The Employee Ownership Update
October 3, 1997
The Road Ahead for S Corporation ESOPsWith the new tax law making it possible for S corporations to have ESOPs as owners, many C corporations with ESOPs are considering switching to S status. Especially where the ESOP owns a substantial part of the company's stock, this can provide a substantial tax benefit, even reducing taxes to zero where the ESOP owns 100% of the shares. Indeed, it is arguably a duty of ESOP fiduciaries to consider such a switch. Several issues need to be kept in mind, however:
- The election requires the consent of all shareholders.
- An S corporation can only have 75 shareholders (the ESOP counts as one). S corporations can only have one class of stock, with the one exception that it can have voting and nonvoting common shares. Some C corporation ESOPs use convertible preferred or super-common stock for various reasons. These may or may not be sufficiently compelling to warrant not changing.
- S corporations must operate on a calendar year.
- On conversion, S corporations using last in, first out (LIFO) accounting are subject to a LIFO recapture tax. This could be substantial in some cases, especially in capital intensive businesses.
- For a 10-year period after conversion, if the company sells any asset it held on the day of its S corporation election, it will have to pay "built-in gains" tax on that sale. This tax is in addition to taxes paid by shareholders.
- In S corporations, some fringe benefits paid to 2% or more owners are taxable.
- Net operating losses incurred as a C corporation are suspended while an S corporation. These losses may be applied against LIFO or built-in gains taxes, however.
- State laws vary, and some states may not track federal laws. In California, for instance, ESOP are subject to state unrelated business income tax.
But Will the S Corporation Tax Benefit Last?Many would argue that Congress did intend to provide an incentive for S corporations to set up ESOPs, but did not intend to provide an incentive for C corporations with ESOPs to switch to S. The tax cost of this oversight could be substantial. There is a realistic chance, therefore, that Congress could decide to prevent this kind of conversion. Whether Congress would allow a painless way to convert back to C status cannot be predicted.
In fact, there are already calls to abolish the ESOP tax exemption in S corporations altogether. Given that the tax estimate for this provision (under $100 million) is probably very understated, these must be taken seriously.
Farnum ReduxSeveral years ago, the Department of Labor initiated a legal action against Wardwell Braiding Company (the so-called "Farnum" case) accusing the ESOP of overpaying for the shares. The ESOP had borrowed money to buy ownership in Wardwell and, as is usually the case, the share value dropped after the transaction to reflect the debt the ESOP had taken on to make the purchase. The DOL argued that the ESOP should only have paid the post-transaction value.
ESOP advocates pointed out that this hardly made sense. If someone were to sell a house worth $200,000, they would not agree to sell it to someone borrowing money to buy the house for $40,000, on the argument that the buyer's post-transaction equity interest would only be worth that much if the buyer borrowed 80% of the house's value. If the Farnum view prevailed, no one would sell to an ESOP.
Apparently recognizing the absurdity of the position, the DOL withdrew from the case. Now comes word that the IRS is auditing a number of ESOPs on the same theory, and that the DOL may be ready to revive it. In a coming column on this site, Ronald Ludwig, a prominent ESOP attorney, will talk about an approach that might satisfy the government, the seller, and the ESOP.