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ESOP Operational Issues

Impact on ESOP Participants of S Corporation Status

Nancy Dittmer

August 6, 2009

(Nancy Dittmer)Time certainly does fly - it seems hard to believe that we have had S corporation ESOPs for over a decade now. Still, I continue to get questions that relate to the impact of the S corporation provisions of the Internal Revenue Code ("Code") on ESOP participants.

At the time that the law was changed to allow an ESOP to be a shareholder of an S corporation, there already existed an expansive set of requirements applicable to S corporations and their shareholders within the Code. Since these provisions of the Code were written prior to the possibility of an ESOP as a shareholder, the application of certain of the provisions to ESOP participants can be confusing. Here are two of these issues:
  1. ESOP Participants as Shareholders for Purposes of the Fringe Benefit Rules
    A negative associated with an S election is that more-than-2% shareholders lose the benefit of many otherwise tax-exempt fringe benefits. Absent sufficient direct stock ownership, an employee is not considered a more-than-2% shareholder even if his or her account receives an allocation of more than 2% of the company's stock through the ESOP. Thus, he or she retains the rights to tax-sheltered fringe benefits.
  2. ESOP Participants as Shareholders for Purposes of the Bonus Deductibility Rules
    Another rule that applies to certain S corporation shareholders is found in Code Section 267. Code Section 267 limits the deduction by an accrual-basis corporation of payments to a cash-basis shareholder. Code Section 267(e) provides that any direct or indirect shareholder in an S corporation is considered to be a related party for this Section's purposes of limiting deductions. So are ESOP participants considered to be indirect shareholders for this purpose? We have had clients who have had this issue raised by the IRS and the IRS's position has been that the ESOP participants are indeed indirect shareholders.

    The result of that position by the IRS would be that since most individuals are cash-basis taxpayers, an employer may not accrue deductions at year-end for amounts payable to such participants. The normal year-end bonus accrual becomes subject to Sec. 267 and is deductible in the year paid to the participants. The option to allow a current deduction if paid within two-and-a-half months of year-end would not apply, except for the portion of the bonus paid to employees who are not participants in the ESOP or who have no shares allocated to their account as of the end of the tax year.

    The determination of whether an employee has shares in his or her account as of year-end raises additional questions for new participants. If a contribution is accrued as of year-end, but satisfied by a contribution of shares or a payment of debt and release of shares after year-end, is the participant deemed to have shares as of year-end? As a practical matter, attempting to distinguish between bonus awards that may or may not be accrued at year-end may be more of a hassle than it is worth.

    While there may be some argument against considering the ESOP participants as indirect shareholders, it may just be easier to take the deduction for the bonuses in the year that such bonuses are paid.

In my next column, I will outline how the S corporation status can affect the cost basis of the shares owned by the ESOP and the taxability of a distribution of shares to an ESOP participant.

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