Rev. Rul. 71-522

Advice has been requested whether the issuance of stock under the circumstances described below will prevent a corporation from qualifying for treatment as a small business corporation under Subchapter S of the Internal Revenue Code of 1954.

The corporation was incorporated under the laws of California in 1969 with an authorized capitalization of 20,000 shares of no par common stock. Six individual subscribers to the stock contributed cash, and two individual subscribers contributed intangible property consisting of licensing agreements.

The law of California requires that before stock can be issued by any corporation, permission to issue such stock must be obtained from the Commissioner of Corporations of the State of California. In the instant case, the Commissioner of Corporations granted permission for the corporation to issue common stock to its subscribers subject to the following conditions: (1) that all stock issued be deposited with an approved escrow holder and that the owners thereof not sell or transfer such securities without the Commissioner's consent; (2) that the shareholders who were to receive stock in exchange for property were to agree in writing with the corporation that the holders of the stock issued for cash would have an irrevocable power of attorney to vote for the board of directors upon default in payment of two year's dividends at the rate of 5 percent per annum on the selling price of the stock; (3) that no shares were to be issued in exchange for property except upon execution of a waiver of all rights to participate in any distribution of assets of the corporation until the holders of the stock issued for cash received the full amount of their purchase price and any unpaid accumulated dividends thereon; (4) that the holders of the shares issued for property were to waive all rights to receive any dividends until the shareholders contributing cash received cumulative dividends equal to 5 percent per annum on the selling price per share; and (5) that the above conditions remain in effect until the Commissioner of Corporations by order releases the shares from escrow.

The shareholders executed an agreement whereby those shareholders who received stock for property agreed to adhere to the conditions set forth above.

Section 1371(a) of the Code provides, in part, that the term "small business corporation" means a corporation which does not have more than one class of stock.

Section 1.1371-1(g) of the Income Tax Regulations provides, in part, that 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 from being treated as a small business corporation.

The effect of the conditions on the shares issued in exchange for the intangible property, commonly referred to as promotional shares, is to subordinate them with respect to the control, profits, and assets of the corporation. The effect of the priorities on the shares issued for cash is to give them a prior claim to the income and assets of the corporation and contingent exclusive voting rights if a 5 percent priority dividend is not paid on the cash shares.

Because of the conditions placed upon the holders of the promotional shares in the instant case, it is held that their rights and interest in the control, profits, and assets of the corporation are not identical with the rights and interests of the holders of the cash shares, and therefore the corporation has more than one class of stock. Accordingly, the corporation does not qualify as a small business corporation.