Rev. Rul. 63-226

Advice has been requested whether a corporation, which otherwise qualifies as a small business corporation, meets the requirement of section 1371(a)(4) of the Internal Revenue Code of 1954 where there is an agreement between the shareholders which requires shareholders who are not actively engaged in the business to grant irrevocable proxies to an active shareholder to vote their shares.

In the instant case a partnership, consisting of eight active partners and two limited partners, was incorporated. Voting common stock was the only class of stock authorized and issued. The stock was issued to the former partners of the partnership in accordance with their pro rata interest in the partnership.

All of the shareholders of the corporation entered into an agreement which provides that any shareholder who at any time is not actively engaged in the business of the corporation will grant an irrevocable proxy to one or more active shareholders to vote his shares of stock.

This required the former limited partners, who are now inactive shareholders, to grant irrevocable proxies to vote their shares to active shareholders. The specific issue is whether this requirement results in the corporation's having more than one class of stock.

One of the requirements which a corporation must meet in order to qualify as a "small business corporation" is that it must not have more than one class of stock. Section 1371(a)(4) of the Code.

In connection with the requirement that the corporation not have more than one class of stock, section 1.1371-1(g) of the Income Tax Regulations provides, in part, as follows:

* * * If the outstanding shares of stock of the corporation are not identical with respect to the rights and interest which they convey in the control, profits, and assets of the corporation, then the corporation is considered to have more than one class of stock. Thus, a difference as to voting rights, dividend rights, or liquidation preferences of outstanding stock will disqualify a corporation. * * *

Because of the restrictions placed upon the inactive shareholders under the agreement in the instant case, it is held that their rights and interests in the control of the corporation are not identical with the rights and interests of the active shareholders. Furthermore, in the event that the outstanding stock of a corporation is subject to any other type of voting control device or arrangement, such as a pooling or voting agreement or a charter provision granting certain shares a veto power or the like, which has the effect of modifying the voting rights of part of the stock so that particular shares possess disproportionate voting power as compared to the dividend rights or liquidation rights of those shares and as compared to the voting, dividend and liquidation rights of the other shares of stock of the corporation outstanding, the corporation will be deemed to have more than one class of stock. Accordingly, the corporation does not qualify as a small business corporation.