An S corp cannot have two classes of stock. The IRS sets a number of requirements for S corporations, one of which is that the company have only one class of stock. Violating this requirement for your S corp, even accidentally, can have severe tax consequences both for your business and your personal income tax return.
No Multiple Classes
Companies electing S corp status must meet a number of requirements, including having only one class of shares. For example, if a company issues one class of preferred stock and one class of common stock, it would violate the one-class limitation for S corps. Violations also occur if there are differences in the common shares issued. For example, if one set of common shares receives a greater share of the profits than other common shares, the company has two classes of shares and cannot be an S corp.
Different Voting Rights Okay
An S corp can, however, have different voting rights for different shares, as long as that is the only difference. For example, an S corp could issue some shares without voting rights and not violate the restriction requiring the S corp have only one class of stock. However, if the shares with voting rights also received a larger share of the profits and losses or had a liquidation preference, then the shares are considered different classes and the S corp violates the requirement.
Why Use Different Voting Rights
The exception allowing different voting rights is often used when you want to transfer some of your ownership of the company without giving up control. For example, you may want to begin transferring a portion of your ownership to your daughter each year to lower your estate tax burden. However, you may want to retain total control of the company. To accomplish this, you could transfer nonvoting shares and retain your voting shares so that even though you may have transferred a majority of the ownership of the company, you still control the company.
Effects of Two Classes
A company that made the S corp election that has more than one class of stock is no longer an S corp. Once the second class is issued, the entity reverts back to being a C corporation. As a C corp, the company is no longer a pass-through entity, which means the profits and losses do not pass through to the shareholders. Instead, the company must pay the corporate income tax and any distributions made to shareholders are taxed as dividends.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."