Tax Bill Makes Changes to ESOPs, ISOs, ESPPs, and Deferred Compensation Plans

On October 22, 2004, the President signed the American Jobs Creation Act tax bill. The bill contains several changes important to S corporation ESOPs and to equity compensation plans.

S Corporation ESOPs

Under existing regulations, in a leveraged ESOP in an S corporation, companies can use distributions on unallocated ESOP shares to repay a plan loan, but not allocated shares. The law would change that to allow distributions on either to be used to be used to repay a loan, just as in C corporation ESOPs.

In addition, S corporations can have 100 owners, with family members counting as a single owner. IRAs can be eligible shareholders of S corporations, but only to the extent of bank stock held by the IRA on the date of enactment of the bill. (This provision was designed to allow small banks, where existing IRAs hold their stock, to elect S status.)

Also important to S corporation ESOPs are changes in deferred compensation plans rules. It is not clear, as explained below, if these rules will apply to phantom stock, stock appreciation rights, and other synthetic equity plans often found in S ESOPs.

Equity Compensation

The new law provides statutory blessing to the argument that disqualifying dispositions of stock acquired from incentive stock options and employee stock purchase plans is not subject to payroll taxes. The IRS had argued that these dispositions should be subject to these taxes, but it then indefinitely postponed the implementation of any regulations to require it.

Deferred Compensation

A much more complex change was made to the treatment of deferred compensation. Employees can now defer the receipt of a vested (and thus taxable) award under deferred compensation plans by making an election. Rules for how to do this have been ambiguous. In this bill, employees will only be able to elect to defer if several conditions are met:

1. The employee dies, becomes disabled, there is a change in control, there is an unforeseen emergency (as rigorously defined in the law), or there is a fixed date or schedule specified by the plan.
2. Elections for deferral must be made not later than the close of the preceding taxable year in which the award would vest or, if made in the first year of the award, within 30 days after the employee first becomes eligible for an award. If the employee is a key employee (as defined by statute) of a public company, receipt of the benefit must be not earlier than six months after separation
3. If the award is performance-based, the election must come not later than six months before the end of the performance period.
4. There can be no acceleration of benefits once a deferral election has been made.
5. Any subsequent elections for an award must be at least 12 months after the
   prior election and must defer receipt for at least five years in the future.

The law does not apply to qualified benefit plans, such as ESOPs or 401(k) plans, as well as sick leave, death benefits, and similar arrangements. Existing rules for incentive stock options or ESPPs would not be changed by this law. If the employee is granted an option on stock at not less than the fair market value, normal deferral features of such plans would not be covered. Other kinds of equity awards, such as restricted stock or phantom stock, are not explicitly discussed. The Senate bill specifically covered exchanges of stock awards when they vest for a right to deferred future income, but the conference rejected this language, leaving the issue of deferring gains on restricted stock and similar plans somewhat ambiguous because the conference agreement only explicitly exclude option awards and ESPPs. The effective date is December 31, 2004, but deferrals made after October 2, 2004, under a plan that has been materially modified after that date would be covered.

Now it is up to the IRS to determine whether other forms of equity compensation, such as restricted stock, phantom stock, and stock appreciation rights would also be covered. The IRS has promised to act within 60 days on this issue.