An employee stock ownership plan (ESOP) is a powerful tool that can greatly benefit both employees and their employer. When an ESOP owns an S corporation, it is partially or wholly exempt from federal income taxation (and possibly state taxation, depending on the state), making it an even more powerful tool in many cases. With the tax-planning possibilities offered by the S corporation ESOP structure, many companies investigate ESOPs and S corporate status. But there are many issues to deal with along the way, ranging from valuation issues to matters that arise when making the S corporation election (if the company is not already an S corporation) to dealing with the unavailability of the tax-deferred ESOP "rollover" for S corporation owners. Most importantly, however, it is imperative for any company considering or maintaining an S corporation ESOP to test its compliance with the strict anti-abuse rules for S corporation ESOPs.
This book deals with all these issues and more in a clear and understandable style. This fourth edition has been updated throughout, with every chapter either being updated or (in the case of chapter 7) replaced. Additionally, a new chapter at the end of the book addresses the increasingly important and much-discussed topic of creating a sustainable ESOP company.
Also see our issue brief S Corporation ESOP Traps for the Unwary, often bought together with this book.
Table of Contents
1. How ESOPs Work
2. Legal Considerations for S Corporation ESOPs
3. A State-by-State Analysis of S Corporation Tax Treatment
4. Valuing S Corporation ESOP Companies
5. Administrative Issues for S Corporations
6. Complying with the Section 409(p) Anti-Abuse Rules
7. Long-Term Incentive Plans in S Corporation ESOP Companies
8. Ownership, Motivation, and Company Performance
9. An Integrated Framework for Sustainability in S Corporation ESOPs
About the Authors
About the NCEO
From Chapter 2, "Legal Considerations for S Corporation ESOPs" (footnotes omitted)
If prohibited allocations are made to disqualified persons, then the company will be subject to an excise tax equal to 50% of the amount of the prohibited allocations, and the shares allocated to the accounts of the disqualified persons will be treated as having been distributed to the disqualified persons and they will be subject to tax on the value of those shares. The regulations seem to imply that these penalties are imposed for each nonallocation year, regardless of whether anything is added to the disqualified person's account for that year, although this result seems contrary to the general structure of the statute, which differentiates between the penalties for the initial nonallocation year and the penalties for subsequent nonallocation years. The statute does not specify how shares that are deemed to have been distributed are to be treated in future years. If they are treated as continuing to be held by the persons to whom they were deemed to have been distributed, then those persons will be personally liable for tax on their proportionate share of the S corporation's income.
In addition to the penalties described above, it is possible that if prohibited allocations are made by an S corporation ESOP, the ESOP then may be disqualified. The law requires that the plan document must prohibit allocations to disqualified persons during nonallocation years, so any prohibited allocation would violate the plan document. The IRS takes the position that violation of a plan document results in disqualification of the plan. If an S corporation ESOP is disqualified, then the ESOP no longer would be a permitted holder of S corporation stock, and the corporation's S election would be automatically terminated. There is a footnote in the legislative history of Section 409(p) which states that this result is not the congressional intent, but it is not known what position the IRS would take on this matter.
Additional penalties will be imposed if any synthetic equity is owned by a disqualified person in any nonallocation year. Then the company will be subject to an excise tax equal to 50% of the value of the shares on which the synthetic equity is based. It is important to note that the tax is imposed on the value of the shares to which the synthetic equity relates, and not the value of the synthetic equity itself. Therefore, a substantial tax may be assessed even where the synthetic equity itself is of little or no value, as for example where the strike price with respect to an option is equal to or greater than the fair market value of the stock covered by the option. The tax on synthetic equity appears to be especially onerous because the tax appears to be imposed on the same synthetic equity for every nonallocation year. For the first nonallocation year of an S corporation ESOP, a 50% excise tax will be applied against the total value of all of the deemed-owned shares of all of the disqualified persons, regardless of the amount actually allocated to their accounts during that year.
From Chapter 5, "Administrative Issues for S Corporations"
Additionally, allocations attributable to distributions on allocated shares must pass the "fair value rule." This rule requires that the number of shares allocated to the participant's account must be at least equal in value to the cash the participant would have received if the distribution had remained in cash in the plan. In the event there is a shortfall in the amount allocated, plan sponsors may use shares that have been released on unallocated shares to cover the shortfall. Additionally a special cash contribution may be made; however, this can create additional problems in conjunction with the Section 404 limits on the deductibility of contributions.
This particular problem seems to be prevalent in mature ESOPs where most of the shares are allocated or alternatively in newer ESOPs where the value of the shares is still depressed due to the outstanding debt. Careful planning and projections when S corporation distributions are used for note payments is prudent.