What the heck are share classes?
As a CPA who regularly helps new businesses incorporate, this is a question I often here. It is an important topic if you are incorporating and one that can have big tax complications down the road.
In this article, I walk you through my recommendations for setting up the share structure of a corporation so you will feel confident in moving forward.
Let's start with the basics.
What Are Shares?
Shares are ownership rights of a corporation. When first incorporating, shares are issued from a corporation and bought by shareholders.
As an example, if you hold investments, you may hold stocks of various corporations.
These stocks are ownership rights of the company and may allow you to vote in an annual general meeting in addition to buying and selling your ownership rights to other investors.
At a smaller level, this is what you or your lawyer need to create for your new corporation.
When a company is created the allowable number of shares, the shares classes, and the share rights and restrictions are set. Let’s break each of these down.
Decision # 1: Number of Shares
How many shares should you create?
This has two parts. The first is the ‘authorized’ shares. This is the total number of shares a company can ever issue and represent potential ownership rights.
In the past I’ve seen clients designated huge numbers like 1,000,000 shares; however, there is an even easier option.
I’d recommend issuing ‘unlimited’ shares for your authorized shares. This gives you lots of flexibility down the road.
The next decision to make is how many shares you ‘issue’ yourself upon incorporation.
Issued shares are those actively held by shareholders and represent current ownership.
Authorized shares are potential ownership – issued shares are current ownership.
The number of shares issued can change at a later point in time.
For example, new shareholders can buy in and more shares issued or the corporation can buy back its shares to remove shareholders.
To hold ownership rights of your own corporation you are going to need to issue shares to yourself from your total authorized shares.
The most common choice I see is 100 shares. This isn’t a magic number but makes documentation easy and still gives you flexibility down the road.
To summarize – I’d recommend unlimited authorized shares and 100 issued shares per shareholder.
The next decision you must make is about your share classes.
"Authorized shares are potential ownership. Issued shares are current ownership." - Jillian Battaglio, CPA, CA
Decision #2: Share Classes
So what the heck is a share class?
A share class represents a group of shares that all have the same rights and restrictions; but, they are different rights and restrictions from another group of shares.
Think of them like grade 5 classes.
In my elementary school, we had 2 different grade 5 classes. Each class was led by a different teacher who had different rules in their classroom.
All of us were grade 5 students but we had different rights and restrictions for how we went about our day.
Wearing a hat may have been acceptable in one class but was strictly forbidden in another. Some rules may have been the same for each class – for example – being late was unacceptable to either teacher.
Share classes are similar, and the corporation sets the rights and restrictions for each group of shares just like a teacher sets in her classroom.
Each group of shares can have ‘unlimited’ authorized shares with a specific number of issued shares.
Let’s go through an example.
Greg is starting a company and wants to give himself lots of flexibility down the road. To ensure he has options he sets up multiple share classes Greg’s authorized shares are:
Unlimited Class A shares
Unlimited Class B shares
Unlimited Class C shares
Greg is incorporating with his wife as a 50% shareholder. Greg decides he’ll hold 100 Class A shares with his wife holding 100 Class B shares.
Greg does not include his children who are under 18 because of adverse tax considerations that can cause surprise tax bills.
I generally recommend that shareholders of small corporations hold different share classes. This is because of dividend allocations.
Dividends are like ice cream sandwiches in a classroom. You can’t give them to just one student without causing a lot of crying.
Dividends allocated to a particular class of shares need to be given to every shareholder who holds that particular type of share.
We can’t pick and choose select shareholders unless they hold different share classes.
In Greg’s example, this is accomplished by himself holding Class A shares while his wife holds Class B shares.
"Dividends are like ice cream sandwiches in a classroom. You can’t give them to just one student. We can’t pick and choose select shareholders unless they hold different share classes." - Jillian Battaglio, CPA, CA
The option to issue dividends is because of the rights and restrictions assigned.
Decision #3: Rights & Restrictions
Rights and restrictions are like the rules of the classroom.
They designate whether dividends can be issued or not, in what order they must be paid, and whether shareholders can vote in shareholder meetings, and any other stipulations you’d like to put in place.
For the best tax planning options have multiple classes with a variety of rights and restrictions including, voting, non-voting, preferred redeemable and preferred non-redeemable is best.
A lawyer’s generic template is usually sufficient for most businesses.
Where to Next?
If you'd like a bit more guidance on share structures check out our handout available on our website.
That is all I have on share structures for today. I hope this article has helped you feel more confident in moving forward with your incorporation plans.