Can an s corp issue stock options

By Kathleen A. Kelley on August 15, 2014.
Many of my clients are interested in forming S corporations instead of C corporations so they can save money on taxes. S corps are great, but the Internal Revenue Code imposes many requirements on S corps, some of which may trip up small businesses.
The requirement I get asked about most often is the restriction that all shareholders or members must share in one class of stock. This can be an issue for early stage companies that like to issue stock as compensation or reward for employees, but that don’t want to give out the exact same stock that is owned by the founders. Thankfully, the IRS only requires the stock to have identical rights to distributions and liquidation proceeds, not identical rights in voting. With this in mind, it is possible to provide your employees with non-voting common stock instead of voting common stock and not affect your S election.
S Corporations vs. C Corporations.
An S corporation is a corporation or LLC formed under the laws of a state that then elects to be treated as an S corporation. The election is not made in the Articles of Incorporation or Articles of Organization of the entity, but typically made promptly after formation on form 2553, filed with the IRS. By electing S status, the entity can pass through all of its gains, losses, deductions and credits to its shareholders or owners so there is only one level of tax, at the respective owner’s federal tax bracket. In contrast, a corporation that does not elect S status, called a C corp, will recognize all the gains, losses, deductions and credit at the corporate level and at the shareholder or owner level, resulting in a double tax.
Requirements for S Corporations.
Not all corporations or LLCs can qualify to elect S status. Among other requirements, the entity must:
Be a corporation formed in the United States; Have only natural persons or certain trusts as shareholders (no corporate or partnership owners in an S corp); Have no more than 100 shareholders or members; and Have only one class of stock.
Employee Stock Plans/Equity Compensation.
In order to incentivize employees, companies frequently issue stock options or restricted stock to employees. The stock is issued to attract talent, as a reward for performance or as an incentive to remain at the company, or all three. The thinking is that as a part-owner, the employee will be more invested in the company and work harder to achieve results that he or she will ultimately share with the other owners.
While the employer may recognize the benefit to having employees share in the profits of the company as an equity owner, employers tend not to want these same employees to have the exact same rights in the stock as the company’s founders. The easiest way to distinguish the founders from the employee-owners is to limit the voting stock to the founders or angel investors. This structure keeps management at the founder level, those who hold voting common stock, but profits and all economic ownership is shared among all the common-stock owners.
A company that desires the flow-through taxation benefits of an S corporation is not required to issue identical stock to all of its owners. The company can issue voting common stock and non-voting stock as long as the stock has identical rights to distributions and liquidation proceeds.

Executive Compensation Plans for S Corporations.
Incentive Compensation.
Stock Options.
1. Nonqualified Stock Options. Instruments granted by the corporation to the employee, giving the employee the right to purchase corporate stock at a designated price through some future date. Under IRC §83(e)(3), options are not taxed at the date of grant unless they have a readily ascertainable fair market value. Must be careful that options do not create a second class of stock and violate S corporation status.
2. Incentive Stock Options. An option to purchase stock in the corporation at some future date. However, incentive stock options allow the holder to receive special tax treatment upon their exercise that is not available to the holder of a nonqualified stock option, provided the incentive stock option meets rigid statutory qualifications. See IRC §422. If these requirements are met, the holder may generally exercise the options free of tax, and postpone the taxable event until such time as the stock received is sold (after a two-year holding period of the option and a one-year holding period of the stock) for capital gains treatment.
Restricted Stock.
1. Voting or nonvoting stock that contains certain restrictions, such as a required service term, performance goals or certain events that must be met before the employee takes unfettered possession of the securities.
2. The stock is provided at no cost or nominal cost to employee, with the restrictions often lifted on a vesting schedule.
3. Restrictions generally constitute a substantial risk of forfeiture, thereby postponing taxation to the employee under IRC §83(a) (and the employer s deduction) until such time as the substantial risk of forfeiture lapses. However, the employee can elect under IRC §83(b) at the date of grant to take into income as compensation the difference between the stock s value and the price the employee has paid for the stock at grant date, regardless of the presence of the substantial risk of forfeiture. Employee is not a shareholder during the vesting period.
4. As a result, the use of restricted stock represents a way to postpone taxation or spread taxation to the employee over a number of years, while retaining the employee s services.
5. Could create potential problems if the stock is treated as a second class of stock during the restriction period.
Example — PLR 200118046. S corporation shareholders transferred stock to employees in order to eventually transfer ownership. Ruled that (a) the issuance of nonvoting common stock will not cause the S corporation to have more than one class of stock; (b) the employee is not a shareholder during the vesting period but becomes a shareholder when vested; (c) the shareholder s transfer of incentive stock to the employee is treated as a contribution of stock to the S corporation and an immediate transfer by the S corporation to the employee under IRC §83.
Phantom Stock/Stock Appreciation Rights.
1. Phantom Stock. Employer awards bonuses to employee in the form of “phantom” shares of corporate stock. No tax is paid by the employee at the time these amounts are credited to his account; however, the employee s receipt of payments on the phantom units will be treated as a compensatory event subject to tax, and will be deductible by the S corporation. GCM 39750 (May 18, 1988) indicated that phantom stock and other similar arrangements would not create a second class of stock as long as they are offered to employees, are not property under Regs. §1.83- 3, and do not convey the right to vote.
2. Stock Appreciation Rights. Similar to phantom stock. Represent the right to receive the appreciation in the value of a share of stock that occurs between the date of grant and the date of exercise. The grant is not taxable; however, upon exercise, the employee must treat all benefits as taxable compensation at which time the employer also receives a deduction.
3. Performance Bonuses. Linked to corporate performance. Units corresponding to shares of stock are credited to an employee s account. The number of shares to be credited is generally based upon the fair market value of the employer s stock or, in the case of closely held corporations, its book value. Also, the employee s account is credited with the dividend equivalents on such phantom stock.
Unreasonable Compensation.
Excessive Compensation.
Generally, excessive compensation is not a problem unless there is an attempt to manage taxable income for purposes of the built-in gains, passive income or state income taxes.
Inadequate Compensation.
1. Rev. Rul. 74-44, 1974-1 C. B. 287 (when a shareholder receives corporate distributions in lieu of wages, the IRS may recharacterize such distributions as wages and thus assess FICA and FUTA.
(a) Dunn and Clark , P. A. v. C. I.S. for and on behalf of U. S., 57 F.3d 1076 (C. A. 9, Idaho, 1995).
(b) Joseph Radtke v. U. S ., 712 F. Supp. 143 (E. D. Wis. 1989), aff d per curiam, 895 F.2d 1196 (7th Cir. 1990).
(c) Spicer Accounting v. U. S. , 918 F. 2d 90 (9th Cir. 1990), aff’g an unreported District Court decision.
2. Courts have reclassified where shareholders not actively involved in running corporation, see e. g., Davis v. U. S. , 74 AFTR 2d-94-5618 (D. Colo. 1994).
3. Unclear as to whether courts will support that compensation (and payroll taxes) should have been paid.
(a) Paula Construction Co. v. Com’r , 58 T. C. 1055 (1972), aff’d per curiam, 474 F.2d 1345 (5th Cir. 1973), (court looked at intent of parties and would not allow a reclassification of dividend to compensation).
(b) Electric and Neon, Inc. v. Com’r , 56 T. C. 1324 (1971), aff’d, 496 F.2d 876 (5th Cir. 1974) (Tax Court indicated that a corporate deduction for compensation may be claimed, as long as payments (i) do not exceed the reasonable compensation for the services actually rendered, and (ii) are actually intended to be paid purely for services. Based upon the facts of this case, no deduction was allowed).
4. Reasonable salaries must be paid to employees. See TAM 9530005 (a corporate officer of an S corporation performed significant services for an S corporation and had to include his “management fee” as wages subject to FICA and FUTA).
S Corporations and Self-employment Income.
Rev. Rul. 59-221, 1959-1 C. B. 225 (income passing from an S corporation to its shareholders is not earnings from self-employment).
1. Durando v. United States , 70 F.3d 548 (9th Cir. 1995).
2 . Crook v. Comm’r , 80 T. C. 27 (1983).
3. Katz v. Sullivan , 791 F. Supp. 968 (D. NY 1991).
4. Pointer v. Shalala , 841 F. Supp. 201 (D. Tex 1993).
5. Ding v. Comm’r , 200 F.3d 587 (9th Cir. 1999).
Fringe Benefits.
1. IRC § 1372(a)(1). An S corporation will be treated as a partnership for purposes of applying the IRC provisions relating to employee fringe benefits. Any 2% shareholder shall be treated as a partner of such partnership.
2. A 2% shareholder means any person who owns (or is considered owning within the meaning of IRC § 318) on any day during the taxable year of the S corporation more than 2% of the outstanding stock of such corporation or stock possessing more than 2% of the total combined voting power of all stock of such corporation.
3. Compare to C-corporation and to partnership-type entities.
4. Effect of partnership treatment:
(a) Rev. Rul. 91-26, 1991-1 C. B. 184, (health insurance premiums paid on behalf of more-than-2% shareholder to be treated in a manner similar to guaranteed payments under IRC §707(c)).
(b) Effect on employee.
(c) Reporting and withholding requirements.
(d) Application to other benefits.
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How to Issue Stock.
Corporations issue shares of stock to raise money for their business. The shares that are issued represent the amount of money invested by the shareholders in the company. Shareholders have an ownership stake in the company and enjoy certain rights such as voting rights and the receipt of dividends. Therefore it is very important to consider how to issue stock when organizing your corporation.
Steps Edit.
Method One of Two:
Deciding Whether To Issue Stock Edit.
Method Two of Two:
Community Q&A.
No, companies are not required to issue stock. It's usually done just to raise operating capital.
It depends on the circumstances. For example, a share can be transferred as a gift from parent to child, but stocks given away by a company has to be declared to the proper authorities.
Share values reflect public opinion about the future prospects of the issuing company.
Warnings Edit.
Related wikiHows Edit.
Calculate Safety Stock.
Invest in Stocks.
Buy a DRIP Stock.
Calculate Variable Costs.
Do a Cost Analysis.
Calculate Food Cost.
Calculate the Cost of Debt.
Calculate Marginal Revenue.
Expert Review By:
This version of How to Issue Stock was reviewed by Michael R. Lewis on February 18, 2017.

Can an S Corp Issue Stock?
An S corporation may issue stock to its owners. However, the Internal Revenue Service imposes a significant number of restrictions on the stock issued by the S corp, which may make an S corp an ineffective business entity for certain entrepreneurs. Knowing the restrictions before you decide the entity type you want to use for your business helps you make a better decision.
An S corporation may issue stock to its owners. However, the Internal Revenue Service imposes a significant number of restrictions on the stock issued by the S corp, which may make an S corp an ineffective business entity for certain entrepreneurs. Knowing the restrictions before you decide the entity type you want to use for your business helps you make a better decision.
Classes of Stock.
S corps may not issue more than one class of stock. For example, an S corp could not issue one class of stock that received dividends and one class of stock that did not. The IRS does make an exception to the one-class-of-stock rule if the only difference between the two classes of stock is the voting rights. For example, an S corp is permitted to have one class of stock with voting power and one class of stock without voting power. This is particularly helpful when shareholders of family-owned S corps want to begin passing ownership to their heirs, but still want to retain control of the company. For example, if a shareholder wanted to begin transferring ownership to his children to limit his estate tax, but did not want his children running the company, he could transfer non-voting stock to the children.
Number of Shareholders.
An S corp cannot have more than 100 shareholders. However, the IRS allows family members to agree to be counted as one person for the purposes of this limit. A "family member" includes any lineal descendent of a common ancestor no more than six generations prior to the youngest member of the family, any spouse or prior spouse of the common ancestor, or any of the lineal descendants. For example, a husband and wife, their two children, their children's spouses, and their three grandchildren and spouses, would all be considered one shareholder as long as they agreed to be treated as one owner. To ensure that the S corp does not run afoul of this restriction, most S corps have restrictions on when shares can be sold and who may purchase the shares.
Allowable Stockholders.
The IRS also limits who can be a shareholder in an S corp. Unlike C corporations, shareholders must be individuals that are either U. S. citizens or U. S. residents. Shareholders can also be the estate of a former shareholder, certain domestic trusts, and certain tax-exempt entities such as 501(c)(3) organizations. However, if even one shareholder does not meet the requirements, such as a U. S. resident electing to become a nonresident, the S corp no longer complies with all the S corp restrictions.
Results of Violations.
If the S corp violates one of the restrictions on its stock, such as the number of shareholders or having more than one class of stock, it loses its S corp status. When an S corp loses its status, it becomes a regular C corporation, which means that the income and losses no longer flow through to the shareholders. Instead, the company must pay the corporate income tax. Losses cannot be used on the personal returns of the shareholders and any distributions from the company are taxed as dividends.
References.
Related articles.
S Corp Restrictions in Georgia.
Eligible Georgia business can elect S corporation status for purposes of federal taxation. The benefit of making the election is that it allows your business to avoid paying income taxes at the corporate level. Instead, the profit of the business passes through to each shareholder, who declares the income on his personal tax return. The business's profits are therefore taxed only once. Certain restrictions prevent every business entity from electing to be treated as an S corporation.
S-Corp Shareholder Requirements.
An S corporation is a business that has made the election to be taxed as a pass-through entity, meaning that each shareholder reports her portion of the business's income on her personal tax return. However, noncompliance with the shareholder limitations could terminate the S corporation election, causing the company to be taxed as it was before the election. For example, if the company was a C corporation before the election, it goes back to being taxed as a C corporation. Instead of the company’s income being taxed just once, it’s hit with the corporate tax when the company makes the money and with the personal income tax when the company distributes it to shareholders.
S Corp Vs. Corp.
Incorporating a business creates a separate legal entity and protects shareholders with limited liability. However, a corporation can be either a C corporation or an S corporation. An S-corp is a C-corp that has made a special election. The differences relate to who can be a shareholder and how the company and shareholders pay taxes on the business's profits and losses.
Relevant links.
Related articles.
S Corporation Qualifications.
Many small businesses elect to be treated as S corporations. This is often a smart business decision because with an S .
S Corporation Restrictions.
An S corporation offers companies the ability to funnel their earnings and losses directly to the owners, thereby avoid .
Can an S Corp Have Two Classes of Stock?
An S corp cannot have two classes of stock. The IRS sets a number of requirements for S corporations, one of which is .
S Corporation Compliance.
Corporations that meet the qualifications to be an S corp can be taxed as a pass-through entity. This allows the .
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