Technical Issues:
Update for S Corp
ESOPs
Helen H. Morrison
Principal, Deloitte
Becky Hoffman
Principal Group
Hugh Reynolds
Crowe Chizek and Company LLC
Tim Jochim
Jochim Co., LPA
18th Annual Ohio
Employee Ownership
Conference
April 16, 2004
Akron, Ohio
What is an “S Corp”?
How does it differ from a “C Corp”?

C Corporation



Corporation under
state law
Separately taxable
entity
Shareholders subject
to tax on dividend
payments (now 15%
tax for eligible
dividends)

S Corporation


Corporation under
state law
“Pass through” entity

Nature of income (for
losses and expenses)
retains its character
in hands of
shareholder)
What are the Advantages of S Corp
over C Corp Status?






No double taxation
Increase in stock basis
Tax free distributions
Capital gain retains its character
Individual use of corporate earnings or losses
Sale of appreciated asset without double tax; Sale of
business as asset sale




Exception: built-in gain tax
Sale of asset within 10 years of making the S corp election
Estate planning advantages
Highest corporate tax and individual tax rate are the same
Tax Model of Operations
C Corp
S Corp
Tax on Corporate Earnings
Net Income From Operations
Effective Corporate Tax Rate
Effective Individual Tax Rate
50,000,000
35.00%
n/a
50,000,000
n/a
35.0%
Corporate Taxes
17,500,000
17,500,000
Discretionary Distribution
Effective Individual Tax Rate on Distribution
Tax Paid on Receipt of Distribution
10,000,000
15.0%
1,500,000
10,000,000
n/a
-
Total Taxes Paid
19,000,000
17,500,000
Taxation of Discretionary Distribution
Stock Sale Tax Model
C Corp
S Corp
Individual Level Taxation
Cash Received For Stock
Less: Tax Basis From Initial Investment
Less: Tax Basis Increases From Undistributed Earnings
Equals Gain on Sale of Stock (A)
Individual Effective Tax Rate on Gain
Individual Level Tax on Gain (B)
After-tax Cash Flow (A) - (B)
Increase in Cash From S Corp Conversion
400,000,000
(1,000,000)
399,000,000
400,000,000
(1,000,000)
(200,000,000)
199,000,000
15.0%
59,850,000
15.0%
29,850,000
340,150,000
370,150,000
30,000,000
Add the ESOP Tax Benefit



ESOP is a exempt from income tax
Under special rule also exempt from
unrelated business tax (UBIT)
Seems too good to be true - where is the
catch?
S Corporation Requirements

Limit of 75 shareholders


Shareholders may only be individuals, estates
and certain trusts


ESOP is a single shareholder
No partnerships
Shareholders may not be nonresident aliens

Beware of community property states
S Corporation Requirements (cont)

Only one class of stock allowed







Fringe benefit limitation for 2% or more shareholder
Shareholders must file state returns in every state of
operation


Debt ok, provided satisfies “safe harbor” or general test
Stock options, warrant ok, provided exercise price is at least 90%
of fair market value
Phantom stock, SARs, nonqualified deferred compensation ok,
provided reasonable compensation
Benefits allocation issue for less than 100% ESOP
IRC section 409(p) issue
Composite return mitigates this requirement
Recognition of income regardless of distribution
Requirements to Convert to S
Corporation Status

Valid election must be filed within 2½ months of the
effective date of the election




Form 2553 filing
100% of the outstanding shareholders (including a spouse in
a community property state) must sign a consent
LIFO reserve recapture over four years
Calendar year, unless 100% ESOP in which case can
use ESOP plan year
Unique S Corporation ESOP Issues

Going from C to S to C


IRS permission required in first five after S
termination. IRC §1362(g)
Possible solution: Minnow swallows whale
merger
 Two Classes of Stock

Voting and nonvoting permitted
Compliance and Practical Issues



Built-in Gains tax issues and planning
techniques
Federal and State S Election / QSub Election
Requirements
Tax Distributions to Outside Shareholders /
Composite State Individual Returns
Compliance and Practical Issues

State Treatment of S Corporations Varies
Widely
 S Corporation Recognition
 QSub Treatment
 Built-in Gain Treatment
 Composite Individual Return Requirements
 Nonresident Withholding Requirements
The S Corp. ESOP
Anti-abuse Rules
The Reason Behind the Madness




Preventing abusive arrangements
Establish testing method to determine
“good” ESOPs
Broad-based employee ownership is
crucial to being considered a “good”
ESOP
Some “good” ESOPs will be unfairly
classified as abusive
Anti-Abuse Rules Effective
Dates
Code Section 409(p):


Was effective on enactment as to S
Corporation ESOPs established on or after
March 14, 2001
As to S Corporation ESOPs in existence prior
to March 14, 2001, effective for the first plan
year beginning after December 31, 2004
Anti-Abuse Rules Effective
Dates
Temporary Regulations:


Effective for plan years ending after October
20, 2003 (i.e., effective as of January 1,
2003, for a calendar year plan)
NQDC distributed by July 21, 2004 will not be
considered Synthetic Equity
Anti-Abuse Rules – Defined
Terms

Deemed-Owned Shares
Allocated ESOP shares
 Pro rata portion of shares in
the ESOP loan suspense
account
 Synthetic Equity

Anti-Abuse Rules – Defined
Terms

Synthetic Equity




Stock option, warrant, restricted stock,
deferred issuance stock right, “similar”
interest or right that gives the holder the
right to acquire or receive stock
Stock Appreciation Right (SAR) or “similar”
right to a future cash payment based on the
value of stock or appreciation in value
Nonqualified deferred compensation
Right to acquire interests in certain related
entities
Anti-Abuse Rules – Defined
Terms

A “Disqualified Person” is a person who:
1. owns 10% or more of all of the DeemedOwned Shares of a corporation,
2. is a member of a Family that owns 20% or
more of the Deemed-Owned Shares of the
corporation, or
3. [has Deemed-Owned Shares and] is a Family
member of an individual who is a
“Disqualified Person” under the 20% Family
rule above
Anti-Abuse Rules – Defined
Terms

“Family” is defined broadly to include:
1.
2.
3.
4.
the spouse of the individual,
an ancestor or lineal descendant of the
individual or the individual’s spouse,
a brother or sister of the individual or the
individual’s spouse and any lineal descendant
of the brother or sister, and
the spouse of any individual in two or three
above
Don’t forget to ask about living ancestors who
are not reported because they don’t have any
ownership themselves.
Anti-Abuse Rules – Defined
Terms

Nonallocation Year



Disqualified Persons own at least
50% of stock in S corporation at
any time during the plan year
Ownership includes Deemed-Owned
Shares and direct ownership
Attribution rules apply here
Prohibited Allocation
No portion of the assets of the plan
attributable to (or allocable in lieu of)
the company stock may accrue for
the benefit of any Disqualified Person
during a Nonallocation Year.
Effect of Nonallocation Year
If there is a Nonallocation Year,
then:



The value of any prohibited allocation
is taxed to the Disqualified Person
A 50% excise tax is imposed on the
amount of the prohibited allocation
A 50% excise tax is imposed on
Synthetic Equity of Disqualified
Persons
First Nonallocation Year Rule
In the first Nonallocation Year the
excise tax is 50% of the total value
of the Deemed-Owned Shares of all
Disqualified Persons
How is Synthetic Equity
Applied in the Testing?


Prior to temporary and proposed regulations
we took a conservative approach, only using
the Synthetic Equity of the individual or group
being tested in the denominator.
The temporary and proposed regulations
clarified the mechanics of including Synthetic
Equity in the testing. The Disqualified Person
test and the Nonallocation Year test are
tested by including no Synthetic Equity and
again by including ALL synthetic equity.
How are unallocated shares
attributed to participants?

In the same proportions as the most
recent stock allocation under the plan



Same manner as the total of all share
allocations under the plan (contribution,
forfeitures, recycled shares, etc.)
Same manner as released shares were
allocated
Based on total stock balance to date
Family Group - Hypothetical Example
Siblings
Becky
Jeff
Scott
Children
of each
(cousins)
Sean
Corey
Max
Becky, Jeff, and Scott are independently wealthy, enjoying the good life traveling
among their multiple homesites aligned with the seasons.
Sean, Corey & Max start and build a company together. No other family members
participate.
Sean, Corey & Max each own 1/3 of the company.
Each sells the same % to the ESOP, keeping 11% each outside the ESOP.
After the sale, the ESOP owns 67%.
Within the ESOP, each cousin is allocated 7% of the deemed owned shares.
No synthetic equity.
Are there any Disqualified Persons?
Hypothetical Testing Example for Nonallocation Year
Outstanding Shares:
ESOP Shares:
Unallocated Shares:
A
B (A's brother)
F (no relation)
Others
1,600.0 (excluding synthetic equity shares)
1,000.0
300.0
Direct
500.0
100.0
0.0
0.0
600.0
ESOP
60.0
30.0
0.0
610.0
700.0
Mock Alloc
of Unalloc Synthetic
25.7
150.0
12.9
75.0
0.0
40.0
261.4
0.0
300.0
265.0
Hypothetical Testing Example for Nonallocation Year
STEP 1 - Determine DQPs
A
B (A's brother)
F (no relation)
Others
Direct
500.0
100.0
0.0
0.0
600.0
ESOP
60.0
30.0
0.0
610.0
700.0
w/o SYN w/o SYN
FAM D-O
IND D-O
Mock Alloc
Shares
Shares
of Unalloc Synthetic
Percent
Percent
25.7
150.0
12.86%
8.57%
12.9
75.0
12.86%
4.29%
0.0
40.0
0.00%
261.4
0.0
300.0
265.0
DQP = None at this point
D-O = Deemed-Owned
DQP = Disqualified Person
IND = Individual
FAM = Family
SYN = Synthetic Equity
Hypothetical Testing Example for Nonallocation Year
STEP 1 - Determine DQPs
A
B (A's brother)
F (no relation)
Others
DQP = A & B
Direct
500.0
100.0
0.0
0.0
600.0
ESOP
60.0
30.0
0.0
610.0
700.0
Mock Alloc
of Unalloc Synthetic
25.7
150.0
12.9
75.0
0.0
40.0
261.4
0.0
300.0
265.0
w/SYN
FAM D-O
Shares
Percent
27.95%
27.95%
w/SYN
IND D-O
Shares
Percent
18.63%
9.32%
3.16%
Hypothetical Testing Example for Nonallocation Year
A
B (A's brother)
F (no relation)
Others
Direct
500.0
100.0
0.0
0.0
600.0
ESOP
60.0
30.0
0.0
610.0
700.0
Mock Alloc
of Unalloc Synthetic
25.7
150.0
12.9
75.0
0.0
40.0
261.4
0.0
300.0
265.0
DQP = A & B
STEP 2 - Test for Nonallocation Year
w/o SYN
(A+B)
728.6 45.54% O'ship of DQP
1,600.0
Denominator
with/SYN
(A+B)
953.6
1,865.0
51.13% O'ship of DQP
Denominator
Testing assumes attribution among DQPs already in the testing group is not required
Applying the S Corp. ESOP
Anti-abuse Rules
Questions?
Administration of S
Corporation ESOPs
S v. C Distribution Differences
Issues
C Corp
S Corp
Distributions from
leveraged ESOPs
Distributions can be
delayed until the loan is
repaid
It is not clear if the
distribution can be
delayed until the loan is
repaid
Distributions of Stock
Participant must generally Stock distributions are
be permitted to demand
not required. If
a distribution in stock
distributions of stock are
allowed, the plan must
protect itself from
violating the 75
shareholder limit and
from distributing stock to
ineligible shareholders
S v. C Distribution Differences
Issues
Determining Cost Basis of
Stock
C Corp
S Corp
Cost basis IS NOT
Cost basis is(?) adjusted
adjusted for earnings and for earnings and
distributions of earnings
distributions of earnings
per an IRS revenue
ruling.
It is not clear if the IRS
has properly interpreted
the law.
S v. C Distribution Differences
Issues
Distribution timing for
terminated participants
C Corp
S Corp
Decision on timing of
distributions generally not
impacted by large
dividends on company
stock.
Decision on timing of
distributions can be
impacted by significant SCorp distributions.
Cash-out terminees right
away or allow them to
keep getting S-Corp
distributions.
S v. C: Contribution and Allocation
Differences
Limit
Deductible Contribution
Limits
C Corp
S Corp
25% of compensation
25% of compensation
Contribution used to pay
interest on acquisition
loan is not counted under
this limit
Includes entire
contribution
S v. C: Contribution and Allocation
Differences
Limit
Annual Additions
C Corp
S Corp
Lesser of 100% of
compensation or $40,000
Lesser of 100% of
compensation or $40,000
If One-Third Test is met,
contribution used to pay
interest and forfeitures of
shares purchased with
the acquisition loan are
not Annual Additions
One-Third Test does not
apply, so all contributions
and forfeitures are
counted as Annual
Additions
S v. C: Contribution and Allocation
Differences
Limit
Haves and Have-nots
C Corp
Generally not an issue
S Corp
Can be a big issue in
mature ESOPs: Earnings
distributions allocated
based on stock accounts.
Very small allocations to
new participants
Primarily Invested in
Employer Securities
Generally not an issue
Can be an issue in
mature ESOPs
S v. C Dividend Differences
Type/Use of
Dividend
C Corp
S Corp
Dividends (Earnings
Distributions) on Allocated
Shares
Considered an “applicable Cannot be used to pay
dividend” under IRC
debt
Section 404(k), eligible
for a tax deduction when
used to pay debt
Dividends (Earnings
Distributions) on Suspense
Shares
Considered an “applicable
dividend” under IRC
Section 404(k), eligible
for a tax deduction when
used to pay debt
Can be used to pay debt,
but not considered an
“applicable dividend,” so
a deduction is not
permitted
S v. C Dividend Differences
Type/Use of
Dividend
C Corp
S Corp
Dividends Passed-Through
Considered an “applicable
dividend,” eligible for a
tax deduction and not
considered a distribution
subject to consent rules
and early withdrawal
penalties
Not considered an
“applicable dividend” and
is therefore not
deductible and is subject
to the regular distribution
rules, including early
withdrawal penalties
S v. C Other Differences
Issues
C Corp
S Corp
Section 1042 Tax Deferral
Available
Not Available
Prohibited Allocation Rules
under IRC Section 409(p)
Do not apply
Apply – Effective for
ESOPs established after
3/14/01 or where the
sponsoring corporation
makes an S election after
3/14/01.
Otherwise, the rules are
effective for plan years
beginning after 12/31/04