This article discusses using a buy-sell agreement to protect the S election from unintended termination.

 

Buy sell agreements predetermine what happens to a business owner's interest upon certain triggering events such as death, disability or retirement.  Additionally, agreements usually restrict transfers of the business interest during life.

 

Buy-sell agreements should address many issues including business valuation, agreement funding, agreement type (cross-purchase, entity purchase or a hybrid), triggering events, permitted transfers (e.g., family gifts) and the estate planning needs of individual owners.

 

The potentially negative tax impact of a termination of S status creates additional issues to consider when drafting a buy-sell agreement for S corporations.

 

Subchapter S corporations combine limited liability with "pass-through" taxation.  In exchange for pass-through taxation, the Internal Revenue Code imposes certain restrictions on S corporations to limit abuses.  Violation of these restrictions can terminate a corporation's S election.  The IRS can waive inadvertent terminations in certain circumstances.

 

S Corporations may have no more than 75 shareholders and those shareholders must be individuals (other than nonresident aliens), estates or eligible trusts.  If stock is transferred to an ineligible shareholder, or if more than 75 people become shareholders, the S election terminates automatically in most cases.

 

To prevent termination of the S election unless all parties agree, shareholders should consider a provision limiting transfers to impermissible shareholders.  The agreement may require notice to the corporation prior to all transfers and give the corporation a right of first refusal if an impermissible transfer is proposed. 

 

A corporation's S status terminates if it has more than one class of outstanding stock.  Obviously this precludes S corporations from issuing both common and preferred shares, but any differences in economic rights (e.g., dividend rights) among outstanding S shares may be deemed to create a second class of stock.

 

Debt owed by an S corporation can be deemed a second class of stock unless the note meets the Code's safe harbor requirements.  Similarly, a buy-sell agreement can be deemed a second class of stock if it provides for differences in dividend rights or liquidation preferences.  Legitimate agreements are given broad latitude, however.

 

As with shareholder restrictions, business owners should consider including a provision preventing issuance of a second class of stock unless all parties agree.  The agreement could require that prior to issuance of new stock or debt the corporation must obtain an opinion of counsel that such action will not create a second class of stock.

 

Note that different voting rights in common shares do not create a second class of stock, a point that can be helpful in estate planning.  Also, the IRS has privately ruled that split-dollar arrangements compensating select executives do not create a second class of stock.

 

Just as with any other entity, a buy-sell agreement for an S corporation provides stability for the business and security for families of owners.  The agreement can also do double-duty by reducing the chances that the S election will be terminated inadvertently or intentionally by a minority shareholder.