IRS Clarifies That Distributions to Participants in S Corporations Can Only Be Based on Account Balances, Not Compensation; Allows Accounts for Terminated Employees to Be Held in Non-Stock Investments

In a Technical Assistance Memorandum dated November 5, 2001 and recently released, the IRS ruled that distributions on ESOP stock in an S corporation ESOP must be based on account balances, not compensation. The IRS argued that distribution of capital is a right that "adheres to the stock." On a second issue, the IRS ruled that the company could hold the account balances of former employees in investments other than company stock until paid out. However, the IRS did not allow the company to permit employees with account balances of $150,000 or more to direct the investments in these accounts. The company had withdrawn that provision in the course of negotiations with the IRS on this issue.