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.

NCEO employee ownership FAQ hero (keyboard)

What are some of the financial circumstances that would make it not make sense to convert from a C to an S corporation?

There are several typical scenarios:

1. The C corporation has little or no taxable income.

2. There is a backlog of net operating losses for the C corporation to use.

3. The company has a leveraged ESOP and would violate the 25% of pay Section 415 limitations if it had to count interest payments on the loan towards the limit, as required in an S corporation ESOP.

4. There are multiple classes of stock, and it is important for the company or the ESOP to retain this feature. For instance, if the ESOP has convertible preferred shares, changing to an S corporation would require they be converted to common. In some cases, this may not be practical. There is also a fiduciary issue for the conversion (is it in the interest of the ESOP participants as shareholders to do it?) that could affect this transaction.

5. The ESOP owns less than 100% of the stock. Here, the scenario is more ambiguous. Assume the ESOP owns 50%, for instance, and the company converts to an S corporation. Also assume the company distributes dividends to shareholders in amounts at least sufficient to cover their taxes. Assume earnings of $1 million and that the personal tax rate of the owners is 40%. The company thus pays a distribution of $200,000 to the owners and $200,000 to the ESOP. Total retained earnings are now $600,000. If the company stayed a C corporation, and paid 38% state and federal tax on the $1 million earnings, it would have $620 million in retained earnings. The payout to owners, however, will increase their basis and thus reduce their long-term capital gains obligation. If owners in this scenario did not want to pay out earnings, but preferred to retain them for corporate reinvestment, or did not want the additional $200,000 going to the ESOP, converting would not make sense.

6. There are special tax considerations, such as the built-in gains tax or the first-in, first out accounting rules. C corporations that sell appreciated assets within 10 years of conversion to S must pay tax on the value of these gains. C corporations that use Last-In, First-Out Accounting for tax purposes, must pay taxes over a four-year period on the excess value of its inventory as determined on a First-In, First-Out basis.

7. The company would not be able to comply with the special S corporation ESOP anti-abuse rules, discussed in detail under a separate heading.

8. The C corporation has substantial passive income (more than 25%), such as franchise fees, interest, or investment income. This passive income may generate an additional tax when the company converts to S.

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

Link to this FAQ Topic: S Corporation ESOPs