Can an S Corporation Issue Incentive Stock Options?

Managers and owners of businesses are often looking for ways to motivate their employees. Incentives, such as pay raises or vacation time, are often used. Incentive Stock Options, called ISOs, are another popular option. Giving employees a chance to own stock in the company helps them feel like an integral part of the operation and can result in increased productivity. Issues arise as to whether an S corporation can issue ISOs.

S Corporations

S corporations are corporations that have made a formal election under the Internal Revenue Code to be taxed differently from the standard C corporation. Essentially, the tax rules allow S corporations to avoid paying taxes on corporate income. Instead, that income passes through the corporation and is reported on the shareholders personal income tax returns. In return for favorable tax status, the S corporation must meet strict rules set forth by state law and the Internal Revenue Service. S corporations can only have a limited number of shareholders (100 under the federal rules as of January 2011). Further, S corporations can only issue one class of stock.

Single-Class of Stock Rules

According to an accounting article published by the California State Polytechnic University in Pomona, all outstanding shares of stock must “confer identical rights to proceeds upon distribution and liquidation.” Frascona.com differentiates between different classes of stock. In a C corporation, classes of stock can confer rights to receive proceeds prior to holders of a different class of stock in a set up between preferred and common shares of stock. S Corporations cannot issue preferred and common stocks, but as long as they stay within the confines of the rules regarding one single class of stock, an S corporation may be able to issue incentive-like stock options.

Incentive Stock Options

ISO plans must be approved by the board of directors and the shareholders of the company. The company allows employees to obtain shares of stock once they comply with the rules and regulations set forth in the company’s ISO plan. Employees holding an ISO are able to defer taxes on the shares until the shares are sold.

ISOs and S Corporations

An S corporation must abide by the relevant rules regarding the single class of stock when contemplating implementing an ISO plan. The S corporation must ensure that the ISO does not result in the corporation exceeding the number of allowable shareholders, and the shares of stock in the ISO must be identical to the stock held by the other shareholders so as not to violate the single-class of stock rule. It is better to err on the side of caution: losing S corporation status may result in retroactive taxation on corporate profits. Readers must speak to a professional in their area, such as a business attorney or certified public accountant, before issuing an ISO for their S corporation.