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Tax Facts: The Twists And Turns Of S Corporation ESOPs

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The Twists And Turns Of S Corporation ESOPs


One reason the tax code is so complicated is that when Congress enacts legislation to accomplish a policy goal, it may take several more changes to arrive at a final “product” that works to Congresss liking. For example, it has taken nearly five years, but it seems that Congress may have the rules in place that it wants regarding S corporations and employee stock ownership plans (ESOPs).

In 1996, as part of the Small Business Job Protection Act of 1996 (SBJPA 96), Congress allowed certain tax-exempt entities, including ESOP trusts, to own the stock of S corporations. Congresss reasoning was that prior rules that did not allow these tax-exempt entities to own S corporation stock inhibited employee ownership of closely held businesses, as well as frustrating estate planning, discouraging charitable giving, and restricting the sources of capital for closely held businesses.

As part of these new rules, the income of the S corporation would flow through to the tax-exempt shareholder, whether a pension plan or a charity, as unrelated business taxable income. UBTI is taxed at the regular corporate income tax rates, which range from 15% to 35%.

However, the UBTI provision made S corporation ESOPs unattractive, because ESOP participants would now be subject to a double tax–first on the income of the S corporation that passes through to the ESOP, and then again when S corporation stock or cash is distributed to the ESOP participants. This double taxation would defeat one of the purposes of an S corporation election, which is to avoid the double taxation on corporate shareholders.

Before these provisions of SBJPA 96 took effect, however, Congress enacted new rules exempting S corporation ESOPs from these UBTI rules.

Now it seemed that Congress had what it wanted; but soon after these rules came into effect in 1998, Congress became aware that some creative taxpayers were engaging in “inappropriate deferral and tax avoidance in some cases.” This might occur, for example, in a very small S corporation where the only employees, and thus the only participants in the ESOP, are also the historic owners of the business.

Congress thought that S corporations should encourage employee ownership through an ESOP, but that the tax-deferral opportunities of an S corporation ESOP should be limited to those situations where there is broad-based employee coverage under the ESOP, with the ESOP benefiting both rank-and-file and highly compensated employees.

Because of these concerns, the tax legislation that was recently signed by President Bush contains provisions to try to ensure that ESOPs of S corporations benefit a wide range of employees.

The new rules provide penalties if an S corporation ESOP is not broadly based. An S corporation can generally avoid these penalties if it does not have any “disqualified persons.” A disqualified person is generally either a member of a family that together owns more than 20%, or an individual who owns more than 10% of the S corporation. If disqualified persons, together, own 50% or more of the company (special rules apply to unallocated stock), these penalties may kick in.

One penalty provision is that amounts allocated to certain owners of the S corporation will be treated as a distribution, so that the amount will be included in income in the year of the allocation. Another penalty provision is a 50% excise tax imposed on an S corporation for the amount it allocates to an ESOP for disqualified persons.

One bright spot for those ESOPs of S corporations that may be too concentrated to avoid the penalty provisions is the effective date for these rules. For S corporation ESOPs established before March 14, 2001, these new rules are not effective until after 2004. However, for ESOPs established after March 14, 2001, or for a corporation that was not an S corporation on March 14, 2001, the effective date is for tax years ending after March 14, 2001.

, JD, CLU, ChFC, is an assistant editor of Tax Facts, a National Underwriter publication.

Reproduced from National Underwriter Life & Health/Financial Services Edition, August 6, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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