Determining the Cost Basis of S Corporation Shares

As I mentioned in my last column, the status of the ESOP plan sponsor as an S corporation can trigger different consequences for the participants in such ESOP than if the plan sponsor were a C corporation. The determination of the cost basis of the shares owned by the ESOP is one of those circumstances.

First, we should discuss the relevance of the cost basis of the shares owned by an ESOP. If a distribution from an ESOP to a former participant is made in the form of company stock and such distribution is a lump sum distribution, the taxation to the participant is different than a cash distribution (assuming the distribution is not rolled over into an IRA or other qualified plan.) Specifically, the cost basis of the shares would be taxable as ordinary income like a cash distribution. The excess of the current fair market value of the shares at the time of the distribution over such cost basis is known as Net Unrealized Appreciation (NUA) and is taxed at the long term capital gains rate.

Example: Emily receives a lump sum distribution of 10,000 shares of EFG, Inc. from the EFG ESOP. The shares were purchased many years ago and have a cost basis of $2 per share. The fair market value at the time of the distribution was $20 per share. So the value of total distribution is $200,000. Emily elects to receive such distribution and then immediately sells the shares back to EFG, Inc. Her taxation is as follows - $20,000 would be taxed at the ordinary income rates and the NUA of $180,000 would be taxed as a long term capital gain. Since the long term capital gains rate is currently lower than ordinary income tax rates, this can be a valuable benefit.

In very general terms, the cost basis of C corporation shares owned by an ESOP is the cost at which such shares were acquired by the ESOP. Note, the regulations on determining cost basis were adopted in 1956. As you might suspect, these regulations do not really address the current recordkeeping practices for ESOPs. Still, there are some principles that would seem to constitute best practices for tracking cost basis. One of those is the need to maintain shares acquired in different transactions in separate buckets as discussed in an earlier column.

Since an S corporation passes through its items of income and expense to its shareholders, the basis for an S corporation shareholder is continually updated. The basis is increased for the items of income on which the shareholder must pay taxes and it is reduced to the extent that the shareholder receives distributions from the S corporation.

The IRS has indicated that an ESOP should adjust the cost basis of its S corporation shares in the same manner as a non ESOP shareholder. But again, the problem is that the regulations on adjusting the basis of S corporation shares were written before an ESOP was an eligible S corporation shareholder. For example, the S corporation adjustments are typically made on a per share, per day basis for non ESOP shareholders. So how is that S corporation adjustment applied to ESOP participants when ESOP account balances are typically only adjusted annually? This is just one of the questions relating to the application of S corporation cost basis adjustment provisions to ESOP shares. And there is not any definitive guidance from the IRS to answer these questions. This means that you should consult with your ESOP advisor as to how to adjust the basis of the ESOP shares for the items of S corporation income and expense.

If we assume that the cumulative S corporation adjustment in the above example increases the cost basis to $10 per share, the taxation of the $200,000 distribution is significantly different. In that situation, the ordinary income portion of the distribution is increased to $100,000 and the capital gain portion is reduced to $100,000.