S Corporation ESOPs

Introduction: How S Corporation ESOPs Came to Be
How ESOPs Work
Legal Considerations for S Corporation ESOPs
A State-by-State Analysis of S Corporation Tax Treatment
Valuing S Corporation ESOP Companies
Administrative and Operational Issues Resulting from the S Election
Complying with the Section 409(p) Anti-Abuse Rules
Phantom Stock and SARs in S Corporation ESOP Companies
Ownership, Motivation, and Company Performance

From "Administrative and Operational Issues Resulting from the S Election"

One major change to ongoing ESOP allocations arises as a result of the fact that an S corporation may only issue a single class of stock, and ESOP companies have often created systems to allow for the treatment of ESOP shares to differ from the treatment of other non-ESOP-owned shares. Where certain shares are treated materially differently than others, the IRS can declare that that different treatment constitutes a separate class of stock (regardless of the technical fact of the matter), and your S election can be voided.

This tends to show up where an ESOP company is applying dividends as a way of funding the ESOP either to supplement contributions for loan payment purposes or to pass through to participants as a current cash incentive. C corporation ESOPs can deduct dividends paid on ESOP shares when the dividends are used to repay an ESOP loan (dividends are also deductible in C corporation ESOPs if they are passed through to employees and/or employees voluntarily reinvest them in company stock). Dividends used to repay an ESOP loan in a C corporation also do not count against contribution limits. That has often meant that in C corporations, a separate class of ESOP stock is created (or that other shareholders waive their right to dividends) so that dividends can be focused only where needed to assist funding. Used in that manner, C corporation dividends have become a reliable way of supplementing employer contributions to repay ESOP debt or creating additional tax deductions through the pass-through. And, acknowledging this, Congress has carved out a set of provisions in the Internal Revenue Code (the "Code") designed to control how C corporation dividends are used in order to insure that ESOP participants receive fair value for any dividends they might receive.

When you convert to S corporation status, all of those practices change materially. Since an S corporation may issue only one class of stock, any special focusing of dividends to special ESOP shares will not be possible without risking the election itself. Any distribution of earnings (the equivalent of a dividend in a C corporation) must be distributed evenly to all shares of issued and outstanding stock and to all shareholders. Favoring one shareholder over another can be interpreted to be creating that separate class of stock (with a preference for dividends), and that would void the S election.

This fact cuts both ways. It is not possible to focus the application of dividends (distributions) only on ESOP shares, so if you are planning to use them to supplement contributions for ESOP funding, you will have to gross up the distributions to cover all shareholders ratably. At the same time, where it is the practice of S corporations to distribute earnings to shareholders to, at least, cover their tax liability, the ESOP must be in line to receive its share of distributions as well. In either case, there may be a larger commitment of cash to the process than was the case under the C corporation rules.