Rev. Rul. 73-611

The Internal Revenue Service has reconsidered Rev. Rul. 63-226, 1963-2 C.B. 341, in light of the decision of the United States Tax Court in Parker Oil Company, 58 T.C. 985 (1972).

Rev. Rul. 63-226 holds that where, pursuant to a shareholder agreement, the inactive shareholders of a newly formed electing small business corporation grant irrevocable proxies to vote their shares to other shareholders actively engaged in the business, the shares upon which the proxies were given constitutes a second class of stock because of the disproportionate voting rights they convey. Thus, the corporation is disqualified from making the Subchapter S election under section 1371 of the Internal Revenue Code of 1954.

In Parker Oil Company, the United States Tax Court held that a difference in voting rights between shares of stock in an electing small business corporation resulting from the transfer of irrevocable proxies pursuant to an agreement among the shareholders did not create a second class of stock in the corporation. It therefore held that the corporation remained qualified to be treated as an electing small business corporation under section 1371 of the Code. The Court held that section 1.1371-1(g) of the Income Tax Regulations and Rev. Rul. 63-226 were invalid, and distinguished Pollack v. Commissioner, 392 F.2d 409 (5th Cir. 1968).

Section 1.1371-1(g) of the regulations provides, in part:

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.

In the Pollack case, a corporation's articles of incorporation were amended to provide for four classes of stock, each having the right to elect one director. Affirming the decision of the United States Tax Court (47 T.C. 92 (1966)), the Court of Appeals held that the amendment created more than one class of stock in the corporation, and that the corporation was no longer qualified to be treated as an electing small business corporation under section 1371 of the Code and section 1.1371-1(g) of the regulations.

In Parker Oil Company, the Tax Court distinguished Pollack on the grounds that the difference in voting rights there arose by virtue of the amendment to the corporation's articles of incorporation, while the proxies on the shares of the Parker Oil Company shareholder were given pursuant to a shareholder agreement.

Accordingly, it is held that, if disproportionate voting rights in stock of a small business corporation arise out of the corporation's charter or articles of incorporation, the corporation has more than one class of stock, and is thereby disqualified from making the Subchapter S election under section 1371 of the Code. However, if disproportionate voting rights arise out of agreements among shareholders or between shareholders and third parties not involving the corporation's formal ownership structure, such disproportionality does not cause a second class of stock to arise in the corporation for purposes of section 1371(a)(4).

The Service acquiesces in result only in Parker Oil Company, 58 T.C. 985 (1972). See page 3 of this Bulletin. The acquiescence is limited because of the continued applicability of section 1.1371-1(g) of the regulations in the circumstances described above.

Rev. Rul. 63-226 is hereby revoked.