Wednesday, April 30, 2008

Tax Risk - S Corporations and different voting stock & a voting stock trust

Question posted:

I prepared a SH agreement for a client company with 2 shareholders. I drafted it such that if either of the SHs gets a divorce, and the ex-wife is awarded any of the shares, then the company has the right to buy the shares from the ex-wife and the ex-wife must sell to the company. After some discussion, the 2 shareholders want to revise the SH agreement so that if either of them gets a divorce, the ex-wife can keep the shares, but upon the award of the stock to the ex-wife, the shares convert to non-voting stock. This way, the ex-wife's have ownership in the company, but absolutely no control/voting rights.

All of the stock of the corporation is common stock. Can this be done?

The comments that follow are NOT advice but for information purposes only that must first be checked by a professional:

1. It can be done, but the advisability of doing it is another matter.

I assume one class of stock now exists. Amend the articles of incorporation
to create a two series of common stock, one voting and one non-voting with
an equal number of shares authorized for each series. The existing shares
are converted into voting stock on a share for share basis. No non-voting
shares are issued at this time.

In the agreement, which each wife must sign, the parties agree that upon the
wife becoming a shareholder, she agrees to exchange her voting stock for
non-voting shares. I don't think that there would be any tax issue with the
exchange, but I really don't know for sure and would research that issue.

I would recommend that the wife be given the option to compel a buy-out of
her stock.

2. would have to add a caveat to the comment that it can be done. You do
not mention whether the corporation is a C corp or an S corp. If it is an
S corp (and has pass through taxation) then it can only have one class of
shares. Converting some of the shares to a second class would destroy the
S Corp eligibility. So if it is an S Corp make sure the client
understands the implications and still wants to go forward.

3.This can be done. If this is implemented, create a class of non-voting
common stock at the same time the SH agreement is finalized. This is
permissible even if the corp is a Sub S corp as long as that is the only
difference between the 2 classes (i.e. no different dividend rights,
redemption rights, etc.).

4.The tax regs allow an S Corp to have voting stock and non-voting stock
provided the vote is the only difference between the "classes".

5. Why not have the stockholders all sign a voting trust agreement (not sure whether your state allows them, CA does)? Then contractual require new stockholders to agree to the trust, with one of the clients as the trustee. In effect, trasnfering the voting rights to the trustee. Then you don't have to create new series/class of stock or deal with the sub S issues.

6. I agree with the consensus of previous comments. What is proposed (either variation) can be done but in many cases would not be a good idea. Usually the non-deceased business owner doesn't want the spouse and/or heirs of the deceased owner involved in the business, AND the flip side is that the business owners (when they're alive) don't want to stick their spouses and/or heirs in a situation with no vote, no participation in the business (i.e., no salary and benefits) and no cash since there is no market for the stock. The best answer in most cases is an automatic buyout funded by life insurance. But life insurance is not always readily available at a reasonable price, depending on the health and age of the principals. There is not one right answer for this type of situation, and tricks of the trade and nuances are more numerous than can be reasonably discussed on a listserv. The starting point should be what are the co-owners real-life intentions and desires, not their usually ill-informed notion that they should pursue a particular legal strategy that someone told them about. Some clients are more savvy about these things than others.

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