Subchapter S Reform

The Act corrects a number of defects in the 1996 tax act's provisions concerning subchapter S corporations and ESOPs. The previous law allowed employee benefit plan trusts to hold stock in an S corporation starting in 1998, but, as structured, made it impractical to do so. The new law fixes these problems, but retains the old law's exclusion of S corporation ESOPs from a number of special ESOP tax benefits. The changes are effective in 1998.

Under the new law, ESOPs in S corporations can now require employees to take the cash value of their plan distribution rather than the stock itself. This is a critical change because the holding of company shares by departed employees could cause the company to lose its S status in some cases, such as if the employee puts the stock into an IRA (an IRA is not a qualified S corporation owner). The Act also exempts from the prohibited transaction rules of the Internal Revenue Code and ERISA sales of stock to an ESOP (but not to other qualified plans), as well as loans to an ESOP, by 5% shareholder-employees or the company. As the law was written in 1996, such sales or loans could expose fiduciaries and other parties to the transaction to liabilities and penalties.

Perhaps most important, the Act repeals the 1996 provision requiring ESOPs to pay unrelated business interest taxes (UBIT) on their share of S corporation earnings. Without this change, the trust could have been held responsible (presumably by using corporate contributions and cash dividends) for taxes both on its allocated share of earnings from annual S corporation profits and on any gains realized from the sale or distribution of stock. There had been an effort to extend this UBIT exemption to profit sharing plans, stock bonus plans, and 401(k) plans, but the Act limits it to ESOPs.

However, the Act does not provide S corporation ESOPs with the special ESOP tax benefits available to C corporations, including the deductibility of dividends used to repay ESOP loans or passed through to ESOP participants, section 1042 rollover treatment, or the higher contribution limits for leveraged ESOPs.

While this is a disappointment to ESOP advocates, some of these tax benefits are not as critical for S corporations, particularly the section 1042 provisions. Many S corporation owners have a substantially stepped-up basis when they sell because of taxes they have already paid on distributed earnings. The new law will not result in a flood of new ESOPs (most S corporations who wanted to set up an ESOP simply switched to C status in the past), but its impact should be noticeable nonetheless.

The language of the Act is notable in that the changes are specifically for ESOPs. Subchapter S corporations wishing to use other employee benefit plans to own employer stock will still find they face technical problems that will almost invariably make it impractical to do so. Practically speaking, this means S corporations who want to share ownership will have to comply with the additional protections ESOPs provide for employee owners, such as annual valuations and minimal voting rights.