Can an S Corp Issue Nonvoting Stock and Keep One Class of Stock? (w/Examples) + FAQs

Yes, an S corporation can absolutely issue both voting and nonvoting stock without violating its special tax status. This is one ofthe most powerful yet misunderstood strategies available to small business owners.

The core conflict stems directly from the Internal Revenue Code, specifically IRC § 1361(b)(1)(D). This law states that an S corporation can only have “one class of stock.” The immediate negative consequence of violating this rule is the automatic termination of the S corp election, which instantly converts the business into a C corporation and subjects it to the painful reality of double taxation.¹ This single rule creates a paradox for founders who want the tax savings of an S corp but also need the control of issuing different types of shares.

This isn’t a niche issue; S corporations are the most popular corporate structure in the United States, with the IRS reporting over 5 million S corp tax returns filed annually. Many of these business owners grapple with the need to transfer ownership value without giving up control.

Here is exactly what you will learn by reading this article:

✅ The Secret Exception: Discover the specific IRS regulation that explicitly allows S corps to have different voting rights, separating economic ownership from control.⁴
📜 Your Company’s “Rulebook”: Understand why your corporate documents—not your daily actions—are the only thing the IRS looks at to determine if you have one class of stock.⁴
👨‍👩‍👧 Strategic Scenarios: See real-world examples of how to use nonvoting stock for family succession, employee incentives, and attracting investors without losing control.⁷
💣 Avoiding Landmines: Learn how common business agreements, like buy-sell agreements and loans, can accidentally create a second class of stock and destroy your S corp status.⁴
🆘 The “Oops” Button: Find a step-by-step guide to fixing a late or terminated S corp election using special IRS relief procedures, potentially saving you tens of thousands in fees and taxes.¹³

The Golden Rule of S Corps: One Economic Family, Many Voices

To understand how an S corp can have two types of stock (voting and nonvoting), you first need to understand what the IRS really means by “one class of stock.” The government’s definition is surprisingly narrow and focuses entirely on money.

The core principle is found in Treasury Regulation § 1.1361-1(l). This rule states that a company has one class of stock if all its shares give owners identical rights to distribution and liquidation proceeds.⁵ Think of it like this: every share of stock must be entitled to the exact same slice of the pizza (distributions) and the exact same share of the assets if the pizza shop closes down (liquidation).

The entire purpose of this rule is to keep things simple for the IRS.⁴ If different stock classes had different rights to profits, the IRS would have a nightmare trying to figure out how to allocate the company’s income to each shareholder for tax purposes. By forcing every share to have the same economic rights, the math stays simple.

This focus on money is the key. The rule intentionally ignores other differences between shares, which leads us to the most important exception in the entire S corp playbook.

The Voting Rights Carve-Out: Your Path to Retaining Control

The same regulation that establishes the “identical economic rights” rule provides a massive and explicit exception. Treasury Regulation § 1.1361-1(l)(1) clearly states that “differences in voting rights among shares of stock… are disregarded” when determining if a corporation has one class of stock.⁴

This is the legal green light. It means you can create a capital structure with both powerful voting stock and completely nonvoting stock, and as long as a share of each type gets the same dividend payment and the same payout in a sale, the IRS considers them to be the same class of stock.¹⁷

This allows for several powerful arrangements:

Class A Voting & Class B Nonvoting: The classic structure where one class controls all decisions and the other has no say.¹⁷
Limited Voting Rights: You could have one class that votes on everything and another that can only vote on huge decisions, like selling the company.⁴
Director Elections: You can even create different groups of shares with the right to elect different members of the board of directors.⁴

This legal distinction separates governance rights (like voting) from economic rights (like dividends). For S corps, only the economic rights must be identical.

The “Governing Provisions”: Why Your Paperwork Is More Important Than Your Actions

The IRS doesn’t determine if your company has one class of stock by looking at your bank statements or who you actually paid. Instead, they look at a specific set of documents called your “governing provisions.” These documents are the official rulebook for your company, and they are the ultimate source of truth.⁴

This “rulebook” includes:

Your corporate charter or articles of incorporation.
Your corporate bylaws.
The laws of the state where you are incorporated.
Any binding agreements between shareholders that relate to how money is distributed.⁴

Importantly, normal business contracts like office leases or employment agreements are not considered governing provisions unless you create them with the specific purpose of getting around the one-class-of-stock rule.⁵

A Shocking Court Case: Embezzlement Didn’t Terminate S Corp Status

The power of the governing provisions was proven in the stunning Tax Court case, Maggard v. Commissioner. In this case, two of an S corp’s three shareholders embezzled over $1 million by paying themselves distributions that were far larger than their ownership share. The third shareholder, who was underpaid, argued that this illegal act created a second class of stock, terminated the S election, and meant he shouldn’t have to pay taxes on his share of the income he never received.¹⁹

The court disagreed. It ruled that the S election was still valid. The court’s logic was simple: the actual distributions didn’t matter. What mattered was that the company’s “rulebook”—its articles and bylaws—still said that all shareholders had identical rights to distributions. The criminal actions of the other shareholders didn’t change the official corporate documents, so the one-class-of-stock rule was never technically broken.¹⁹

This case provides a critical lesson: perfectly drafted legal documents act as a shield for your S corp status. They can protect you from being destroyed by operational mistakes or even intentional wrongdoing by a partner.

How State Law Can Be a Hidden Trap

Your state’s laws are part of your governing provisions and can create unexpected problems. For example, if your state’s law requires that shareholders who contribute property instead of cash have to wait to receive distributions until the cash investors get their money back, that state law creates a second class of stock. Because the rights to distributions are not identical, your company would be ineligible to be an S corp from day one.⁵

However, some state laws are disregarded. If a state requires the S corp to withhold state income tax from distributions made to out-of-state shareholders, the IRS ignores this. As long as the in-state shareholders’ rights are adjusted to account for the money withheld for the others, all shares are still considered to have identical rights.⁵

Strategic Scenarios: Putting Nonvoting Stock to Work

The ability to issue nonvoting stock is not just a legal curiosity; it’s a powerful tool for solving some of the biggest challenges faced by private business owners. Here are the three most common and effective ways to use this strategy.

Scenario 1: The Family Business Succession Plan

A founder, “Brenda,” built a successful manufacturing company and wants to pass its economic value to her three children. Only one child, “Alex,” works in the business and is capable of running it. Brenda wants to treat her children equally financially but retain control and ensure Alex leads the company.

Brenda’s goal is to transfer wealth to all three children without giving up control or creating conflict between the active and inactive children.

Brenda’s Move	The Legal and Financial Outcome
Recapitalization	Brenda’s attorney amends the corporate articles to create two classes of stock: 1,000 shares of Class A Voting Stock and 9,000 shares of Class B Nonvoting Stock. Both classes have identical rights to dividends and liquidation proceeds.⁸
Stock Swap	Brenda exchanges her original 10,000 shares for the 1,000 new voting shares and 9,000 new nonvoting shares. This is generally a tax-free exchange under IRC § 1036.²¹
Gifting Program	Over several years, Brenda gifts the nonvoting shares equally to all three children (3,000 shares each). She retains all 1,000 voting shares, giving her 100% of the voting control.⁷
Valuation Discount	For gift tax purposes, the nonvoting shares are valued at a discount because they lack control and marketability. This allows Brenda to transfer more company value to her children while using less of her lifetime gift tax exemption.²²
Final Result	Brenda maintains complete control of the company. Alex, the active child, can be groomed to take over and eventually inherit the voting stock. All three children share equally in the company’s profits and future growth through their nonvoting shares.⁹

Scenario 2: Incentivizing a Key Employee

“David” and “Sarah” are the 50/50 owners of a rapidly growing software S corp. They need to hire a star developer, “Maria,” who wants an equity stake in the company. David and Sarah want to give Maria a piece of the financial upside to align her interests with theirs, but they are unwilling to give up any voting control.

The goal is to provide a meaningful equity incentive to a key employee without diluting the founders’ decision-making power.

Founders’ Strategy	The Legal and Tax Outcome for Maria
Stock Grant	The company grants Maria 500 shares of nonvoting common stock, representing a 5% stake. The shares are subject to a four-year vesting schedule, meaning she earns them over time as long as she stays with the company.⁶
Taxation Under § 83	As the shares vest each year, their fair market value is taxed to Maria as ordinary income. The company gets a corresponding tax deduction for that amount.⁶
The 83(b) Election	Maria can make a “Section 83(b) election” within 30 days of the grant. This allows her to pay ordinary income tax on the entire value of the stock today (when its value is lower) instead of as it vests. Any future appreciation will then be taxed as a long-term capital gain when she sells, which is a much lower rate.⁶
Protecting the S Election	The stock grant agreement includes a clause that restricts Maria from ever selling or transferring her shares to an “ineligible shareholder” (like a corporation, partnership, or non-resident alien). This protects the company’s S corp status.⁶
Final Result	Maria is now a part-owner, highly motivated to help the company succeed. David and Sarah have attracted top talent without giving up an ounce of control over their company’s direction.⁷

Scenario 3: Attracting a Passive Investor

An S corp that runs a chain of successful coffee shops needs $500,000 to expand into a new city. The founder, “Tom,” has an interested investor, “Laura,” who is an eligible S corp shareholder. Laura loves the business model and wants to share in the profits, but she has no interest in the day-to-day operations and doesn’t want the responsibility of voting on corporate matters.

Tom’s goal is to raise expansion capital from an outside investor without ceding any control over his business strategy.

Tom’s Capital Strategy	The Legal and Financial Outcome for Laura
Issuing New Shares	The corporation authorizes and issues new nonvoting shares. It sells a block of these shares to Laura for her $500,000 investment. The number of shares gives her a 20% economic stake in the company.¹⁰
Shareholder Agreement	Tom and Laura sign a shareholder agreement. The agreement confirms that her nonvoting shares have the exact same rights to distributions and liquidation proceeds as Tom’s voting shares.⁴
Pass-Through Profits	As an S corp shareholder, Laura now receives a Schedule K-1 each year. 20% of the company’s profits are passed through to her, and she pays the tax on that income on her personal tax return.²⁴
No Governance Role	Laura receives her share of the profits but has no right to vote on electing directors, approving budgets, or changing the company’s menu. Tom retains 100% of the voting control to run his business as he sees fit.⁷
Final Result	Tom successfully funded his expansion without giving up control. Laura has a passive investment that provides a direct share in the profits of a growing company, which was exactly what she wanted.¹⁰

The Danger Zone: How Agreements Can Accidentally Kill Your S Corp Status

While the voting rights exception is powerful, you can still accidentally violate the one-class-of-stock rule through poorly drafted agreements. The IRS will scrutinize any agreement that could indirectly create different economic rights for different shareholders. Fortunately, the regulations provide several “safe harbors” that protect common business practices.

The Two-Pronged Test for Shareholder Agreements

Buy-sell agreements, redemption agreements, and other restrictions on transferring stock are essential for any well-run company. For S corps, the IRS disregards these agreements unless they fail a two-part test:

A principal purpose of the agreement is to get around the one-class-of-stock rule, AND
The agreement sets a purchase price that is significantly above or below the stock’s fair market value (FMV) when the agreement is signed.¹¹

This test shows the IRS is targeting shady deals designed to funnel money to one shareholder over another, not standard agreements designed for business continuity.

| Agreement Type | Safe from IRS Scrutiny (Safe Harbor) | At Risk of Creating a Second Class of Stock |

|—|—|

| Buy-Sell / Redemption Agreements | Agreements triggered by death, divorce, disability, or termination of employment are always safe, regardless of the price.4 | The agreement’s main purpose is to circumvent the rule AND the price is significantly different from the fair market value.11 |

| Debt Instruments (Loans) | The loan qualifies as “Straight Debt” under IRC § 1361(c)(5): it’s a written promise to pay, interest isn’t tied to profits, it can’t be converted to stock, and the lender is an eligible shareholder.4 | The loan is really an equity investment in disguise (e.g., repayment is contingent on profits) and its main purpose is to get around the rule.5 |

| Options and Warrants | An option issued to an employee for services, or to a bank in connection with a loan. Also safe if the strike price is at least 90% of the stock’s FMV when issued.5 | The option is substantially certain to be exercised AND its strike price is substantially below the stock’s fair market value when it was issued.5 |

Do’s and Don’ts for S Corp Agreements

Do’s	Don’ts
✅ Use a Formula for Buy-Sell Pricing. Set the price at book value or a value between book value and fair market value. This falls into a specific IRS safe harbor.¹¹	❌ Don’t Tie Loan Repayments to Profits. A loan from a shareholder where interest payments depend on company performance looks like a second class of stock to the IRS.⁴
✅ Put All Shareholder Loans in Writing. To qualify for the “straight debt” safe harbor, the loan must be a written, unconditional promise to pay a specific amount on a specific date or on demand.⁴	❌ Don’t Create Different Payouts in Your Operating Agreement. For LLCs electing S corp status, make sure your operating agreement doesn’t have special allocations or preferred returns. It must mandate pro-rata distributions.³
✅ Restrict Stock Transfers to Ineligible Shareholders. Your shareholder agreement should explicitly void any attempt to sell shares to a corporation, partnership, or non-resident alien.⁶	❌ Don’t Ignore State Law. Remember that state laws are part of your “governing provisions.” A state law that forces non-identical distribution rights can invalidate your S election.⁵
✅ Document a Good Faith Determination of Value. When setting a price in an agreement, perform reasonable diligence to determine fair market value. The IRS will generally respect a good faith effort.⁵	❌ Don’t Issue Deep In-the-Money Options. An option with a strike price far below the stock’s current value that is almost certain to be exercised can be treated as a second class of stock.⁵
✅ Review Agreements After Major Events. After a change in ownership, a new round of financing, or a change in state law, review all governing provisions to ensure they remain compliant.	❌ Don’t Make “Side Deals” to Pay Shareholders Unequally. A binding agreement to give one shareholder a “bonus” distribution to cover their higher state taxes creates a second class of stock.⁴

Top 5 Mistakes That Can Inadvertently Destroy Your S Corp Status

Even with the best intentions, simple mistakes can lead to a catastrophic termination of your S election. Here are the most common errors business owners make.

Using a Generic LLC Operating Agreement. Many LLCs elect to be taxed as S corps. The problem is that standard LLC operating agreements often contain language allowing for “special allocations” of profits or preferred returns to certain members. This directly violates the S corp rule requiring identical rights to distributions and is one of the most frequent causes of a blown S election.³
Setting an Unreasonable Buy-Sell Price. You create a buy-sell agreement that allows you to buy back shares from a departing shareholder for $1 per share when the fair market value is $1,000 per share. If the main purpose of this agreement is seen as a way to create different economic outcomes, it could be treated as a second class of stock.¹¹
Accepting a Loan with Equity-Like Features. A shareholder gives the company a loan, but the agreement says interest will only be paid in years the company is profitable. Because the repayment is contingent on performance, the IRS can reclassify this “debt” as a second class of stock, terminating the S election.⁴
Transferring a Single Share to an Ineligible Shareholder. In a moment of carelessness, you sell or gift one share of your S corp to your friend who is not a U.S. citizen, or to a partnership you own. The moment that ineligible shareholder owns the stock, your S election is automatically terminated.⁶
Failing to Amend Documents After a State Law Change. Your state passes a new corporate law that inadvertently changes the distribution rights for different types of shareholders in a way that conflicts with the S corp rules. Because state law is part of your governing provisions, this change could terminate your S election if you don’t amend your corporate documents to override it.⁵

Your Step-by-Step Guide to Electing and Fixing S Corp Status

Navigating IRS forms and procedures can be daunting. Here is a detailed breakdown of the two most critical processes: making the initial S corp election and fixing it if something goes wrong.

Part 1: Making the S Corp Election with Form 2553

To become an S corp, you must file Form 2553, Election by a Small Business Corporation. The deadline is strict: it must be filed no more than 2 months and 15 days after the beginning of the tax year the election is to take effect .

Line-by-Line Breakdown of Form 2553 (Part I):

Name and Address: Enter the corporation’s exact legal name and address as it appears on other legal documents.
A. Employer Identification Number (EIN): You must have an EIN. If you don’t, you can apply for one online at IRS.gov/EIN. Do not leave this blank .
B. Date Incorporated: The date your corporation was legally formed.
C. State of Incorporation: The state where you filed your articles of incorporation.
D. Checkbox for Name/Address Change: Check this only if your name or address has changed since you applied for your EIN.
E. Election Effective Date: This is the most critical line. This is the date your S corp status begins. For a new corporation, it’s usually the date of incorporation. For an existing C corp or LLC, it’s typically the first day of the new tax year (e.g., January 1, 2025) .
F. Selected Tax Year: Most S corps must use a calendar year ending December 31. There are exceptions for businesses with a natural business cycle (like a seasonal ski resort), but this requires a more complex justification.
G. Name and Title of Officer: If you are also a shareholder, you can sign here.
H. Signature: The officer’s signature.
I. Reasonable Cause Explanation for Late Filing: This is your lifeline if you missed the deadline. You must explain why you are filing late. More on this in the next section.
J. Shareholder Information: You must list every single shareholder’s name, address, signature, number of shares, and date acquired. Every shareholder must consent and sign. A missing signature will invalidate the election .

Part 2: The IRS “Oops” Button – Relief for a Late Election

What if you miss the 2 month, 15-day deadline? For years, this was a disaster. Now, thanks to IRS Revenue Procedure 2013-30, you have a powerful way to fix it. You can get relief for a late election up to 3 years and 75 days after the intended effective date .

To get this relief, you must show you had “reasonable cause” for filing late.

Step-by-Step Guide to Filing a Late Election:

Complete Form 2553: Fill out the entire form just as you would for a timely election.
Write the Magic Words: At the very top of page 1 of Form 2553, you must write: “FILED PURSUANT TO REV. PROC. 2013-30” . This tells the IRS agent handling your case which relief procedure you are using.
Write the Reasonable Cause Statement (Line I): This is your story. You must explain why you failed to file on time. The IRS is generally lenient here.
- Commonly Accepted Reasons: “I was unaware of the filing deadline for Form 2553.” or “My accountant/officer of the corporation neglected to file the form on time.” These simple explanations are almost always approved .
- What to Include: State that the corporation intended to be an S corp from the effective date, that it has filed all tax returns consistent with being an S corp (if any were due), and that you acted diligently to correct the mistake as soon as you discovered it .
Get All Shareholder Signatures: This is non-negotiable. Every person who was a shareholder from your intended effective date to the date you file the late election must sign the consent statement in column K .
File the Form: You can attach the completed Form 2553 to your first S corp tax return (Form 1120-S) or file it separately by mail or fax .

Part 3: Fixing a Blown S Election – Relief for Inadvertent Termination

What if you were operating as an S corp and accidentally terminated your status by, for example, having a non-compliant operating agreement? The consequences are severe: immediate conversion to a C corp and a five-year ban on re-electing S status.²

However, the IRS provides relief for “inadvertent” terminations. The traditional method was to request a Private Letter Ruling (PLR), a process that is incredibly expensive (user fees can exceed $30,000) and slow.¹³

Recognizing that many terminations are honest mistakes, the IRS issued Revenue Procedure 2022-19. This created a simplified, cheaper, and faster way to get relief for certain common violations without a PLR.¹³

How to Use Rev. Proc. 2022-19 for a “Non-Identical Governing Provision”:

This is the most common issue for LLCs that elect S status. Here’s how to fix it:

Discover the Problem: You realize your LLC operating agreement contains language that violates the one-class-of-stock rule.
Act Before the IRS Does: This relief is only available if you find and correct the problem before the IRS discovers it during an audit.³ This rewards proactive compliance.
Amend the Document: Work with your attorney to amend the operating agreement, removing the problematic language and ensuring it explicitly states all members have identical rights to all distributions and liquidation proceeds.
Ensure No Disproportionate Distributions Occurred: To qualify for this simplified relief, the corporation must not have actually made any disproportionate distributions based on the faulty agreement.³ If it did, you may need to pursue a more complex PLR.
Prepare Statements: The corporation and all shareholders must prepare signed statements describing the situation, the facts of the non-identical provision, and that they have always filed tax returns consistent with S corp status.
Keep Documents with Corporate Records: You do not file these statements with the IRS. You simply keep them with your corporate records. By taking these corrective actions, your S election is considered valid from the date the faulty provision was adopted .

Pros and Cons of an S Corp Dual-Class Stock Structure

Pros	Cons
👍 Maintain 100% Control: Founders can sell or gift a majority of the economic ownership in the company while retaining absolute voting control.⁷	👎 Potential for Investor Skepticism: Sophisticated investors may be wary of investing in a company where they have no say in its governance, which could limit capital-raising options .
👍 Facilitates Family Succession: Allows for the smooth transfer of wealth to the next generation without causing disputes over management between active and inactive family members .	👎 Reduced Accountability: Concentrating all voting power in a small group can insulate management from accountability, potentially leading to decisions that benefit insiders at the expense of nonvoting shareholders .
👍 Powerful Employee Incentives: You can grant real equity to key employees, aligning their financial interests with the company’s success, without diluting your vote.⁷	👎 Complexity in Agreements: Requires extremely careful drafting of articles, bylaws, and shareholder agreements to avoid accidentally creating a second class of stock and terminating the S election.⁴
👍 Estate Tax Savings: Nonvoting shares often receive a valuation discount for lack of control, allowing you to transfer more value out of your taxable estate using less of your gift tax exemption.²²	👎 Strict Shareholder Limits Remain: You still cannot have more than 100 shareholders, and all shareholders (voting or nonvoting) must be eligible individuals, estates, or specific trusts.²⁴
👍 Attracts Passive Investors: Ideal for bringing in capital from investors who are only interested in the economic return and do not want the responsibility of management.¹⁰	👎 No Preferred Returns: Unlike a C corp or LLC, you cannot offer preferential treatment, such as a guaranteed dividend or a priority payout in a sale, to any group of shareholders.¹⁷

Frequently Asked Questions (FAQs)

1. Can my S Corp have Class A voting stock and Class B nonvoting stock?

Yes. This is explicitly allowed as long as both classes of stock have identical rights to distributions of profit and assets upon liquidation.17

2. Can we pay a larger dividend to voting shareholders than to nonvoting shareholders?

No. This is strictly forbidden. All distributions must be made pro-rata based on the number of shares owned. Doing otherwise would create a second class of stock and terminate your S election.4

3. What happens if we accidentally paid one shareholder more than another?

Not necessarily. If your corporate documents mandate equal distributions, an accidental unequal payment does not automatically create a second class of stock. You should correct the error with a “true-up” distribution.19

4. Does a simple loan from a shareholder create a second class of stock?

No, as long as it’s a real loan. To be safe, ensure it meets the “straight debt” safe harbor rules: it’s in writing, has a fixed interest rate, and isn’t convertible to stock.4

5. Does a buy-sell agreement priced at “book value” create a problem?

No. An agreement that sets the purchase price at book value falls within a specific regulatory safe harbor and will not jeopardize your S election.11

6. What happens if we miss the deadline to file Form 2553 for our S election?

You can get relief. Under IRS Revenue Procedure 2013-30, you can file for late relief within 3 years and 75 days by showing you had reasonable cause for the delay.32

7. Can a trust own shares in our S Corp?

Yes, but only specific types of trusts are eligible. These include Grantor Trusts, QSSTs, and ESBTs. Each type has complex rules and may require a separate election to be filed with the IRS.6

8. Can nonvoting shares be converted into voting shares?

Yes, if your corporate documents allow for it. An exchange of nonvoting common stock for voting common stock in the same corporation is generally a tax-free exchange with no gain or loss recognized .