S Corp Requirements (disproportionate distributions)

The first rule is that shareholders have to choose to be taxed as an S corporation. Shareholders do so by filling out a Form 2553, Election by a Small Business Corporation, that they file with the IRS. See Treas.
Reg. § 1.1362-6(a)(2)(i). Once the IRS approves, the election remains effective indefinitely. § 1362(c); see Mourad v. Commissioner, 121 T.C. 1, 4 (2003), aff’d, 387 F.3d 27 (1st Cir. 2004).

A great many small and medium-sized businesses elect S corporation status because the Code affords them special treatment—income earned by the corporation escapes corporate-level taxation. Mourad, 121 T.C. at 3; see §§ 1363, 1366. That income is instead “passed through” to its shareholders pro rata. See §§ 1363, 1366. But electing to be an S corporation is not enough. The Code has several other requirements. These include having no more than 100 shareholders, having only shareholders who are individuals—or certain trusts or nonprofits—and not having any nonresident alien shareholders. § 1361(b)(1). The parties don’t dispute that Schricker met these requirements.

There’s one other requirement. Section 1361(b)(1)(D) allows a corporation to be an S corporation only if it has no more than one class of stock. What does that mean? Section 1361 doesn’t say, but we know that run-of-the-mill debt isn’t a second class of stock. § 1361(c)(5)(A). And neither are differences in common-stock voting rights. § 1361(c)(4).

The regulation gives us a little more help. It generally treats a corporation as having only one class of stock so long as all the shares confer equal rights to dividends and liquidation proceeds. Treas. Reg. § 1.1361-1(l)(1) (“[A] corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds”).

The regulation also tells us to determine whether stock confers identical rights to distributions and liquidation proceeds based on the corporation’s governing provisions. Id. subpara. (2)(i). These are
documents like a corporate charter, articles of incorporation, and bylaws. Id. The IRS has said it won’t treat any disproportionate distributions made by a corporation as violating the one-class-ofstock requirement if the governing provisions provide for identical rights. Rev. Proc. 2022-19, § 3.02, 2022-41 I.R.B. 282, 286.

The regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what shareholders actually do. The regulation states that uneven distributions don’t mean that the corporation has more than one class of stock. Treas. Reg. § 1.1361-1(l)(2) (“[A] corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights . . . .”).