Debt-restructuring warrants do not create a second stock class

Plain-English summary

The IRS ruled that warrants issued to commercial lenders as part of a debt restructuring were not treated as a second class of stock of an S corporation. The lenders were actively and regularly engaged in lending, and the warrants were issued in connection with commercially reasonable loans, placing them within the regulatory exception for certain options. The ruling also concludes that the warrants did not cause the lenders to be treated as shareholders before exercise. It does not address whether the company otherwise qualifies as a small business corporation or S corporation.

Ruling snapshot

• Question: Do the debt-restructuring warrants create a second class of stock or make the lenders shareholders before exercise?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362, and 6110; Treas. Reg. § 1.1361-1(l)(4)(iii)(B)(1)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

                                                           Third Party Communication: None

Number: 201043015 Date of Communication: Not Applicable
Release Date: 10/29/2010
Person To Contact:
Index Number: 1361.01-01, 1361.01-04 ------------------------, ID No. -------------
Telephone Number:
-------------------------------------------------- ---------------------
-------------------------------------- Refer Reply To:

------------------------------ CC:PSI:B02
------------------------- PLR-109232-10
Date:
July 29, 2010

Legend

X = ----------------------------------------

A = --------------------------------

B = -----------------

L = --------------------------------------------------

M = ------------------------------

N = --------------------------------------------------------

O = --------------------------------------------------------------------------

a = --

b = -----

c = ---

d = ---

e = -------------

f = ----

Date1 = -----------------------

PLR-109232-10 2

Date2 = -----------------

Date3 = ---------------------

Date4 = ---------------------

Date5 = -------------------------

State = -------------

Year = -------

Dear ---------------:

   This responds to a letter dated March 1, 2010, submitted on behalf of X by X’s

authorized representative, requesting rulings under §1361(b)(1) of the Internal Revenue
Code (the Code).

   The information submitted states that X was incorporated under the laws of State

on Date1, and X elected to be an S corporation effective Date2. X has a shares of
Class A voting common stock outstanding, which are owned by A. X also has b shares
of Class B nonvoting common stock outstanding, c shares of which are owned by A and
the remaining d shares are owned by B.

   As part of its normal business operations, X borrows funds from commercial

lenders. In Year, X restructured some of its outstanding debt. On Date3, certain
lenders agreed to restructure X’s existing debt and to extend new debt to X. In return
for these agreements, the lenders received warrants to acquire Class B nonvoting
common stock of X. The debt restructuring was effectuated through an amendment and
restatement of X’s existing debt, which was held by entities affiliated with L, including M,
N and O (collectively referred to as the “Lenders”). In this restructuring, the Lenders
provided additional financing to X through the creation of three tranches of new debt
aggregating $e. The existing debt, prior to the restructuring, was set to mature on
Date4. Pursuant to the restructuring, both the existing debt and the new debt mature by
Date4.

   The warrants entitle the warrant holders to purchase, upon exercise, a specified

amount of Class B common stock of X for $f per share (the “exercise price”). The
warrant holders may exercise the warrants during the period between Date5 and Date4.
The exercise price of the warrants is subject to reduction if X distributes to its
shareholders cash, evidence of indebtedness, or other property. The exercise price is
reduced to the extent of the value distributed on a per share basis. If the exercise price

PLR-109232-10 3

is reduced to zero as a result of a distribution, any remaining portion of such distribution
is distributable to the warrant holders. X represents that it has made no distributions
since the issuance of the warrants that would require such adjustment or distribution.

   The exercise price and the number of shares that may be purchased upon the

exercise of the warrants are also subject to customary anti-dilution adjustments
regarding stock distributions, stock splits, and other similar corporate events. The
warrant agreement also provides for customary anti-dilution adjustments in the case of
the merger, reorganization, or recapitalization of X. X represents that none of the
foregoing events have occurred since the warrants were issued.

    The warrants are subject to various put and call rights that are effective for

periods before the exercise period of the warrants. Warrant holders may put the
warrants to X during a certain period of time prior to the exercise period. In addition, X
may call the warrants during another certain period of time prior to the exercise period.
The amount payable upon the exercise of the put and call options represents a total
repurchase price for the X stock that falls within the range of estimates of the fair market
value of the stock underlying the warrants at the time of their issuance. These put and
call rights were designed by X with the intent that such warrants would never be
exercised.

   X further makes the following representations:

   1)       The Class A voting common stock and Class B non-voting common
            stock of X differ only as to voting rights, and each outstanding share of
            X stock has identical rights to distribution and liquidation proceeds;
   2)       The principal purpose of X’s issuance of the warrants was to secure the
            agreement of the Lenders to a restructuring of the debt of X;
   3)       The warrants were not issued by X with a principal purpose of
            circumventing the one class of stock requirement of § 1361(b)(1)(D), or
            the limitation on S corporation shareholders of §§ 1361(b)(1)(A), (B)
            and (C);
   4)       The issuance of the warrants did not have a tax avoidance purpose;
   5)       The Lenders are actively and regularly engaged in the business of
            lending, within the meaning of § 1.1361-1(l)(4)(iii)(B)(1);
   6)       The warrants were issued in connection with a commercially reasonable
            loan to X, within the meaning of § 1.1361-1(l)(4)(iii)(B)(1), and are
            typical of financing arrangements with commercial lenders;
   7)       X has made no distributions since issuing the warrants and,
            accordingly, no distributions have been made to the warrant holders;
   8)       No events have occurred since X issued the warrants that would trigger
            any of the anti-dilution adjustments applicable to the warrants;
   9)       The warrant holders have not transferred any portion of their rights with
            respect to the warrants;

PLR-109232-10 4

   10)       X and its shareholders have not treated the warrants as outstanding
             stock of X or the warrant holders as shareholders of X for any purpose;
             and
   11)       X’s intent has always been to repurchase the warrants before their
             exercise by the warrant holders.

    Section 1361(a)(1) provides that the term “S corporation” means, with respect to

any taxable year, a small business corporation for which an election under § 1362(a) is
in effect for such year.

    Section 1361(b)(1) provides that the term “small business corporation” means a

domestic corporation which is not an ineligible corporation and which does not (A) have
more than 100 shareholders, (B) have as a shareholder a person (other than an estate,
a trust described in § 1361(c)(2), or an organization described in § 1361(c)(6)) who is
not an individual, (C) have a nonresident alien as a shareholder, and (D) have more
than one class of stock.

   Section 1.1361-1(b)(1) provides that, for purposes of subchapter S, chapter 1 of

the Code and the regulations thereunder, the term small business corporation means a
domestic corporation that is not an ineligible corporation (as defined in § 1361(b)(2))
and that does not have (i) more than the number of shareholders provided in
§ 1361(b)(1)(A); (ii) as a shareholder, a person (other than an estate, a trust described
in § 1361(c)(2), or, for taxable years beginning after December 31, 1997, an
organization described in § 1361(c)(6)) who is not an individual; (iii) a nonresident alien
as a shareholder; or (iv) more than one class of stock.

    Section 1.1361-1(l)(1) provides that, in general, a corporation that has more than

one class of stock does not qualify as a small business corporation. 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. Thus, if all shares of stock of an S corporation have identical rights to
distribution and liquidation proceeds, the 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 with respect to rights to elect members of
the board of directors.

    Section 1.1361-1(l)(4)(i) provides that, in general, instruments, obligations, or

arrangements are not treated as a second class of stock for purposes of § 1.1361-1(l)
unless they are described in § 1.1361-1(l)(4)(ii) or (iii). However, in no event are
instruments, obligations, or arrangements described in § 1.1361-1(l)(4)(iii)(B) and (C)
(relating to the exceptions and safe harbor for options), § 1.1361-1(l)(4)(ii)(B) (relating to

PLR-109232-10 5

the safe harbors for certain short-term unwritten advances and proportionally-held debt),
or § 1.1361-1(l)(5) (relating to the safe harbor for straight debt), treated as a second
class of stock for purposes of § 1.1361-1(l).

     Section 1.1361-1(l)(4)(iii)(A) provides, in part, that, except as otherwise provided

in § 1.1361-1(l)(4)(iii), a call option, warrant, or similar instrument (collectively, call
option) issued by a corporation is treated as a second class of stock of the corporation
if, taking into account all the facts and circumstances, the call option is substantially
certain to be exercised (by the holder or a potential transferee) and has a strike price
substantially below the fair market value of the underlying stock on the date that the call
option is issued, transferred by a person who is an eligible shareholder under § 1.1361-
1(b)(1), or materially modified. Section 1.1361-1(l)(4)(iii)(A) further provides that a call
option does not have a strike price substantially below fair market value if the price at
the time of exercise cannot, pursuant to the terms of the instrument, be substantially
below the fair market value of the underlying stock at the time of exercise.

   Section 1.1361-1(l)(4)(iii)(B)(1) provides, in part, that a call option is not treated

as a second class of stock for purposes of § 1.1361-1(l) if it is issued to a person that is
actively and regularly engaged in the business of lending and issued in connection with
a commercially reasonable loan to the corporation.

    Based solely on the facts submitted and the representations made, we conclude

that the warrants described above fall within the exception under § 1.1361-
1(l)(4)(iii)(b)(1) and therefore are not treated as a second class of stock of X for
purposes of § 1361(b)(1)(D) and § 1.1361-1(b)(1)(iv), and the warrants described above
(prior to their exercise) do not cause the Lenders to be treated as shareholders of X for
purposes of § 1361(b)(1) and § 1.1361-1(b)(1).

   Except as specifically set forth above, no opinion is expressed concerning the

federal tax consequences of the facts described above under any other provision of the
Code, including whether X was or is a small business corporation within the meaning of
§ 1361(b).

   The ruling contained in this letter is based upon information and representations

submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

   This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)

of the Code provides that it may not be used or cited as precedent.

PLR-109232-10 6

     In accordance with the power of attorney on file with this office, a copy of this

letter is being sent to X’s authorized representative.

                                    Sincerely,



                                    Bradford R. Poston
                                    Senior Counsel, Branch 2
                                    Office of Associate Chief Counsel
                                    (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes