Corporations are usually subject to federal income tax, but an important exception is made for “S corporations.” The items of income and gain of an S corporation are not, in general, taxed at the corporate level, but rather are “passed through” and taxed to its shareholders (whether or not distributions are made to them). There are numerous requirements that a corporation must meet in order to qualify as an S corporation, one of which is that the corporation may have only one class of stock. The Treasury Regulations explain that this “one class of stock” requirement is met only if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.1
Under certain circumstances, a right to acquire stock (or another instrument) that on its face is not stock may be characterized as a “second class of stock” for purposes of this requirement, thereby causing the corporation issuing that right (or instrument) to lose its status as an S corporation.2 However, the Treasury Regulations include exceptions and safe harbors that may permit options and similar interests to be issued on commercially reasonable terms with little or no risk of characterization as stock for this purpose, and taxpayers and their advisors often take advantage of these rules to enable S corporations to develop more flexible capital structures within the framework of the statutory “one class of stock” requirement.
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