S Corporations Planning Opportunities
In the business planning of S corporations dealing with family shareholder issues, keeping key employees can be very challenging.  Many businesses are operated today by S corporations.  If there is a choice between a C corporation vs S corporation for closely held businesses, usually an S corporation is the preferred choice because of the elimination of double taxation.  S corporation’s have unique challenges in the business world because of many different limitations including who can be shareholders, their number and only one single class of stock.

In a recent article by Michael Schlesinger, he discusses the planning dealing with avoiding the loss of losing the S corporation classification by having two classes of stock among the shareholders.  The balance of this article is from his discussion on this subject based upon a private letter ruling he had obtained that is contained in the example below.

Voting rights, buy-sell agreements, commercial contractual arrangements, and redemption agreements.  Differences in voting rights among shares of stock of the S corporation are disregarded in determining whether a corporation has more than one class of stock. Likewise, Section 1361(b)(1)(D) provides that buy-sell agreements among shareholders and restrictions on the transferability of stock are disregarded unless a principal purpose of the agreement is to circumvent the one-class-of-stock requirement. Additionally, commercial contractual arrangements (such as leases, employment agreements, or loan agreements) are disregarded unless a principal purpose of the agreement is to circumvent the one-class-of-stock requirement. Redemption agreements are similarly disregarded to determine whether an S corporation has more than one class of stock unless the agreement restricts the rights of the holders of the stock to share in liquidation proceeds or provides for distributions that would be treated as nonconforming distributions.

To maintain control in an S corporation, parents sometimes transfer nonvoting stock to children using minority discounts, and the parents keep the voting stock. However, this is a potentially dangerous situation because while children may not be able to vote, they can bring derivative actions under state law for corporate “waste” if they do not like the manner in which their parents who control the corporation through voting stock are operating the company. Consequently, the nonvoting shareholders actually have a very effective voice in the operation of the S corporation.  Nevertheless, the example below illustrates how nonvoting stock was used to achieve estate and business planning objectives.

Example. Greg Amato owns all the stock (voting and nonvoting) of Viva Inc., an S corporation. Amato has four children: Tony, a son, and three daughters, Mara, Jenna, and Elsa. Tony works for Viva Inc. While Amato is living, he does not want to give Tony any stock for fear of alienating his daughters and committing an irreversible act—namely, gifting stock to his children. Amato also has a trusted employee, Ed Shumann, whom he wants to reward for being so loyal. Again, while Amato is living, he does not want to give Schumann any stock to ensure that Schumann stays with Amato for a lifetime. Thus, Amato's will becomes the means for giving Viva Inc. stock as desired.

In his will, Amato bequeaths all Viva's voting stock to Tony, his son. To his three daughters, he leaves 95% of the nonvoting stock to be divided equally among those surviving him. To protect against his daughters ever transferring the nonvoting stock to anyone else, such as a son-in-law through a divorce settlement, Amato imposed stipulations in his will that a daughter parting with any of her stock must sell the stock to the corporation for its fair market value at the time of redemption.
As to employee Schumann, Amato gave him 5% of the remaining nonvoting stock to reward him for his faithful performance, subject to the same transferability restrictions and conditions imposed on his daughters. Furthermore, to prevent difficulties, additional restrictions were imposed on Schumann's stock: (1) Schumann may keep the stock only while still employed by Viva Inc., and (2) if Schumann leaves Viva Inc. to enter into a competing business within a certain geographical area within a certain period of time, then Schumann will forfeit his stock redemption proceeds as well.

Ltr. Rul. 9022045 held that the restrictions imposed by Amato's will as set forth in the above example did not create a second class of stock, which would cause the S corporation to lose its S election. Instead, Amato was able to accomplish a major goal: maintaining family control of the business. By using a will, he can easily change it if one of his children or trusted employee angers him, striking out the provision for that beneficiary. However, if stock had been issued to that same individual during Amato's life, he would be forced to buy that individual out, which could prove costly as well as lead to lawsuits.
By using the will format, Amato is able to provide funds for his daughters, assuming that the business generates profits, but at the same time, allow Tony to run the business without fear of being outvoted by his sisters. Of course, Tony, by controlling the company, can prevent any earnings from flowing to his sisters by increasing salaries, expending funds, etc., but his sisters always have the rights of shareholders, such as inspection, derivative suits, etc., to protect themselves. One of the disadvantages of using a will is that there is no means to bequeath the stock to after-born grandchildren.

It may be wondered why Amato did not use a shareholders' agreement to accomplish his objectives. The simple reason is that a shareholders' agreement is not effective while there is only one shareholder. Additionally, Amato did not want to give, transfer, or sell the stock in the S corporation during his lifetime to his children or the trusted employee, preferring to keep his options open. Thus, because there were no other individuals Amato wanted as shareholders, a shareholders' agreement would not have been effective.