In order to make an election to be treated as an S corporation pursuant to IRC §1361(b), an otherwise eligible entity must only have one (1) class of stock outstanding. There are numerous regulations and cases debating whether certain instruments or obligations constitute a second class of stock. In a recent case, Santa Clara Valley Housing Group, Inc. v. U.S., 109 A.F.T.R.2d 2012-554 (N.D. Cal. 2012), the court examined the second class of stock safe harbor provisions concerning warrants. Treas. Reg. §1.1361-1(l)(4) contains the rules treating certain instruments, obligations or arrangements as a second class of stock. Generally, a call option, warrant or similar instrument issued by a corporation is treated as a second class of stock if taking into account all of the facts and circumstances, the call option is substantially certain to be exercised and has a strike price substantially below the fair market value of the underlying stock on the date that the call option is issued.
In finding that the warrants in question did not constitute a second class of stock, the court in Santa Clara focused on the safe harbor provisions contained in Treas. Reg. §1.1361-1(l)(4)(iii)(C). The safe harbor provides that a call option is not treated as a second class of stock if, on the date the call option is issued, the strike price of the call option is at least ninety percent (90%) of the fair market value of the underlying stock on that date.