What Is It?
Nonvoting stock allows your nonparticipating children to share ownership of your closely held business without giving them control over business decisions and operations. The holder of nonvoting stock has an ownership interest in the business, but has no right to vote on corporate matters that require shareholder approval. This means that holders of nonvoting stock have no say about who will run the company. Without any control over who runs the company, holders of nonvoting stock have no control over day-to-day decisions. In contrast, holders of voting stock may vote on issues of control. In a closely held business, this can be a powerful right. If only a small number of people hold the majority of voting stock, they can vote themselves onto the board of directors and hire themselves as managers. Once that is done, they have full control of the business.
How Do You Create Nonvoting Stock?
You can create voting and nonvoting stock for distribution to your children by conducting a recapitalization of the business. A recapitalization is a process that allows you to reorganize or restructure ownership interests within a business. When you recapitalize, you can exchange some or all of your stock for another class of stock in the corporation.
In the case of a C corporation , you can recapitalize and create common stock and preferred stock, either of which may be voting or nonvoting. The common stock will be voting stock and will be transferred to participating children. Preferred stock, with no voting rights, can be created and transferred to nonparticipating children. Preferred stock can also be tailored to provide your nonparticipating children with first rights to any company distribution. This ensures that your nonparticipating children will receive stock dividends, if any, before participating children can take dividends for themselves. Under corporate law, an S corporation can only issue one class of stock. You can create voting and nonvoting stock, but you can't issue stock with different distribution or liquidation rights. If your company is an S corporation, you will not be able to issue stock that gives nonparticipating children first rights to stock dividends or liquidation proceeds. A partnership and a limited liability company (LLC) can also recapitalize. However, they do not issue stock. Instead, they create a preferred interest by amending their partnership agreement or operating agreement.
What Are The Tradeoffs of Using Nonvoting Stock?
Stock dividends are only paid out when management decides to do so. If your participating children (holders of voting stock) are compensating themselves with high salaries, they may choose not to issue a stock dividend. This leaves your nonparticipating children (holders of nonvoting stock) with no share of your wealth and no power to force a dividend or elect new management.
The problem is compounded in S corporations because holders of nonvoting stock pay income taxes that are based on the corporation's annual earnings and shareholders' ownership percentage. In an S corporation, your nonparticipating children could incur income tax liability while receiving no income from the company.
Is There Any Way to Avoid Tradeoffs?
There is a way to avoid some of these problems. The nonvoting stock can be created with a right to an annual payment. This ensures that your nonparticipating children will receive an annual dividend. The stock can also be issued with a put option, allowing the holders of nonvoting stock to cash in (force the corporation to redeem) their stock at its fair market value. If the participating children don't arrange for the company to pay out dividends, the company may face a forced redemption of the nonparticipating shareholders' stock.
What Are The Tax Implications?
A recapitalization is not a taxable event to the shareholders or the corporation, provided that it is conducted for a business purpose and that the value of stock exchanged is equal to the value of the stock issued.
Caution: However, the Internal Revenue Code provides special valuation rules that may apply to recapitalizations involving family members, especially if the transfer of stock to your children occurs during your lifetime. These rules are somewhat complex. You should hire a tax planner or attorney to determine whether these rules apply in your case.
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