ESOPs and S Corporations.

• Position: Employee stock ownership plans

Sen. Russell Long (D-LA), the long-time tax dean of the Senate Finance Committee, believed that if labor were allowed to share in the rewards of capital, productivity would increase, making the U.S. economy stronger. He thus promulgated the concept of employee stock ownership plans (ESOPs). Eventually, the idea made its way into the tax law, primarily benefiting C corporations and their owners, banks and (maybe) employees.

The original version of ESOPs was not available to S corporations; as discussed below, employee trusts were finally deemed qualified shareholders in 1996 legislation. Even if they had been qualified, the Secs. 511-514 unrelated business income tax (UBIT) rules would have defeated a major goal--deferral.

The main tax benefits of ESOPs were threefold: (1) a bank could lend to an ESOP with a guarantee by the corporation and report only half the interest income (a provision since repealed); (2) the corporation's founder could use Sec. 1042 to sell his or her interest to the ESOP for cash (usually borrowed from a bank), reinvest the proceeds in publicly traded stocks or securities, hold them until death and pay no income tax on the built-in gain; (3) under Sec. 404(k), the corporation could deduct dividends paid to the ESOP on its stock ownership. None of these provisions are currently available to S corporations.

Law Changes

In 1996, Congress believed that encouraging S corporation funding and ownership would be accomplished by allowing charitable organizations and pension trusts (except IRAs) to be eligible S corporation ESOP (SESOP) shareholders. This change, enacted by Section 1316 of the Small Business Job Protection Act of 1996, allowed an ESOP to be an S shareholder. In addition, the enactment of Sec. 512(e) (3) by Taxpayer Relief Act of 1997 Section 1523 exempted SESOPs from UBIT on S earnings.

IRAs and S stock: When a SESOP owns an S corporation, what happens when an employee retires and rolls over recently distributed S stock into an IRA? Normally, this would terminate S status, because an IRA is not an eligible S shareholder. (1) To correct this problem, Rev. Procs. 2004-14 (2) and 2003-23 (3) held that a SESOP or S corporation could buy back the stock from the IRA, without loss of S status. Also, none of the income or loss would be allocated to the IRA.

Related taxpayers: Another issue is the potential application of Sec. 267(e) to postpone the deduction of compensation between an accrual-basis S corporation and its cash-basis employee/ deemed-owner. The IRS has informally stated...