ESOPs and S corporations.

The Small Business Job Protection Act of 1996 (SBJPA) liberalized the S corporation eligibility rules by allowing organizations described in Sec. 401(a) (qualified retirement plans) and exempt from Federal income tax under Sec. 501(a) to be S shareholders for tax years beginning after 1997. The SBJPA, however, also mandated that all items of income, loss, credit or deduction allocated to an exempt organization and any gain or loss recognized on the disposition of the S stock must be taken into account in computing the organization's unrelated business taxable income (UBTI). This UBTI requirement made the ownership of S corporations unattractive to tax-exempt organizations.

In the Taxpayer Relief Act of 1997, Congress repealed the UBTI requirement for employee stock ownership plans (ESOPs) that own S stock for tax years beginning after 1997. In repealing the UBTI rule for S shareholder ESOPs, Congress continues to adhere to the philosophy that (1) workers are more motivated and productive when they acquire an ownership interest in the company for which they work and (2) ESOPs provide the most effective means of broadening the ownership of wealth.

Existing C Corporations

For a C corporation wholly owned by an ESOP, an Selection would be a very attractive proposal. The existing C corporation may be paying up to 40% in Federal and state income taxes, with the ESOP participants paying a second level of tax as they receive distributions from the ESOP. If it elected S status, the corporation's taxable income would flow through to the ESOP, which is tax-exempt. This would allow all of the corporation's earnings to accumulate inside the corporation. Only one layer of tax would be collected; the ESOP participants receive distributions from the ESOP several years in the future.

If a C corporation is owned by both non-ESOP shareholders and an ESOP, the choice becomes more difficult. If the corporation elects S status, its taxable income will flow through to the individual owners and the ESOP based on their ownership percentages. The non-ESOP shareholders will require distributions from the corporation to pay their income taxes. Since an S corporation cannot have more than one class of stock, it is required to make pro rata distributions to its shareholders. The distributions may create a cash accumulation in the ESOP. This could pose a problem, because an ESOP, as a general rule, needs to keep at least 50% of its portfolio invested in its sponsor company stock.

Cash flow could be another concern. A profitable C corporation may be accustomed to paying out 40% of its taxable income in Federal and state income taxes. If it elects S status, it may have to increase its payout to 45% to cover the income tax liabilities for its individual shareholders. Therefore, modeling must be performed in order to maximize business and tax objectives with cash-flow limitations.

Another important aspect to consider is Sec. 1042, under which noncorporate shareholders of privately held companies can liquidate their ownership without recognizing gain. Sec. 1042 provides rollover treatment on the sale of qualified employer securities to an ESOP if qualified replacement property is acquired within the period beginning three months before and ending 12 months after the sale of the employer securities to the ESOP This rule provides a retiring owner with an excellent way to diversify his investment portfolio and defer gain on the disposition of his stock.

Any C corporation considering electing S status should fully understand how the LIFO recapture tax under Sec. 1363(d), the built-in gains tax under Sec. 1374 and the passive investment income tax under Sec. 1375 will affect it. Of course, the corporation must also be eligible to elect S status under Sec. 1361 (b).

Existing S Corporations

Establishing an ESOP for an existing S corporation can provide a way for owners to reward their valued and dedicated employees. A company considering such an action must not only perform the necessary modeling to determine the optimal ownership percentage between the ESOP and its other shareholders, but must also consider if any advantages gained outweigh administrative burden of maintaining the plan. ESOPs are qualified plans; thus, they are subject to the same Sec. 401 nondiscrimination and vesting requirements as are other qualified plans. ESOP rules also require that a determination, by an independent appraiser, of the sponsor corporation's fair market value, be made at least annually. Further, ESOP rules require an independent trustee be appointed to vote on significant corporate matters on behalf of the ESOP participants. The trustee is legally responsible to perform such responsibilities and can be sued if he does not act in their best interests. These are just a few of the more significant ESOP requirements. A company considering implementing such a plan should consult with a qualified plan specialist to fully understand all the requirements.

Note, however, that the tax-free rollover provision of Sec. 1042 is not available for existing S corporations.

Summary

New tax law changes have created an opportunity for some companies to grow their businesses faster by deferring income tax liabilities and, at the same time, rewarding valuable and dedicated employees with company ownership. A company considering using the ESOP/S corporation combination should consider all of the risks carefully before implementing such a structure.