ESOP Repurchase Obligation Insights
ESOP Repurchase Obligation Issues in S Corporations
December 2000At a recent ESOP conference, a large percentage of companies in attendance had elected to be taxed as S corporations. These companies had questions about how repurchase obligation funding is different for an S corporation ESOP than it is for a C corporation, so this column will explore those issues.
First, a little background. When a company has elected to be taxed as an S corporation, taxation of income at the corporate level is eliminated. Instead, the shareholders are taxed on their proportionate share of the corporation's income. Usually, the corporation will distribute enough of its earnings to the shareholders to cover the taxes they will owe on their share of the corporation's income.
When an ESOP trust is one of the shareholders, the income attributable to its share of the corporation's income is not subject to income tax, but if other shareholders are receiving a distribution, so must the ESOP, because an S corporation can have only one class of stock. The cash that the ESOP trust receives from S corporation distributions provides liquidity for the trust that can potentially be used to fund ESOP distributions to participants.
If the ESOP owns 100% of the company, taxes on corporate income are completely eliminated. This gives companies that are entirely or mostly owned by an ESOP a big advantage, and explains why so many companies at the recent conference had elected S status.
So, how does S corporation status affect planning and funding for ESOP repurchase obligations? The answers are slightly different depending on whether or not the ESOP owns 100% of the stock.
Again, a little background is needed. ESOP repurchase obligations can be handled in two different ways. The first is redemptions: Distributions are made in stock, and the recipient can "put" those shares back to the corporation, which redeems them. The second way is by recirculating stock in the ESOP: The ESOP trustee makes distributions in cash, and the stock remains in the trust and is reallocated to the remaining participants. The cash can come from prior accumulations in the ESOP, or from a current contribution or S corporation distributions to the trust.
In the C corporation ESOP, the deductibility of contributions to the ESOP provides a tax advantage for shares to be recirculated in the ESOP, because the contributions that the company makes to the ESOP are tax deductible. The tax savings reduce the cost of repurchases. Although more shares will have to be repurchased over time, the higher cost is offset wholly or in part by the tax savings. In the S corporation ESOP, the tax savings associated with recirculating are eliminated or reduced. Since more shares will be repurchased over time when recirculating, the cost will be higher than handling repurchases through redemptions. The higher cost may be partially offset if redemptions have an antidilutive effect on the value of the stock by reducing the number of shares outstanding.
Cost is not the only consideration in the redeem versus recirculate decision, though. There are effects on individual account balances and the balance of ownership between the ESOP and non-ESOP shareholders that also need to be considered. Recirculating stock will result in larger numbers of shares in participants' accounts, and provides a way for new participants to receive allocations of company stock when no new shares are available. It also leaves the ESOP's percentage of ownership of the company unchanged, while redeeming stock will cause the ESOP's relative ownership to decline (except if the ESOP owns 100% of the company.)
It is more attractive for an S than for a C corporation to accumulate a "sinking fund" in the corporation to fund repurchase obligations.The reduction or elimination of tax at the corporate level for S corporation ESOPs means that income can be retained in the corporation without being taxed. This allows an S corporation ESOP to create a corporate "sinking fund" to fund repurchase obligations with before tax dollars and to avoid taxation on the investment earnings. By comparison, a C corporation uses after tax dollars to create such a fund and pays tax on the investment earnings unless they are invested in some sort of tax-advantaged vehicle.
A sinking fund in the corporation is attractive because it allows the corporation to remain flexible about whether it will contribute the funds to the ESOP to recirculate shares, or whether it will use the funds to redeem shares. It also strengthens the balance sheet, but this can be a double-edged sword because it may increase the value of the stock. Many appraisers treat non-productive assets (such as a sinking fund) as an add-on to the operating value of the business.
Corporate owned life insurance (COLI) is less attractive as a funding vehicle for repurchase obligation in S corporations.COLI can be an attractive funding vehicle for repurchase obligations in C corporations because of its tax advantages: tax free (or tax-deferred, depending how the policy matures) investment earnings, tax-free withdrawals and loans, and tax free death benefits. But in an environment where there is no tax, it is harder to justify the expenses associated with life insurance funding as an alternative to other sinking fund investments. There are circumstances, of course, where it is desirable to have death benefit coverage, but in general insurance designed for cash accumulation doesn't seem to offer any advantage for S corporation ESOP companies.
The choice between S corporation distributions and regular contributions as ways to get cash into the ESOP have significant implications for individual account balances.Both S and C corporations can contribute cash to the ESOP, and in most ESOPs the contributions are allocated pro rata to compensation (unless the plan document provides a different allocation method.) This results in higher allocations to people with higher compensation, irrespective of their length of service. But when an S corporation makes a distribution to shareholders, or when a C corporation pays a dividend, the distribution or dividend is allocated to the ESOP participants pro rata to the number of shares allocated to their accounts. The result is that the accounts of participants who have accumulated more shares receive more cash and grow much more rapidly than those with fewer shares. This is not necessarily bad, but it is an issue of which the company needs to be aware when it is deciding how to get cash into the ESOP.
There are some situations where there isn't any choice about S corporation distributions. These include distributions to shareholders to cover taxes (in the less-than-100% ESOP), where the distribution has to go to all of the shareholders, including the ESOP, even though the ESOP doesn't have to pay any taxes. There are also situations where S corporation distributions, in addition to regular cash contributions, are needed to meet payments on ESOP loans because of the lower contribution limits for S corporation ESOPs. The distributions attributable to the allocated shares in the ESOP can't be used toward the loan payment, so the S corporation distributions may have to be pretty high to get enough cash into the trust to meet the loan payments from the distributions on the unallocated shares. (This restriction does not apply to C corporations.) The same distributions will also have to go to any non-ESOP shareholders, which can make this a pretty expensive way to meet the payments on ESOP debt.
The cash that accumulates in the ESOP this way can be used to meet repurchase obligations, but will tend to exacerbate the differences between the "haves and have-nots" of company stock. Why? Because if those cash balances are used to fund repurchases, they will come out of individual accounts pro rata to the cash balances and be replaced with shares. The result is that those who had the largest cash balances because they had the most shares end up with even more shares. This is not any different from how a C corporation ESOP would work if dividends were being paid and retained in the trust instead of passed through to participants. Since C corporation dividends that are not passed through to participants are not deductible, this situation doesn't really arise in the C corporation. Again, there isn't necessarily anything wrong with this result, but it may not be the most desirable one for many companies.