Tax Bills Preserve ESOP S Corporation Benefits

The new tax bill passed by Congress (and to be vetoed by the President) preserves the ability for most S Corporation ESOPs to avoid paying unrelated business income tax (UBIT) on their pro-rata share of corporate earnings. Currently, ESOPs do not have to pay any tax on earnings attributed to them in an S corporation. The President proposed that they pay UBIT, but Congress has now rejected that approach.

The bill does, however, attempt to limit the abuse of the law by plans not designed to benefit employees. Under the provision, allocations of stock to people who collectively own 50% or more of the company's shares and either (1) own 10% or more of the ESOP shares or (2) with their family members own 20% or more of the ESOP shares will be subject both to income tax and an excise tax. Language in the conference committee report directs the Secretary of the Treasury to draft regulations so that options and other synthetic equity cannot be used to avoid the 50% limit.

The bill is good news for legitimate ESOPs, but will not prevent the law from being abused by people with little interest in benefiting employees. For instance, S owners could exclude themselves from an S ESOP, put common stock in the plan to avoid corporate taxes, but then dilute the ESOP's ownership by owning synthetic equity outside the plan that provides them with most of the company's real value.

The bill also has a provision allowing the company a deduction for dividends in ESOPs that are reinvested by employees in company stock. Currently, only dividends passed through to employees or used to pay an ESOP loan are deductible. The choice whether to reinvest in company stock must be the employee's, not the company's. The legislation, effective in 2001 if passed, would not exempt the reinvestment from potential securities laws issues that could limit their appeal to private companies (although recent securities rules changes could lessen these concerns).

The bill contains a number of other provisions dealing with benefit plan law, most notably allowing higher contribution limits for 401(k) plans when the company also sponsors other defined contribution plans. Prospects for the overall tax bill are, of course, uncertain, but there is no virtually no chance that most S corporation ESOPs will be required to pay UBIT.