Stock redemption plan does not create a second class of stock

Plain-English summary

An S corporation had voting and nonvoting common shares with identical distribution and liquidation rights. It proposed a voluntary annual stock redemption plan designed to keep voting power and economic ownership approximately balanced between two family groups. The redemption price would generally use a recent independent appraisal, or a good-faith board valuation based on the same methodology. Based on the corporation's representations that the plan was not intended to evade the one-class-of-stock rule and would not use a price significantly above or below fair market value, the IRS ruled that the plan would be disregarded and would not create a second class of stock.

Ruling snapshot

• Question: Will the proposed redemption plan cause the S corporation to have a prohibited second class of stock?
• Outcome: Approved
• 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
Washington, DC 20224

Number: 201506003 Third Party Communication: None
Release Date: 2/6/2015 Date of Communication: Not Applicable
Index Number: 1361.01-04
Person To Contact:
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------------------ Telephone Number:
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---------------------------------------- Refer Reply To:
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PLR-116047-14
Date:
October 06, 2014

LEGEND:

X = ---------------------------------------------------------------------------------------
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State = -----------

Date 1 = ----------------

Date 2 = ------------------

Date 3 = -----------------
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Date 4 = -------------------------------

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

B = ---------------------------------------------------------------------------------------
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a = ---------------------------------------------------------------------------------------
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b = ---------------------------------------------------------------------------------------
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Redemption Plan = ---------------------------------------------------------------------------------------
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Dear-----------------

PLR-116047-14 2

This responds to a letter dated March 28, 2014, submitted on behalf of X by its
authorized representative, requesting a ruling under § 1361(b)(1)(D) of the Internal
Revenue Code.

Facts

The information submitted states that X was incorporated on Date 1 in State and
elected to be treated as an S corporation effective Date 2. Prior to Date 3, X had one
class of stock outstanding and all shares of X stock had identical voting, distribution and
liquidation rights. X’s stock is owned equally between A and A’s family and B and B’s
family. On Date 3, X amended its Articles of Incorporation in order to create non-voting
common stock. On Date 4, X declared and issued a dividend of a shares of non-voting
common stock per each share of X’s voting common stock. X represents that all of the
stock confers identical rights to distributions and liquidation proceeds.

X proposes to adopt a stock redemption plan (“Redemption Plan”). The Redemption
Plan is voluntary at the discretion of the X shareholders on an annual basis and capped
at a specific cash limit. The Redemption Plan provides that any shareholder who
desires to have his X stock redeemed must have his non-voting and voting shares
redeemed in the ratio of a (non-voting) to b (voting) unless the Board of Directors in its
discretion approves the stock redemption in a different ratio. X represents that this
redemption ratio in the Redemption Plan is to ensure that X’s voting power and
economic ownership between A and A’s family and B and B’s family remain
approximately equal and to prevent an individual shareholder from owning a
disproportionate amount of voting versus nonvoting common stock. X represents that
the redemption price for the stock is the appraised value of the voting and nonvoting
common stock (on a minority basis) as shown on the most recent independent appraisal
but if no independent appraisal has been made within a certain time frame of the
redemption, the Board of Directors can determine in good faith the value, which is
intended to be based upon the methodology used by the independent appraisal.

X represents that the Redemption Plan is not designed or intended to circumvent or
otherwise violate the second class of stock rule of § 1.1361-1(l)(2)(iii)(A). X also
represents that the Redemption Plan does not establish a purchase price for the stock
that, at the time the agreement is entered into, is significantly in excess of or below the
fair market value of the stock.

Law and Analysis

Section 1361(a)(1) provides that the term “S corporation” means, with respect to the
taxable year, a small business corporation for which an election under § 1362(a) is in
effect for the year. Section 1361(b)(1)(D) provides that the term “small business
corporation “ means a domestic corporation that, among other things, does not have

PLR-116047-14 3

more than one class of stock. Accordingly, S corporations may not have more than one
class of stock.

Section 1.1361-1(l)(1) of the Income Tax Regulations provides that 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.

Section 1.1361-1(l)(2)(iii)(A) provides that buy-sell agreements among shareholders,
agreements restricting the transferability of stock, and redemption agreements are
disregarded in determining whether a corporation’s outstanding shares of stock confer
identical distribution and liquidation rights unless: (1) a principal purpose of the
agreement is to circumvent the one class of stock requirement of § 1361(b)(1)(D), and
(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.

Agreements that provide for the purchase or redemption of stock at book value or at a
price between fair market value and book value are not considered to establish a price
that is significantly in excess of or below the fair market value of the stock and, thus, are
disregarded in determining whether the outstanding shares of stock confer identical
rights. For purposes of § 1.1361-1(l)(2)(iii)(A), a good faith determination of fair market
value will be respected unless it can be shown that the value was substantially in error
and the determination of the value was not performed with reasonable diligence.

Conclusion

Based solely on the facts submitted and the representations made, we conclude that
the Redemption Plan described above will be disregarded in determining whether the
outstanding shares of X stock confer identical distribution and liquidation rights and will
not cause X to be treated as having a second class of stock within the meaning of
§ 1361(b)(1)(D).

Except as specifically set forth above, we express or imply no opinion as to the federal
tax consequences of the above facts under any other provision of the Code.
Specifically, we express or imply no opinion concerning whether X’s S corporation
election is valid under § 1362.

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-116047-14 4

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,


                                    Joy C. Spies
                                    Joy C. Spies
                                    Senior Technician Reviewer, Branch 1
                                    (Passthroughs & Special Industries)

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

cc: