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July 26, 2009

Internal Revenue Service Determined that an Employment Agreement was not a Second Class of Stock

One of my biggest issues I have with other attorneys, as well as accountants, is that many of them overstate general rules that they hear about, without knowing much about the specifics.  One of those overstated general rules is that: business owners should use an entity taxed as a partnership over an entity taxed as a S corporation because the S corporation is subject to the one-class-of-stock rule, discussed below.  Yet, they do not fully understand the rule and fail to properly explain the rule to the business owner.  The one-class-of-stock rule is very limited and easy to get around.  The attached private letter ruling (PLR 200924019) is a perfect example.

The one-class-of-stock rule simply means that a business entity may not have more than one class of stock.  A business entity is treated as having only one class of stock if all outstanding shares of stock of the entity confer identical rights to distribution and liquidation proceeds.  The important step that many tax practitioners miss is 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 rights.  A commercial contractual agreement, such as a lease, employment agreement, or loan agreement is not a binding 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 rule.

The attached PLR dealt with an employment agreement between officers and employees of the company.  The question was whether the employment agreement caused the company to violate the one-class-of-stock rule.  The IRS discussed the general law dealing with S corporations and then concluded that "the employment agreement was not a governing provision within the definition contained in Section 1.1361-1(l)(2)(i) and therefore did not cause [the Company] to have more than one class of stock..."  The point here is that the one-class-of-stock rule can be planned around.  As an example, when a company enters into an employment agreement, the Company minutes should be prepared simultaneously with the agreements and should provide sufficient detail as to the motivation and goals of entering into the agreement.  It is much more beneficial to have the minutes done at that time, rather than when you are picked up for audit.  And finally, you should not permit your advisor to toss the S corporation option to the side without making them explain to you why it does not make sense.  It remains a very viable option. 

Download S corporation - Employment Agreement - July 25, 2009

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« Internal Revenue Service Audit of Employment Taxes | Main | TAS Objectives for Fiscal Year 2010 »

July 26, 2009

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DC Hats

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The comments to this entry are closed.

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