S Corporations and Employee Stock Compensation

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S Corporations and Employee Stock Compensation

Small business owners have long enjoyed operating under an S corporation umbrella.  First, S corporations provide favorable tax treatment – particularly compared to C corporations – in that earnings from the S corporation are generally taxed only once.  Second, they are fairly easy to form:  the owner or owners organize a limited liability company or a corporation under applicable state law and make a timely S corporation election under federal tax law.

S corporations also have other advantages.  Because ownership of the S corporation is held in stock, an S corporation can incentivize key employees through awards of its stock as additional compensation.  This Insight discusses some of the more common issues that arise when an S corporation makes these stock awards.

One Class of Stock Requirement

The Code does impose certain restrictions on S corporations.  One of the more significant ones is the one-class-of-stock rule.  If the S corporation at any time has more than one class of stock, it loses its S status (and generally its many tax advantages).

An S corporation has only one class of stock if all of its outstanding shares of stock provide identical rights with respect to operating and liquidating distributions.  This determination is made by analyzing the “governing provisions,” which are (where applicable) the corporate charter, articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distributions and liquidation proceeds.

A common issue that arises with respect to S corporation stock awards is whether the awarded shares constitute an impermissible second class of stock.  Significantly, the Regulations permit the S corporation to award non-voting stock, which in and of itself does not violate the one-class-of-stock rule.  This can be particularly advantageous with stock awards in that the S corporation owners can retain voting control of the company while also permitting employees to earn rights to distributions.

Section 83 of the Code generally governs the taxability of stock awards.  Under Section 83, the service provider (e.g.employee) must recognize as income the fair market value of any stock received when such stock is no longer subject to a substantial risk of forfeiture.  However, the employee can make an election (referred to as a Section 83(b) election) to recognize the stock as income immediately.  This election can be advantageous, for example, if the employee expects the shares to substantially appreciate in value after the award or grant of stock, which with the election would later produce capital gains as opposed to ordinary income.

Under the Regulations, the S corporation is deemed the owner of any stock awards that are subject to substantial risks of forfeiture.  See Treas. Reg. § 1.1361-1(b)(3).  If the employee has made a Section 83(b) election, though, the stock is treated as outstanding.   Accordingly, careful attention must be given to stock awards – particularly those outstanding or deemed outstanding – to ensure that such stock meets the one-class-of-stock requirement.

Eligible Shareholders

An additional requirement for S corporations relates to the identity of shareholders.  Specifically, only the following individuals and entities are eligible to be S corporation shareholders:  (1) U.S. citizens and residents; (2) estates of deceased S corporation shareholders; (3) estates of bankrupt S corporation shareholders; (4) certain types of trusts; (5) Section 501(c)(3) organizations; and (6) Section 401(a) qualified pension plans.  Accordingly, ineligible shareholders include:  (1) corporations; (2) partnerships; and (3) nonresident alien individuals.

Similar to the one-class-of-stock requirement above, if an S corporation at any time has an ineligible shareholder, it risks losing its S corporation status.  Therefore, in many stock compensation arrangements it is common to have provisions in the agreement itself restricting the transfer of S corporation stock to ineligible shareholders.  Often times, these provisions will deem the transfer void ab initio—or void from the onset—to ensure the S corporation does not lose its S corporation status.

Section 409A

In 2004, Congress enacted the American Jobs Creation Act of 2004, Pub. L. No. 108-357, which added Section 409A to the Code.  The gist of Section 409A is to ensure employees are paid deferred compensation on fixed intervals or schedules, with some exceptions.  Section 409A applies to “nonqualified deferred compensation plans,” which are defined as plans that provide for the deferral of compensation, other than certain qualified employer plans and other benefit plans.  For these purposes, a “plan” may include any arrangement or agreement including an arrangement or agreement with only one person.  Sec. 409A(d)(3).  Accordingly, the reach of Section 409A is often very broad.

Section 409A has strict requirements governing the deferment of certain types of compensation.  If the compensation runs afoul of Section 409A, all compensation deferred for the tax year and all preceding tax years is included in the employee’s gross income for the tax year to the extent it is not subject to a substantial risk of forfeiture and has not previously been included in gross income.  But worse, the compensation that is included in gross income is subject to statutory interest and a penalty of 20%.  Sec. 409A(a)(1)(B).

The requirements of Section 409A are complex.  In a nutshell, Section 409A often requires both documentary and operational compliance—i.e., the documentation reflecting the stock award must comply with Section 409A in addition to the award itself.  Thus, careful draftsmanship of the stock award is often necessary to ensure the employee is not subject to additional tax, interest, and penalties on the award.

Conclusion

The decision to award S corporation stock to an employee or group of employees is a business decision.  But the federal tax laws permit S corporations the flexibility necessary to make these awards, provided certain precautions are taken to avoid loss of the S corporation election.  If you have any questions about S corporations and/or stock awards, you may contact the author, Matt Roberts, at 214.984.3410 or by e-mail at mroberts@freemanlaw.com.