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Legal Issues
for S Corporation ESOPs
Presented by
Mark R. Kossow
[email protected]
Best Practices for S Corporation ESOPs
Overview of Topics to be Covered
• S qualification, election and other issues
• Planning for stock sales to ESOPs
• S Corporations partially owned by ESOPs
(part-ESOP S corporations)
• Miscellaneous
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
• Limitations on eligible shareholders and 100
shareholder limit
– IRAs, nonresident aliens, corporations,
LLCs, partnerships, and many trusts may
not own shares
– ESOP only counts as one shareholder
– ISSUE: Part-ESOP S corporations need
to protect eligibility through shareholder
agreements.
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
• Single class of stock requirement
– S corporations may have only one class of stock
outstanding
• Under the corporation’s governing provisions
all outstanding shares must confer identical
rights to distributions and liquidation proceeds
• Governing provisions include the corporate
charter, articles of incorporation, bylaws,
applicable state law, and binding agreements
that affect distribution / liquidation proceeds
• Differences in voting rights are permissible
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
•
Single class of stock requirement (cont’d)
– ISSUE: Options, warrants, shareholder agreements, etc.
can inadvertently create second classes of stock, and
must be carefully structured.
• Nominal exercise prices on warrants to lenders /
selling shareholders may cause warrant to be treated
as a disqualifying second class of stock
• TEST: Taking into account all facts and
circumstances
– (A) is the warrant/option substantially certain
to be exercised; and
– (B) does it have a strike price substantially
below fmv of the underlying stock on the
issue date.
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
• Election Issues
– Election may be made any time prior to
beginning of tax year
– Election may be made within 2 ½ months
after start of tax year to be retroactive so
long as the corporation is eligible during
entire retroactive period
– ISSUE: With a retroactive election S status
starts as of the beginning of tax year, so it
is critical to coordinate the time of any 1042
transaction.
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
•
•
Election Issues (cont’d)
The election is not valid unless all shareholders of the
corporation at the time of the election consent to the
election.
– However, once a valid election is made, new
shareholders need not consent to that election.
• If an election is retroactive to the beginning of the
tax year, each person who was a shareholder at
ANY time during the portion of that year which
occurs before the time the election is made (and
who is not a shareholder at the time the election is
made) must also consent to the election.
– Trustee of the ESOP can consent on behalf of the
ESOP
– Shareholder consent is binding and may not be
wtihdrawn after a valid election is made by the
corporation
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
• Tax Year Issues
– Issue: The S corporation’s tax year must be a
calendar year unless:
• The corporation establishes a business
purpose for a year other than the calendar
year
• The corporation agrees to make a
refundable interest-free deposit with the IRS
to eliminate the benefit of any tax deferral
• If the ESOP owns 100% of the company and
it operates on a fiscal year, the S corporation
can adopt the tax year of its principal
shareholder.
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
• Qualified Subchapter S Subsidiaries (Q Subs)
– Must be 100% owned subsidiary
– Must elect S status for QSUB
– QSUB treated as a disregarded entity (tax
treatment of the QSUB is ultimately passed
through to the shareholders of the parent S
corporation)
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
• Distributions
– S corporations having no earnings and
profits
• The distribution is first applied against
basis
• If amount of distribution exceeds the
adjusted basis of the stock, excess
shall be treated as a capital gain
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
• Distributions (cont’d)
– S corporation having E&P
• Portion of distribution that does not
exceed AAA is tax free
• Portion of distribution that exceeds AAA
shall be treated as a dividend to the
extent it does not exceed E&P
• Remainder shall be treated as return on
basis and any excess over basis shall
receive capital gains treatment.
• NOTE: company can make an election
to distribute E&P first.
– Requires the consent of all affected
shareholders
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
•
Termination of S status
– Revocation – an election may be revoked only if
shareholders holding more than ½ of the shares of stock
on the day on which the revocation is made consent to
the revocation.
• Revocation made during the taxable year and on or
before the 15th day of the 3rd month shall be effective
retroactively to beginning of the tax year
• If revocation does not specify a prospective
revocation date and the revocation is made after the
15th day of the 3rd month, the revocation shall be
effective on the 1st day of the following tax year. If
revocation specifies a prospective revocation date,
the revocation is effective on such date.
Best Practices for S Corporation ESOPs
S Qualification, Election and Other Issues
•
Termination of S status
– By corporation ceasing to be a small business corporation
• Such termination shall be effective as of the date in
which the event occurs.
– Termination by reason of excess passive investment
income
• Termination occurs if the company has for 3
consecutive years passive investment income in
excess of 25% of gross receipts.
• Termination is effective on the first day of the first
taxable year following the third consecutive year in
which the company had excess passive investment
income.
• Only applies to S corporations that used to be C
corporations.
Best Practices for S Corporation ESOPs
C Corporations that Become S Corporations
• ISSUE: Built-In Gains (BIG) Tax
– Exposure to corporate level tax on net
realized built in gains for 5 years after S
election
– Appraising assets at the time of election
helps manage this tax
– Accounts Receivable – (accrual method rule)
cash basis corporation subject to BIG tax on
collections after conversion.
Best Practices for S Corporation ESOPs
C Corporations that Become S Corporations
• Presence of C corporation E&P raises issues
– ISSUE: potential taxable dividends if
distributions exceed AAA
• AAA generally reflects the aggregate,
undistributed taxable income or loss of
the S corporation for the continuous
period during which its S election has
been in effect.
– (i.e. previously taxed S corporation
earnings)
– Must monitor distributions to ensure
that taxable dividends are not
inadvertently paid.
Best Practices for S Corporation ESOPs
C Corporations that Become S Corporations
• ISSUE: LIFO recapture tax – a C corporation
that uses LIFO inventory accounting and makes
an S election is taxed on its LIFO recapture
amount
– LIFO recapture amount is the amount by
which inventory computed on the FIFO
method exceeds inventory computed on the
LIFO method
– Tax is computed on last C return and is paid
in four equal installments, which are due on
or before the due dates for the tax returns for
that year and the next three years.
Best Practices for S Corporation ESOPs
Planning for Stock Sales to ESOPs
• Income Tax Deferral
• 100% ESOP owned S corporation has
significant tax saving opportunities.
– If corporation makes an S election there
will be no federal tax on its annual income
(most states mirror this provision).
– Although income will be passed through
to the shareholder (the ESOP), no
shareholder level tax will be imposed
because the ESOP is a tax-exempt entity.
• The income tax liability will effectively
be deferred until the participants in the
ESOP receive their benefits.
Best Practices for S Corporation ESOPs
Planning for Stock Sales to ESOPs
•
Income Tax Deferral (cont’d)
– Company has shareholders in addition to ESOP
• Tax savings will still be available by making S election, but S
election may have a neutral impact on the corporation’s cash
flow.
• Reason, in most cases, S corporation shareholders must
withdraw sufficient funds to cover payment of their taxes on
the passed through corporate income.
• Example, S corp. sponsors ESOP that owns only 30% of
company and taxable income for 2010 was $1 million. Non
ESOP shareholder will have income allocation of $700,000
which will impose federal tax liability of $245,000. The
corporation will also be required to distribute $105,000 to the
ESOP. After distributions, the company will have $650,000
in retained earning. However, if the corporation was a C
corporation, its tax liability would be $350,000 and would
also have retained earnings of $650,000.
• Companies that are expanding and have a need for cash to
fund future expansion may not benefit from a partially ESOP
owned company.
Best Practices for S Corporation ESOPs
Planning for Stock Sales to ESOPs
• ISSUE: Capacity of a leveraged ESOP to carry
purchase debt
– With a C corporation 404 limits contributions
for principal payments on ESOP debt, but
deductions for contributions used to pay
interest are not limited
– The provision for unlimited contributions to
pay interest does not apply to S corporations,
and, because contributions for both principal
and interest payments count toward the 404
limitation, the amount of debt service an S
corporation’s payroll can support will be less
than if it were a C corporation
Best Practices for S Corporation ESOPs
Planning for Stock Sales to ESOPs
• 415 annual addition limits issue
– Generally, 415 limit is the lesser of (a) 100% of
participants compensation and (b) $49,000.
Includes employer contributions, employee
contributions and forfeitures.
– For C corporations only – if no more than 1/3 of
the employer contributions to the ESOP which are
used to pay down an ESOP loan are allocated to
the accounts of HCEs, then the general 415 rules
do not apply with respect to annual additions
attributable to forfeitures of shares and interest
payments on an exempt loan.
• This rule does not apply to S corporations and
therefore may limit the capacity of an ESOP to
carry debt.
Best Practices for S Corporation ESOPs
Planning for Stock Sales to ESOPs
• Stock Redemption Transactions in S
corporation ESOP companies
– Helps obtain capital gain / installment sale
treatment for owners of non-1042
transactions
• ISSUE: Need to ensure that the
redemption qualifies under 302 as a sale
of exchange and not a 301 dividend
– Reduces value of corporation and stock for
sale to ESOP
– Seller Financing (with warrants attached)
permit sellers to participate in future growth
Best Practices for S Corporation ESOPs
Planning for Stock Sales to ESOPs
• S corporation becomes C corporation because
owners want 1042 treatment (intending to
eventually convert back to S status)
– ISSUE: Will 1042 transaction qualify?
• Shares sold to ESOP must be qualified
employer securities
• 3 year holding period
• 30% rule – immediately after the sale, ESOP
must own at least 30% of each class of
outstanding stock or at least 30% of the total
value of all outstanding stock
– Conversion to C corporation my block S status
for 5 years
– Built-In Gains (BIG) tax exposure upon later S
election
Best Practices for S Corporation ESOPs
Part ESOP S Corporations
• ISSUE: Tax funding needs of non ESOP
shareholders may require distributions, which
also must be made to the ESOP, potentially
skewing allocations between younger and
older employees and former participants.
Best Practices for S Corporation ESOPs
Part ESOP S Corporations
•
Use of S corporation distributions to make loan payments
– Allocated Shares – participant shall receive an allocation
of Company Stock for the Plan Year from the Company
Stock released from the Unallocated Stock Suspense
Account as a result of all S Corporation Distributions for
the Plan Year having a fair market value at least equal to
the value of the S Corporation Distribution credited to the
Participant’s Account.
– Unallocated Shares - Company Stock to be allocated as a
consequence of repayment of an outstanding Acquisition
Loan by S Corporation Distributions on unallocated
shares shall be allocated in the same manner as
Company Contributions.
– ESOP loan documents and / or ESOP plan document
may prohibit using S corporation distributions on allocated
shares to make loan payments.
Best Practices for S Corporation ESOPs
Miscellaneous
• ESOP Distribution Rules
– Generally, participants in an ESOP are
entitled to demand their benefits be distributed
in the form of stock.
• This general rule raises issue of involuntary
termination of S election (e.g. rollover to
IRA would terminate S election and
exceeding 100 shareholder rule)
• The 1997 Tax Act resolved this problem.
This act permits an S corporation to require
the participants to take their benefits in
cash (or in the form of stock, subject to a
mandatory put).
Best Practices for S Corporation ESOPs
Miscellaneous
•
Anti abuse rule for S corporation ESOPs
– The economic growth and tax reconciliation act of 2001
(EGTRRA) contained some changes in tax law that were
designed to eliminate two perceived abuses of S corporation
ESOPs
• First abuse arises when ESOP has only one or a few
employees (example, a highly paid professional might defer
taxes indefinitely by forming an S corp and transferring all of
his stock to an ESOP). This use of an ESOP is against
public policy of promoting broad based employee ownership.
• Second abuse involves a “tax holiday” for newly formed
enterprises in which executives and outside investors hold
stock options (and other forms of equity interests) that over
time will substantially dilute the ESOP’s ownership. The
equity interests of the executives could be designed to defer
their recognition of income over a period of years, during
which time all of the corporate earnings would be reported
by the ESOP and thereby escape taxation during this period
(the tax holiday). If the ESOP will be substantially diluted
after the stock options are exercised, the ESOP will have
served only to avoid taxes and not to promote broad based
employee ownership.
Best Practices for S Corporation ESOPs
Miscellaneous
• Anti abuse rule for S corporation ESOPs (cont’d)
– The anti abuse rules under EGTRRA (as set
forth in Code Section 409(p)) are designed to
eliminate these two abuses described earlier.
– Under 409(p), an ESOP that holds shares of an
S corporation is prohibited from allocating or
accruing employer securities to disqualified
persons during any nonallocation year (which is
defined as a year in which disqualified persons
own at least 50% of the outstanding shares of
the company).
• Violation of this rule has devastating effects
Best Practices for S Corporation ESOPs
Questions ?
Mark R. Kossow
Schatz Brown Glassman Kossow LLP
250 Mill Street; Suite 309-311
Rochester, New York 14614
585-512-3414 x 8121
[email protected]
Best Practices for S Corporation ESOPs
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