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Court: distribution preference not automatic second class of S corporation stock

March 17, 2009

Back in the 1990s, the Treasury struck fear in S corporation owners by proposing regulations that would terminate S elections for trivial violations of the "second class of stock" rules. All S corporation shares must have identical economic rights, though voting rights may differ.

The proposed rules would have made operation as an S corporation almost impossible, and after strong taxpayer protests the IRS relented and came up with much more sensible rules. Now the rules focus on the legal rights of the shares, leaving inadvertent disproportionate distributions alone.

A shareholder in Louisiana didn't want to pay taxes on the income from her S corporation K-1, so she argued that preferential payments to her parents constituted a second class of stock. The Fifth Circuit last week ruled that the taxpayer didn't establish how any such payments made to the parents were a binding agreement that gave them different legal rights from the other shareholders.

The moral? While it's surely possible to blow an S election through disproportionate distributions, it's not automatic.

Cite: Minton, CA-5, No. 08-60284

Tags: s corporations.