is the same for all shareholders. Company represents that the
Agreement is a commercial contract negotiated at arm’s length between unrelated
parties as part of the terms of employment of a key Company officer. Company further
represents that it is not a principal purpose of the Agreement to circumvent the single-
class-of-stock requirement of § 1361(b)(1)(D).

       Section 1361(b)(1)(D) provides that for purposes of subchapter S, the term
"small business corporation" means a domestic corporation which is not an ineligible
corporation and which does not, among other things, have more than one class of
stock.

        Section 1.1361-1(l)(1) of the Income Tax Regulations provides that, except as
provided in § 1.1361-1(l)(4) (relating to instruments, obligations, or arrangements
treated as a second class of stock), a corporation is treated as having only one class of
stock if all outstanding shares of stock of the corporation confer identical rights to
distribution and liquidation proceeds. Differences in voting rights among shares of
stock of a corporation are disregarded in determining whether a corporation has more
than one class of stock.

       Section 1.1361-1(l)(2)(i) provides that the determination of whether all
outstanding shares of stock confer identical rights to distribution and liquidation
proceeds is made based on the corporate charter, articles of incorporation, bylaws,
applicable state law, and binding agreements relating to distribution and liquidation
proceeds (collectively, the governing provisions). A commercial contractual agreement,
such as a lease, employment agreement, or loan agreement, is not a binding

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agreement relating to distribution and liquidation proceeds and, thus, is not a governing
provision unless a principal purpose of the agreement is to circumvent the one class of
stock requirement of § 1361(b)(1)(D).

        Section 1.1361-1(l)(2)(iii)(B) provides that 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.

       Based solely on the facts as represented by Company in its request, we rule that
the restrictions placed on the nonvoting common stock by the Agreement will be
disregarded in determining whether Company’s shares of stock confer identical rights.

       Except for the specific ruling above, no opinion is expressed or implied
concerning the federal income tax consequences of the facts of this case under any
other provision of the Code. In particular, no opinion is expressed on whether
Company meets the other requirements of § 1361.

       In accordance with the power of attorney on file with this office, we are sending
you the original of this letter, with copies to the taxpayer and the taxpayer’s other
authorized representative.

      This ruling is directed only to the taxpayer who requested it. According to
§ 6110(k)(3), this ruling may not be used or cited as precedent.

                                         Sincerely,
                                         JONI LARSON
                                         Acting Assistant to the Chief, Branch 3
                                         Office of Assistant Chief Counsel
                                         (Passthroughs and Special Industries)

enclosure: copy for § 6110 purposes