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).

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

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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

An S corporation that maintains an ESOP also generally is exempt from the requirement that employees be able to demand distribution of employer securities.⁴ To do otherwise could violate the IRC limit on the number of shareholders in an S corporation ( Q 3819). An ESOP maintained by an S corporation will not be treated as receiving unrelated business income on items of income or loss of the S corporation in which it holds an interest.⁵

Prohibited Allocations of Stock

An ESOP that holds securities consisting of stock in an S corporation also must provide that no portion of the assets of the plan attributable to such securities will accrue or be allocated, directly or indirectly, to a “disqualified person” during a “nonallocation year.”⁶ Such an allocation is referred to as a prohibited allocation.

A disqualified person is any person for whom:

(1)  the number of the person’s deemed-owned ESOP shares is at least 10 percent of the number of deemed-owned ESOP shares of the S corporation;

(2)  the aggregate number of the person’s deemed-owned ESOP shares and synthetic equity shares is at least 10 percent of the aggregate number of deemed-owned ESOP shares and synthetic equity shares of the S corporation;⁷

(3)  the aggregate number of deemed-owned ESOP shares of the person and his or her family is at least 20 percent of the number of deemed-owned ESOP shares of stock in the S corporation; or

(4)  the aggregate number of deemed-owned ESOP shares and synthetic equity shares of the person and his or her family is at least 20 percent of the aggregate number of deemed-owned ESOP shares and synthetic equity shares of the S corporation.⁸

Family member means the individual’s spouse, an ancestor or lineal descendant of the individual or spouse, a sibling of the individual or spouse, and lineal descendants of any siblings, as well as spouses of the aforementioned individuals (except in the case of a legal separation or divorce).⁹

Deemed-owned shares with respect to any person are the stock in the S corporation constituting employer securities of an ESOP that is allocated to such person’s account under the plan, and the person’s share (based on the same proportions as of the most recent allocation) of the stock in the corporation that is held by the ESOP but that is not allocated under the plan to participants.¹⁰

A nonallocation year means any plan year of the ESOP if, at any time during the year, the ESOP holds any employer securities that are shares in an S corporation and disqualified persons own at least 50 percent of the number of outstanding shares in the S corporation (including deemed owned shares) or the aggregate number of outstanding shares of stock (including deemed owned shares) and synthetic equity in the S corporation.¹¹ For purposes of determining whether there is a nonallocation year, the attribution rules of IRC Section 318(a) apply in determining stock ownership (except that the broader “family member” rules above apply), the IRC Section 318(a) rules regarding options do not apply, and an individual is treated as owning “deemed-owned” shares.¹²

In the event that a prohibited allocation is made in a nonallocation year to a disqualified person, the plan will be treated as having distributed the amount of the allocation to the disqualified person on the date of the allocation.¹³ In other words, the allocation is a taxable distribution to the individual.¹⁴ Furthermore, an excise tax of 50 percent of the amount involved is imposed on the allocation, and a 50 percent excise tax is imposed on any synthetic equity owned by a disqualified person.¹⁵ The 50 percent excise taxes are imposed against the employer sponsoring the plan.¹⁶

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Planning Point: The IRS has released “snapshot” guidance to help S corporations avoid a nonallocation year for employee stock ownership plan (ESOP) purposes. Pursuant to the snapshot, which is not precedential but can be helpful in understanding the IRS’ position on an issue, ESOPs may incorporate a “transfer method” into the plan document, pursuant to which the plan can transfer employee stock from a participant’s ESOP account if that participant is a disqualified person into a non-ESOP account of that same person. Alternative methods are also available, including excluding allocations for participants who may potentially be disqualified persons or increasing allocations to certain employees who are not highly compensated. These methods must also comply with all other qualification rules. Importantly, to use the transfer method, the method must be included in the ESOP plan document prior to the occurrence of a nonallocation year.¹⁷

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Synthetic equity includes any stock option, warrant, restricted stock, deferred issuance stock right, stock appreciation right payable in stock, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future. Synthetic equity also includes a right to a future payment (payable in cash or any other form other than stock of the S corporation) that is based on the value of the stock of the S corporation or appreciation in such value, or a phantom stock unit.¹⁸

Synthetic equity also includes any remuneration under certain nonqualified deferred compensation arrangements for services rendered to the S corporation or a related entity.¹⁹ The stock upon which synthetic equity is based will be treated as outstanding stock of the S corporation and deemed-owned shares of the person owning the synthetic equity, if such treatment results in the treatment of any person as a disqualified person or the treatment of any year as a nonallocation year.²⁰

Final regulations explaining the prohibited allocation rules of the IRC apply to plan years beginning on or after January 1, 2016.²¹ For plan years beginning before January 1, 2016, temporary regulations explain the prohibited allocation rules.²²