Can an S Corporation Issue Warrants?

One of the advantages of operating as a corporation is the number of options a corporation has to raise money. According to the S Corporation Association, there are over 4.5 million S corporations in existence. An S corporation can raise money through the sale of shares and by issuing warrants, which behave similar to options for shares.

A warrant is a financing instrument used by corporations to fund corporate growth or expansion, or to retire other obligations. A warrant enables its owner to buy a specific number of shares at some point in the future at a specified price. Warrants are often tied to debt. A warrant gives the debt holder the potential to participate in the upside should a corporation's stock increase in value.

The Internal Revenue Service restricts S corporations to one class of stock. Warrant agreements must explicitly state that the warrant provides its owner with permission to purchase the existing class of stock at a price that is not substantially below the market price. A warrant issued by an S corporation cannot be tied to a preferred class of stock or to a common stock class with different rights.

The IRS may classify any warrant that has a high likelihood of being exercised at a share value significantly below market pricing as a second class of stock. In a California case decision, a warrant tied to a tax shelter was classified as a second class of stock. If a warrant is classified as a second class of stock, issuance of such warrants will result in the loss of S corporation status because it violates IRS restrictions.

Your corporation may want to raise $2 million from an investor to acquire a competitor. You prefer to use debt, but neither your company nor the competitor qualifies for a pure bank loan for that amount. An investment firm agrees to lend you $2 million at 9 percent interest, but wants 25,000 warrants attached. Each warrant gives the investor the right, for example, to purchase four shares at $10 each up until four years after the loan closing date. If the investor exercises all the warrants -- four shares each, times 25,000 warrants -- the investor will buy 100,000 shares from your company for a total of $1 million.

A corporation elects S corporation treatment for tax purposes by filing Form 2553. Private corporations often elect subchapter S status to avoid taxation at the corporate level. S corporation shareholders receive a schedule that shows their proportionate share of profits or losses, which they include with their personal taxes. S corporations can only have 100 or fewer shareholders, and only U.S. citizens and entities as shareholders.