Service payment arrangements did not create second stock class

Plain-English summary

An S corporation and its sole shareholder entered into two successive arrangements with a service provider. The first contemplated a stock sale if specified conditions were met, but no stock was transferred before the agreement ended. The second gave the provider payment rights upon a liquidity event and allowed a possible earlier buyout, with deferred payments potentially secured by a stock pledge. The IRS concluded that both arrangements met the regulatory requirements for service-related promises that are not treated as outstanding stock. Consequently, neither arrangement terminated the corporation's S election by creating another class of stock.

Ruling snapshot

• Question: Did either service-provider arrangement constitute outstanding stock and thereby terminate the corporation's S election?
• Outcome: No; both arrangements satisfied Treas. Reg. § 1.1361-1(b)(4) and were not considered outstanding stock.
• Key authorities: IRC §§ 1361 and 1362; Treas. Reg. § 1.1361-1(b)(4)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201926008                                              Third Party Communication: None
Release Date: 6/28/2019                                        Date of Communication: Not Applicable
Index Number: 1361.00-00, 1361.01-00,
              1361.01-04                                       Person To Contact:
                                                               ---------------------------, ID No. ---------------
-----------------------------------------------                -----------------
----------------------------------                             Telephone Number:
-------------------------------------                          ----------------------
-------------------------------                                Refer Reply To:
                                                               CC:PSI:B03
                                                               PLR-129748-18
                                                               Date:
                                                               March 29, 2019

Legend

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

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

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

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

State 1           =        --------------

State 2           =        --------------

State 3           =        ---------

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

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

Y                 =        ---------------------------

N1                =        ----

N2                =        ----

N3                =        ----

N4                =        ----
PLR-129748-18                                          2


N5              =       --

Agreement 1 =           ----------------------------------------------

Agreement 2 =           ----------------------------------------------------------


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

This letter responds to a letter dated September 28, 2018, and subsequent
correspondence, submitted on behalf of X by its authorized representative, requesting a
ruling under § 1361 of the Internal Revenue Code.

                                                  FACTS

The information submitted states that X was formed under the laws of State 1 and
elected to be treated as an S corporation effective Date 1. X subsequently changed its
place of organization from State 1 to State 2.

At all relevant times, X had one shareholder, A, an individual. X engaged another
individual, B, through a State 3 corporation, Y, in marketing various business services
and products to its merchant clients. On Date 2, X, A, B, and Y entered into Agreement
1, which provided for the sale of N1 percent of the stock of X held by A upon the
satisfaction of certain conditions. On Date 3, X, A, B, and Y terminated Agreement 1 at
a time when no stock had been transferred pursuant to Agreement 1 and entered into
Agreement 2, which provided B with certain payment rights upon the occurrence of a
Liquidity Event. Under the terms of Agreement 2, a Liquidity Event generally included a
sale of a majority of X’s assets, the transfer of rights to control over any use of all or
substantially all of X’s assets under a lease, exchange, license or similar agreement, a
merger or consolidation in which X’s shareholders own less than 50% of the voting
securities of the surviving company or an IPO of X stock.

Agreement 2 contemplated that X, A, B, and Y may agree to a buy-out of B’s rights
under Agreement 2 prior to the occurrence of a Liquidity Event. In the case of a buy-
out, N2 percent of the amount owed was to be paid within N3 days of the determination
of the amount owed and the remainder was payable in equal monthly installments over
N4 months, including N5 percent interest on the outstanding balance. Monthly
installment payments were to be secured by a pledge of not less than N1 percent of the
X stock held by A.
PLR-129748-18                                3

                                 LAW AND ANALYSIS

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) defines the term “small business corporation” as a domestic
corporation that is not an ineligible corporation and that, among other things, does not
have more than one class of stock.

Section 1.1361-1(b)(4) of the Income Tax Regulations provides that, for purposes of
Subchapter S, an instrument, obligation, or arrangement is not outstanding stock if it:
(i) does not convey the right to vote; (ii) is an unfunded and unsecured promise to pay
money or property in the future; (iii) is issued to an individual who is an employee in
connection with the performance of services for the corporation or to an individual who
is an independent contractor in connection with the performance of services for the
corporation (and is not excessive by reference to the services performed); and (iv) is
issued pursuant to a plan with respect to which the employee or independent contractor
is not taxed currently on income.

                                     CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
Agreement 1 and Agreement 2 satisfy the requirements of §1.1361-1(b)(4).
Accordingly, Agreement 1 and Agreement 2 are not considered outstanding stock, and
X’s S corporation election was not terminated by virtue of the existence of Agreement 1
or Agreement 2.

Except as specifically ruled above, we express no opinion concerning the federal tax
consequences of the transactions described above under any other provisions of the
Code.

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.
PLR-129748-18                                 4


Pursuant to a power of attorney on file, a copy of this letter is being sent to X’s
authorized representative.



                                       Sincerely,



                                       James A. Quinn
                                       Senior Counsel, Branch 3
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)



Enclosures: 2
      Copy of this letter
      Copy for § 6110 purposes