Post-TRA '97 S corps. and ESOPs - an ideal combination.

• Author: Diamond, Louis H.
• Position: S corporations, employee stock ownership plans

EXECUTIVE SUMMARY

* After the SBJPA,

SESOPs provided only marginal benefits.

* The TRA '97 made three major changes that should entice all closely held corporations to re-examine the use of SESOPs.

* Two critical factors have to be considered in determining whether to create a SESOP.

The Small Business Job Protection Act of 1996, while creating opportunities for S corporations to use employee stock ownership plans (SESOPs), left technical glitches that made it disadvantageous to do so. However, the Taxpayer Relief Act of 1997 eliminated a number of these problems, clearing the way for usage of SESOPs. This article explains why SESOPs should now become popular.

Before the passage of the Small Business Job Protection Act of 1996 (SBJPA), S corporations could not adopt employee stock ownership plans (ESOPs); an ESOP was not an eligible stockholder. This prevented many small companies from adopting ESOPs and, accordingly, denied their employees the opportunity to share in the ownership experience. It also prevented C corporations with ESOPs from electing S status. Under SBJPA Section 1316(a), effective for tax years beginning in 1998, an S corporation can adopt and maintain an ESOP (SESOP); this has numerous ramifications, some beneficial and some burdensome. The Taxpayer Relief Act of 1997 (TRA '97) made SESOPs even more attractive, creating a whole new world of planning opportunities.

SBJPA SESOPs

As originally enacted, SESOPs would have provided only marginal benefit and generated little interest. The following provisions would have made SESOPs relatively unattractive:

UBIT application: The SESOP's pro rata share of S income and gain realized by it on a sale of employer stock were treated under SBJPA Section 1316(c) and (d)(3) as unrelated business taxable income (UBIT) and subjected to tax. This tax, which is levied at the corporate income tax rates (i.e., 15-35%), would have been payable by the SESOP.

Sec. 1042 inapplicable: Under SBJPA Section 1316 (d) (3), S shareholders could not sell their stock to a SESOP and use a Section 1042 tax-free rollover. This tax-free rollover has provided the impetus for the adoption of ESOPs by many small, closely held companies.(1)

Sec. 1042 permits noncorporate shareholders to sell nonpublicly traded stock held at least three years to the corporation's ESOP and, within 15 months of that sale (i.e., three months before and 12 months after), defer the gain by purchasing qualified replacement property (i.e., stock, bonds or notes in another operating U.S. corporation) if (1) the ESOP owned at least 30% of its corporate sponsor and (2) the sponsor consents to the payment of a penalty if there is a premature disposition or prohibited allocation of that stock. After the SBJPA, the securities had to be issued by a C corporation to be eligible for a Sec. 1042 rollover.

No Sec. 404(k) dividend deduction: Under SBJPA Section 1316(d)(2), S corporations could not (and still cannot) deduct dividends paid to SESOPs. Sec. 404(k)(1) entitles a C corporation to deduct dividends paid to its ESOP that are (1) passed through to plan participants pro rata, based on account balances or (2) applied in payment of the ESOP loan used to acquire the stock that generated the dividends.(2)

No loans: After the SBJPA, the Sec. 4975 prohibited transaction provisions applied to S corporation "disqualified persons," including officers, directors, 10% shareholders and highly compensated employees. Accordingly, they could not engage in a leveraged sale of their stock to a SESOP.(3)

No expanded deduction limits: After the SBJPA, S corporations were not entitled to the expanded deduction limits under Sec. 404(a)(9) for contributions to SESOPs that otherwise apply to ESOPs.

TRA '97 Changes

The TRA 97 made three major changes that should entice all closely held corporations to re-examine the use of ESOPs.

No UBIT: Under TRA '97 Section 1523(a), effective for tax years beginning after 1997, UBIT no longer applies to a SESOP's share of S earnings or to gain on the sale of its S stock; accordingly, a SESOP's share of its sponsor's earnings or gain on the sale of its stock is subject to tax only when distributed by it to its participants.

Shareholder/ESOP sales: TRA '97 Section 1506(b)(1) cured the technicality in Sec. 4975(f)(6)(B)(ii) that effectively denied SESOPs the ability to purchase stock from their shareholder-employees.(4)

Cash distributions: TRA '97 Section 1506(a) deleted the normal entitlement of ESOP participants to demand distributions of employer stock, to prevent an S corporation from having more than 75 or ineligible shareholders.

SESOP Considerations

A number of factors must be considered in determining whether to create a SESOP.

Dividends vs...