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October 28, 2016

S Corporations and Buy-Sell Agreements: Avoiding the Inadvertent Creation of a Second Class of Stock

Buy-sell agreements are frequently used by shareholders of both S corporations and C corporations to facilitate the orderly transition of ownership in the corporation and restrict the ability of the shareholders to transfer their shares. When preparing a buy-sell agreement for an S corporation, however, special consideration must be given to ensure that the agreement does not create a second class of stock, as an S corporation is not permitted to have more than one class of stock. If an S corporation has more than one class of stock, the corporation’s S status will terminate. The termination of a corporation’s S status can have severe tax implications on the shareholders of the S corporation.

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. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock.

A buy-sell agreement among an S corporation and its shareholders restricting the transfer of shares is disregarded in determining whether an S corporation’s outstanding shares of stock confer identical distribution and liquidation rights unless (1) a principal purpose of the agreement is to circumvent the one class of stock requirement and (2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock.

While buy-sell agreements are helpful in facilitating the orderly transition of ownership in an S corporation and restricting the ability of shareholders of an S corporation to transfer their shares, it is necessary to ensure that the buy-sell agreement does not inadvertently create a second class of stock. The attorneys in Boutin Jones’s Tax and Corporate and Securities group can help you determine if your buy-sell agreement inadvertently creates a second class of stock causing your status of an S corporation to be terminated.

Please contact any member of the Boutin Jones Tax Group or the Boutin Jones Corporate and Securities Group if you have any questions about this article.