S Corporation ESOP Traps for the Unwary

Excerpts

From "S Corporation Distributions" (footnotes omitted)

As previously noted, S corporations do not pay taxes at the corporate level, but their individual owners do pay taxes on their pro-rata share of any profits the company reports. To pay those taxes, the owners usually want the company to distribute enough earnings to them to cover their federal and state tax obligations. S corporation rules require that if distributions are made to any owner or owners, all owners must receive a proportionate share. In an ESOP company, that means that if ESOP owns 40% of the shares, it must receive 40% of the distributions even though it has no tax obligation. In a very real sense, the ESOP is accumulating cash that otherwise would simply have been passed through to other owners to pay taxes (the government does not lose out in this process because employees later pay taxes on their ESOP distributions). This cash can be used to buy more shares, repay an ESOP loan faster, and/or retained to handle repurchase obligations.

Even 100% ESOP-owned S corporations may make distributions. Most often, these distributions are made because the amount required to repay an ESOP loan is too large relative to the plan’s eligible payroll to fall within the Internal Revenue Code’s annual addition and/or contribution limits. Distributions do not currently count toward these limits.

When an S corporation ESOP receives distributions and the ESOP is leveraged, the trustee will apply the distributions in accordance with the ESOP and trust documents. For distributions attributable to shares allocated to participant accounts, the ESOP must allocate the distributions based on relative share account balances. If these allocated S distributions are used to repay the loan, the allocation of the released shares must follow the allocation of those S distributions. So if Sam has 20 shares and Mary has 40, and both are active employees, Mary must get twice as many shares released from the suspense account as Sam. Allocations of the distributions on shares still in the loan suspense account can be made based on the same formula or on the company’s normal allocation formula (most often relative compensation).

Distribution Dilemmas

All this may seem relatively benign so far, but danger can lurk for the unwary. Typical problems include the following:

• Distributions can cause a “have/have-not” problem because participants with shares keep getting more added to their accounts, meaning the next round of distributions will give them even more, while newer employees with smaller accounts get much less than what they would get under a normal allocation formula (e.g., relative compensation).
• If many ESOP participants are former employees still holding shares, they also will receive the benefit of the distribution.
• Using distributions for prepaying debt accelerates the repurchase obligation since shares are released faster.
• Only distributions on shares acquired with a particular loan can be used to repay such a loan. Thus, any distributions not attributable to shares acquired with that loan cannot be applied to the repayment of such loan.
• Using distributions can work when the share value is rising, but if it starts to fall, the distributions can have a value greater than the value of the remaining shares. This creates a very tricky problem because the value of shares released from the suspense account and allocated to employees because of the use of distributions on allocated shares to make debt payments must at least equal the dollar amount of such distributions. This value test does not apply to distributions on suspense account shares. (One of the examples below discusses this value test in more detail.)
• Overreliance on distributions can eventually lead some companies to violate the S corporation ESOP anti-abuse rules because of the concentration of shares in the accounts of long-term participants.
• Companies that rely almost exclusively on distributions to allocate shares can be deemed to be inactive plans because the law requires ongoing contributions (and distributions do not count as contributions since they are earnings on plan assets).

The last two problems in the list above are illustrated by an actual case that came to our attention. We have changed the names to protect the parties involved.