ESOPs and S corporations.

• Author: Smith, Greg W.
• Position: Employee stock ownership plans, Internal Revenue Code Subchapter S

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In the Taxpayer Relief Act of 1997, Congress repealed the UBTI requirement for employee stock ownership plans (ESOPs) that own S stock for tax years beginning after 1997.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...