Frequently Asked Questions

Employee Ownership FAQs

Common questions about employee stock ownership plans (ESOPs), employee ownership trusts (EOTs), and other forms of employee ownership, from the basics to technical topics.

This FAQ is written primarily for business owners, managers, and advisors involved in setting up or running an employee ownership plan. If you're an employee at an ESOP company looking to understand your own benefits and rights, see our articles on Working at an ESOP Company and The Rights of ESOP Participants.

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Can a Subchapter S corporation have an ESOP or other qualified retirement plan own stock?

S corporations can have an ESOP, but it is trickier for them to have another retirement plan own stock. S corporation are taxed like partnerships. That is, the gains and losses are passed directly through to the owners; the corporation does not pay tax. In the past, non-taxable entities such as ESOPs or 401(k) plans could not own S company stock because then no tax would be paid on the earnings being passed through.

In 1996, legislation was passed to deal with this issue. It allowed ESOPs, 401(k) plans, stock bonus plans, and profit sharing plans to own stock in an S corporation. The employee benefit trust, however, would be responsible for its share of taxes, paid at its own tax rate. For instance, if the trust were a 20% owner, and the S corporation had $100,000 in earnings in a year, the trust would pay taxes on $20,000, taxed at the rate applicable to an individual earning $20,000 in a year (assuming the trust has no other income, which it might from non-stock investments or from the sale of assets). Presumably, the company would pay the tax by contributing the money to the plan. This contribution would not, however, need to be allocated to employee accounts.

The 1996 legislation left some technical gaps that made it impractical for qualified plans actually to hold company stock in an S corporation, however. The problem was fixed for ESOPs the next year, but not for other plans. First, if employees put shares distributed to them after termination into an IRA, the S election would be voided because an IRA cannot own S corporation stock. Second, the law did not provide an exemption from "prohibited transaction" rules under the Employee Retirement Income Security Act for sales by "owner employees" to a qualified plan, something that is exempted for C corporations. Finally, it was ambiguous about the tax the trust would pay on any gains in the value of the shares it held when these shares were distributed to employees. Arguably, the trust would have to pay unrelated business income tax (UBIT) on the gain, meaning the gains would be taxed twice, to the employee and the trust.

In 1997, these problems were fixed, but only for ESOPs. The owner employee exemption was added to the law, the trust was exempted from the UBIT tax, and the company can require departing employees to take the cash value of their shares.

The result of all this is that an ESOP is very practical in an S company and highly tax-advantaged. Profits attributable to the ESOP trust are not taxable. That means that if the ESOP owns 30% of the shares, 30% of the profits are not taxable. If the ESOP owns 100% of the shares, all of the profits are not taxable. If the company makes distributions to non-ESOP owners, the ESOP must still get a pro-rata share of these distributions. The ESOP trust can retain these distributions to fund the future repurchase obligation of the company and or use the money to purchase additional shares from existing owners.

For details on S Corporation ESOPs, see our book S Corporation ESOPs.

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Link to this FAQ Topic: S Corporation ESOPs