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Section 415 Limits for S Corporation ESOP Companies

David Johanson

October 1999

This brief summary is intended to identify some of the issues related to the application of Section 415 of the Internal Revenue Code of 1986, as amended (the "Code"), to those companies that have elected subchapter S corporation status and maintain an ESOP.

The 1996 and 1997 legislation that made it possible for subchapter S corporations to sponsor ESOPs imposed special limitations that apply only to certain aspects of ESOPs maintained by such corporations. Of particular relevance is the provision of the 1997 legislation that excluded the application of Code Section 404(a)(9) to ESOPs sponsored by subchapter S corporations. Section 404(a)(9) of the Code permits, among other things, C corporation ESOP sponsors to deduct not only contributions of up to 25% of "covered payroll" to an employee stock ownership trust ("ESOT") to the extent those contributions are used by the ESOT to repay acquisition debt, but also any additional contributions used to pay interest on such debt.

In addition to eliminating this special rule on the deductibility of employer contributions used by an ESOT to pay interest on an acquisition loan, the 1997 subchapter S corporation legislation also indirectly eliminated another special rule that, for C corporations, excludes such contributions from counting against the usual limits on "annual additions" to participant accounts described at Code Section 415(c). The special rule provides in relevant part that any employer contributions which are used by an ESOT to pay interest on an acquisition loan are not included as "annual additions" under Code Section 415(c); provided, however, that this special rule is applicable for any plan year only if not more than one-third of the employer contributions applied to pay principal and/or interest on an acquisition loan are allocated to the accounts of participants who are "highly compensated employees" under Code Section 414(q). The indirect elimination of this special rule occurred because the rule (found at Code Section 415(c)(6)) limits the exclusion to contributions which are deductible under Code Section 404(a)(9). Because employer contributions (beyond 25% of "covered payroll") that are used by an ESOT to pay interest are not deductible by a subchapter S corporation, they no longer come within the special exclusion from the "annual addition" limits of Code Section 415(c). Section 415(c)(6) of the Code also includes a similar provision for forfeitures of financed shares. Therefore, although the Internal Revenue Service ("IRS") National Office has interpreted many of the provisions formerly applicable to C corporation ESOPs and ESOP companies (where their applicability may be unclear under the statute) as not applicable or available to subchapter S corporations and their ESOPs, it is not clear that this same conclusion would apply to forfeitures of financed shares.

These new statutory provisions and IRS interpretations of such provisions may make it difficult for some subchapter S corporations and their ESOPs to satisfy the "annual addition" limits under Code Section 415(c). Advisors to ESOP companies and ESOPs have developed a number of techniques to deal with such limitations. One technique, recently described in IRS Private Letter Ruling 199929045 (April 27, 1999), permits an ESOT that is repaying an acquisition loan to determine its "annual additions" to participant accounts for a plan year based on the fair market value of the shares actually allocated to such accounts in that year, rather than the amount of the employer contributions made in that plan year which the ESOT used toward repayment of its debt. If the shares have not grown greatly in value since the time of their acquisition by the ESOT (and, in fact, may have declined in value), their current fair market value may be less than the amount of employer contributions used by the ESOT to pay the total of principal and interest in that plan year. In the ESOP chapter of the Employee Plans Examination Guidelines set forth in the IRS Manual, the IRS also states that annual additions can be calculated either with respect to employer contributions used to make payments on an ESOP acquisition loan or with respect to the fair market value of the stock that is released when such payments are made.

The second method for dealing with the limits on subchapter S corporation "annual additions" is to supply money to the ESOT in the form of dividends (or, using the correct terminology for subchapter S corporations, "distributions of earnings") rather than contributions. An IRS Private Letter Ruling that we recently received on a client's behalf confirms the ability of an ESOT to use distributions of earnings on shares held in the ESOT's loan suspense account to repay acquisition debt. Such distributions of earnings are generally not counted as "annual additions" under Code Section 415(c).

Editorial note: The rules for S corporation ESOPs were changed in the 2001 tax act. See here for the new rules.

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