S Corporation Changes: ESOPs Allowed, but with Restrictions

Under current law, employee benefit trusts cannot own stock in an S corporation. The new law would change this, effective January 1, 1998, to allow ESOPs, profit sharing plans, stock bonus plans, and 401(k) plans to own stock in their companies. S corporations have the limited liability of a regular C corporation but do not pay tax. Instead, all earnings (income and capital gains) are attributed each year on a pro-rata basis to the company's owners. This applies whether or not the owners actually receive cash or the earnings simply show up on the company's income statement or balance sheet. This means corporate income is taxed at personal tax rates, and no corporate income is taxed twice (as would be the case for dividends paid to owners of a C corporation). The new law also increases the maximum number of shareholders allowed in an S corporation from 35 to 75.

If an S corporation were to have a non-taxable trust as an owner under current law, this would mean that any earnings passed on to the trust would not be taxed. As a result, S corporations were not allowed to have these trusts as owners. Under the new law, profit sharing plans, ESOPs, and 401(k) plans would be allowed to own stock in an S corporation, but they would be responsible for paying taxes on their share of the earnings at the trust's tax rate. Presumably, the corporation would pay these taxes by making contributions to the trusts. In some states, however, the trusts will not have to pay state taxes.

While S corporations can now have ESOPs, there are, however, four major restrictions on their tax benefits:

• Sellers to an ESOP cannot take advantage of the section 1042 rollover provision allowing the deferral of taxation when the sale proceeds are reinvested in other securities.
• Dividends used to repay an ESOP loan or passed through to participants are not tax deductible.
• The maximum contribution level for an ESOP, leveraged or non-leveraged, is 15% of eligible pay, whereas C corporations can contribute 15% to a non-leveraged ESOP but 25% to a leveraged ESOP. However, 25% of pay can be contributed in an S corporation if the ESOP includes a money purchase pension plan (just as with a non-leveraged ESOP in a C corporation).
• When calculating the amount contributed to the plan for testing against annual section 415 contribution limits, interest payments on an ESOP loan must be included. In C corporations, only principal payments count. This will further lower the maximum contribution level in S corporations' leveraged ESOPs by about a third in typical cases.
• The ESOP is taxable on any gains made when it disposes of stock, possibly including distributions to employees.

Because of the restrictions and problems, we anticipate very few S corporations will set up leveraged ESOPs to buy out owners. As is the case now, most will find it worthwhile to convert to C status. On the other hand, some S corporations may find it appealing to contribute their own stock to a profit sharing, stock bonus, or 401(k) plan. Cash contributions to a stock bonus plan, for instance, could be used to provide a tax-deductible way for owners to use corporate cash to buy their shares. Stock contributions to any 401(k) plan, profit sharing plan, non-leveraged ESOP, or stock bonus plan could be used to share ownership with employees at no up-front cash cost.