3825 / What requirements apply when an S corporation maintains an ESOP?

The IRC permits certain qualified retirement plan trusts to be shareholders of S corporations; thus, an S corporation can adopt an ESOP.¹ When a tax-exempt entity (e.g., an ESOP) holds an ownership interest in an S corporation, the distributions from the S corporation received by the tax-exempt entity are not subject to income tax. This unique tax benefit is available to S corporation ESOPs only when certain requirements are met.

First, the IRC restricts the type of entities that can own an interest in an S corporation.

Second, the IRC places certain restrictions on the operation of the ESOP. These operational rules apply to the allocation of S corporation stock within the ESOP to certain individuals, and limit certain tax benefits otherwise available to ESOP sponsors. Those limits apply to the deductions for employer contributions to the plan and for dividends paid on employer securities, and do not permit the rollover of gain on the sale of stock to an ESOP ( Q 3731, Q 3824).

Planning Point: Because there is a possibility for abuse of this benefit, the IRS has targeted S corporation ESOPs for special attention.²

The IRS has stated that an ESOP may direct certain rollovers of distributions of S corporation stock to an IRA, in accordance with a distributee’s election, without terminating the corporation’s S election, provided certain requirements are met. The effect of these requirements is that either the S corporation or the ESOP repurchases the S corporation stock immediately upon the distribution to the IRA and that no income, loss, deduction, or credit attributable to the distributed S corporation is allocated to the IRA.³