When structuring a corporation, particularly an S Corporation (S Corp), understanding the difference between voting and nonvoting shares is crucial for both compliance and strategy. S Corps offer a unique blend of tax advantages and limited liability, but come with very specific requirements under IRS rules. One of those requirements is related to the type and class of shares the corporation can issue. To remain compliant, while also managing ownership and control effectively, many S Corps explore issuing both voting and nonvoting shares. This structure allows companies to raise capital or reward stakeholders without diluting the decision-making power of current owners.
Understanding S Corporation Structure
What is an S Corporation?
An S Corporation is a special tax designation that allows a corporation to pass income, losses, deductions, and credits through to shareholders, avoiding double taxation. To qualify as an S Corp, the entity must meet certain criteria defined by the Internal Revenue Service (IRS), including:
- Be a domestic corporation
- Have only allowable shareholders (individuals, certain trusts, and estates)
- No more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (such as certain financial institutions or insurance companies)
Among these rules, the requirement of having only one class of stock is often misunderstood, especially when a company wants to issue voting and nonvoting shares. However, the IRS has clarified how this works under its guidance.
Voting vs. Nonvoting Shares in an S Corporation
The Myth of the One Class of Stock Rule
Contrary to common misconception, the one class of stock rule for S Corporations does not prohibit issuing shares with different voting rights. Instead, the IRS focuses on whether all shares provide identical rights to distribution and liquidation proceeds. As long as all shares have equal economic rights, the voting structure can differ without violating S Corp rules.
Defining Voting Shares
Voting shares grant the shareholder the ability to influence company decisions through votes. This includes electing board members, approving major business decisions, or altering the corporation’s bylaws. In most S Corps, founders and key stakeholders hold the majority of voting shares to maintain control of the company’s direction.
Defining Nonvoting Shares
Nonvoting shares offer ownership in the company and the right to share in profits and distributions, but do not provide the right to vote on corporate matters. These shares are useful when a corporation wants to raise funds or provide equity compensation without transferring control.
Benefits of Issuing Voting and Nonvoting Shares
Maintaining Control
One of the primary advantages of issuing nonvoting shares is maintaining control while expanding ownership. Founders can retain decision-making authority while offering shares to investors or employees who contribute financially or operationally but do not need voting power.
Attracting Investors
Startups and growing S Corps often need capital. Offering nonvoting shares allows a company to bring in new investors without diluting the influence of original shareholders. This makes it an attractive structure for both entrepreneurs and investors who are focused on returns rather than control.
Succession Planning
In family-owned S Corporations, transferring nonvoting shares to heirs can help with estate planning while ensuring that the management of the business remains in experienced hands. It allows for wealth transfer without relinquishing strategic control.
IRS Compliance and Structure Requirements
Ensuring Economic Rights Are Identical
For an S Corporation to remain in good standing, the IRS requires that all shares voting or nonvoting must have the same distribution and liquidation rights. This means that shareholders must receive proportionate dividends and payments upon dissolution, regardless of voting privileges.
Documenting Share Rights
The corporation’s governing documents, such as its topics of Incorporation and Shareholders Agreement, must clearly define the rights of each share class. These documents should explicitly state that voting and nonvoting shares have equal rights to distributions and liquidation proceeds to avoid any appearance of multiple stock classes.
Potential Consequences of Noncompliance
If the IRS determines that an S Corp has inadvertently created a second class of stock through unequal distribution rights or unclear documentation it can terminate the company’s S Corp status. This would result in the company being taxed as a regular C Corporation, potentially leading to double taxation and other financial setbacks.
Common Use Cases of Nonvoting Shares in S Corps
- Employee Equity Plans: Offering nonvoting shares to employees as bonuses or performance incentives without risking control shifts.
- Angel Investments: Securing funding from individual investors who prefer profit sharing over board involvement.
- Silent Partnerships: Bringing in capital partners who want to participate financially without managing the business.
- Estate and Family Business Transfers: Passing wealth to family members without changing leadership structures.
Practical Tips for Issuing Voting and Nonvoting Shares
Amend Corporate Documents
Before issuing nonvoting shares, amend your topics of Incorporation and bylaws to define the two types of shares. Be sure to consult legal counsel to ensure these changes align with IRS rules and state corporate law.
Keep Detailed Records
Maintain clear shareholder ledgers and issue stock certificates that identify the voting status of each share. This will help clarify ownership and prevent misunderstandings during audits or disputes.
Communicate with Shareholders
Transparency is essential. All shareholders should understand the implications of holding voting or nonvoting shares. Setting expectations early can reduce friction and build trust among stakeholders.
Work With Experienced Advisors
Since S Corporation compliance is delicate, working with attorneys and accountants experienced in corporate tax and structure is essential. Their guidance will help you avoid costly missteps and remain IRS-compliant.
Understanding the dynamics of voting and nonvoting shares in an S Corporation is essential for maintaining control, complying with IRS requirements, and pursuing strategic growth. By issuing nonvoting shares wisely and documenting the structure carefully, S Corps can enjoy the best of both worlds: flexible ownership and secure control. Whether you are attracting investors, incentivizing employees, or planning for succession, the proper use of share classes can make a significant difference in your company’s long-term success.