Hatch and Shaw Introduce ESOP S Corporation Provision to Allow Distributions on Allocated Shares to Repay Loans

Senator Orrin Hatch (R-UT) and Representative Clay Shaw (R-FL) have introduced legislation that would make broad reforms in S corporation law. The bills include a provision that would allow distributions on allocated shares in an S corporation ESOP to be used to repay a loan. The broad-ranging bill makes a number of changes in S corporation law, including increasing the permissible number of shareholders to 150, allowing the issuance of preferred stock, and making a variety of tax changes. Given all the competing tax proposals, prospects are very uncertain.

Under the current law, companies with ESOPs can use dividends paid on both allocated and unallocated shares to repay an ESOP loan. However, S corporations technically do not pay dividends; they make distributions of earnings to shareholders. The IRS has issued private letter rulings suggesting approving the use of distributions on unallocated shares to repay a loan, but not allocated shares. The distinction is based on the requirements of the law that say that any ESOP can use earnings on shares attributable to stock held as collateral for a loan to repay that loan, but cannot use earnings on shares that are not held as collateral.