✅You’ve elected S. Now you have to make sure you keep that status. Maintaining your S status is a matter of continuing to meet the qualification criteria, each and every day of the tax year. One of the criteria that tend to garner the most attention is keeping your corporation to “one class of stock,” or if you are really an LLC, keeping your membership equivalent to one class of stock. This criterion is about distribution rights. All owners have to have pro-rata rights to distribution and liquidation proceeds based on their percentage of equity ownership. I.e. if you own 51% of the equity, you should receive 51% of the distributions.
A traditional C Corporation tax problem would threaten your one class of stock status if it were not for the S Corporation Straight Debt Safe Harbor. One of the long-standing tax games has been to disguise equity as debt so that the distributions to equity holders could be treated as debt repayments and deductible interest expenses. Federal tax law gives the IRS tools to challenge this kind of capital structure by allowing them to re-characterize debt as equity if the features of that debt are not commercially viable. The statutory guidance is not conclusive on when that would be the case, but rather provides a list of factors that would indicate debt is really equity. For example, the statute provides that a thinly capitalized company (a large amount of debt and little equity financing) is a factor in determining the “true” economic character of debt versus equity.
While re-characterizing debt to equity can be an annoyance in the C Corporation world (loss of interest deductions and owner’s recognition of dividend income), it would be devastating in the S Corporation context. If the debt of an S Corporation could be re-characterized by the IRS, based on their analysis of the facts, the result could be a second class of stock and the termination of your S election. Consider the payments on that debt made, which aren’t necessarily pro-rata to your ownership %. Providing “preferential” distributions on that debt, now re-characterized as equity, is the definition of the second class of stock.
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