Clinton Proposes to Cut S Corporation Benefit

President Clinton's revenue proposals for the year 2000 call for the elimination of the special exemption from "UBIT" (unrelated business income tax) for ESOP in S corporations. Under existing law, any earnings attributable to an ESOP in an S corporation are not currently taxed. ESOPs are unique among otherwise nontaxable owners of S corporations (such as a charity) in their ability to avoid this tax, which is normally assessed at the highest marginal rate. The proposal would become effective as of the first committee action taken on it. Language in the proposal might be construed to grandfather existing ESOPs with S corporations, although it is doubtful this is the intent.

Proposals for eliminating corporate tax incentives are often made in conjunction with budget proposals. The road to passage, however, is an arduous one that must travel through a number of subcommittees and committees, any one of which can block enactment.

Background

Until 1997, ESOPs and other nontaxable trusts were not allowed to own stock in an S corporation. Under S corporation law, no taxes are paid at the corporate level. Instead, any taxable income is charged on a pro-rata basis to each of the corporation's owners. They then pay tax based on their personal tax rates, thus avoiding the double taxation on corporate earnings that applies to C corporations. If a non-taxable entity were an S corporation owner, then its share of S corporation earnings would simply go untaxed. Hence, these entities were not allowed to be owners in these corporations.

In 1996, Congress amended the law to allow certain nontaxable entities, including an ESOP, to own stock in an S corporation. These entities would have to pay tax on their earnings as unrelated business income tax (UBIT). UBIT is a long-standing tax concept that, for instance, would require a nonprofit charity to pay tax on leasing space in a building it owns. In this example, any income not related to the charity's purpose would be subject to this tax.

In 1997, Congress further amended the law to exempt ESOPs, and only ESOPs, from UBIT. This prompted a surge of majority-ESOP owned C corporations to reincorporate as S corporations, thus eliminating much of their tax obligation. It appears some S corporations were also motivated to set up ESOPs, although the number of these new plans was much smaller than the number of C to S conversions.

The President's proposal would restore this UBIT obligation on S ESOPs. Existing S ESOPs would probably switch back to C, and provisions would almost certainly be added to the legislation, if passed, to facilitate this without any special tax penalties that might otherwise apply.