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S Corporation ESOPs

David Johanson

October 1996

President Clinton signed the Small Business Job Protection Act of 1996 (the"Act") into law on August 20, 1996. In addition to a number of retirement plan provisions which will probably have a positive impact on ESOPs and other qualified employee plans, and the repeal of the partial interest exclusion for lenders under Section 133 of the Internal Revenue Code of 1986, as amended (the "Code"), the Act included a provision that will permit S corporations to have ESOPs as shareholders. The S corporation provision, originally proposed by Senator John Breaux (D-La.) in a form far different from what President Clinton signed into law, is effective January 1, 1998. The final provision added restrictions that (1) prevent a selling S corporation shareholder from making an election to defer capital gains on the sale of stock to an ESOP under Code section 1042, (2) prohibit the S corporation from issuing dividends on the stock sold to the ESOP and deducting them from any earnings that would otherwise be taxable to the S corporation's shareholders, and (3) treat interest on a loan to an ESOP as an annual addition to participants' accounts under Code section 415 even though not more than one-third of the S corporation's contributions to the ESOP are allocated to highly compensated employees.

The S corporation provision also treats the ESOP trust's share of S corporation earnings and the trust's gain on any "disposition" of S corporation stock (including distributions of stock to departing employee participants) as unrelated business taxable income (UBTI) and subjects such earnings to a 34% tax rate. This means that ESOP participants will be subject to double taxation, once when the ESOP trust pays its share of the UBTI tax on the S corporation earnings that are distributed to it by the corporation and again when former participants receive distributions from the ESOP trust upon leaving the corporation with deferred vested benefits. Although the S corporation could guarantee the payment of these taxes, this is not exactly the result Senator Breaux hoped for when he originally proposed the S corporation provision.

Although some ESOP experts believe that the S corporation provision is "almost unusable in its current form," many S corporations are now studying whether they can establish ESOPs as a business succession planning technique. Given the large number of inquiries, this forum will explore the viability of S corporation ESOPs very carefully in the next few months. Even though many S corporations understand the technical disadvantages of the new law, further inquiry and analysis is warranted because an ESOP can serve many purposes. Most importantly, many companies have established ESOPs in recent years as a business succession planning technique and not simply as a tax planning device. Although many owners are strongly motivated by the ability to defer capital gains on the sale of stock to an ESOP, many others also do not want to sell their companies to third parties, who will likely downsize their workforce and dramatically change the culture of respect for employees that they have worked so long to cultivate.

With this background in mind, this forum will direct further attention to why and how an S corporation ESOP can be an effective tax planning and business succession technique. Please share any thoughts and experiences with us via email and we will address them in this forum.

As always, comments are appreciated. Please share your thoughts via email to Mr. Johanson at drj@esop-law.com.

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