Disproportionate Distributions Do Not Always Endanger S Corporation Status

An election to treat a corporation as an “S corporation” can provide significant tax benefits. Because of these benefits, shareholders are naturally concerned that the corporation maintain this status year-to-year. Finding out that an S election has been inadvertently terminated because one of the many S corporation qualification rules has been violated can cause serious problems, especially when the business is about to be sold.

One qualification rule is that an S corporation can only have one class of stock, although voting and nonvoting stock is permitted. While this means that an S corporation cannot have preferred stock, people often think that inadvertent disproportionate distributions from an S corporation will automatically terminate an S election, since a disproportionate distribution is indicative of a second class of stock.

The fact is that as long as the corporation’s governing documents don’t provide for the disproportionate distributions, if such distributions are made inadvertently, they generally can be “fixed” as a recent private letter ruling (PLR 201444020) held. This PLR discusses a situation where an S corporation made disproportionate distributions to its shareholders, each of which was a grantor trust. These distributions were apparently made over a period of years, so it was not just a one-time occurrence.

The Articles of Incorporation of the corporation provided for only one class of shares, and the corporation represented that it did not intend to create differences in rights between the shares. The corporation also “fixed” the disproportionate distributions by making a corrective distribution.

The IRS noted that second class of stock issues are analyzed by looking at the corporation’s “governing documents“ – Articles of Incorporation, Code of Regulations, Shareholder Agreements, and so forth. If these documents provide for identical rights with respect to distribution and liquidation, inadvertently making disproportionate distributions will generally not terminate an S election, especially where remedial distributions can be made.