The Road Ahead for S Corporation ESOPs

With the new tax law making it possible for S corporations to have ESOPs as owners, many C corporations with ESOPs are considering switching to S status. Especially where the ESOP owns a substantial part of the company's stock, this can provide a substantial tax benefit, even reducing taxes to zero where the ESOP owns 100% of the shares. Indeed, it is arguably a duty of ESOP fiduciaries to consider such a switch. Several issues need to be kept in mind, however:

• The election requires the consent of all shareholders.
• An S corporation can only have 75 shareholders (the ESOP counts as one). S corporations can only have one class of stock, with the one exception that it can have voting and nonvoting common shares. Some C corporation ESOPs use convertible preferred or super-common stock for various reasons. These may or may not be sufficiently compelling to warrant not changing.
• S corporations must operate on a calendar year.
• On conversion, S corporations using last in, first out (LIFO) accounting are subject to a LIFO recapture tax. This could be substantial in some cases, especially in capital intensive businesses.
• For a 10-year period after conversion, if the company sells any asset it held on the day of its S corporation election, it will have to pay "built-in gains" tax on that sale. This tax is in addition to taxes paid by shareholders.
• In S corporations, some fringe benefits paid to 2% or more owners are taxable.
• Net operating losses incurred as a C corporation are suspended while an S corporation. These losses may be applied against LIFO or built-in gains taxes, however.
• State laws vary, and some states may not track federal laws. In California, for instance, ESOP are subject to state unrelated business income tax.