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Uses for S-Corp distributions to sole shareholder


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An ESOP holds 30% of an S-Corp's stock and the owner holds the other 70%. I understand that distributions (not dividends since this is an S-Corp.) are often used to pay down the loan. One article I read says that distributions cannot easily pass through to ESOP participants. However, this client doesn't want to pay down the loan or allocate it to participants. Instead, the company would rather use the distribution for other plan obligations -- perhaps to liquidate the shares of retiring employees or for plan expenses, for example. I'm looking for something that definitively tells me that that would be okay to do. I've looked through the BNA ESOP portfolio, thinking that surely that there would be a discussion about the earnings distributions there, but I didn't see anything. Can somebody point me in the right direction? Before amending the plan, I want to make sure that what they want to do is permissible.

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If I am understanding the question correctly the reason you can't find anything that says it is ok is because it isn't ok. You can't do what you are proposing.

The plan document should tell you what you do with the S corp distributions. It will be different for the S corp distributions related to the allocated shares vs the unallocated shares.

But that money has to be allocated to the participants. It can't be used for the benefit of the plan sponsor. And that is how I understand the question to mean.

Here is a simple example of what I think you are saying:

The company is going to pay $10,000 of S Corp distributions. The ESOP portion is obviously $3,000. The plan sponsor wants to use that $3,000 to pay the benefits of terminated employees from the ESOP by buying the shares (after the ESOP has made share distributions) and making them treasury stock. If true then wouldn't that slowly but surely mean the owner's share of the ownership is going up and the ESOP's is going down? Assume there are 10,000 shares so the ESOP owns 3,000. And the terminated people get 500 shares of stock distributed to them and the sponsor uses the $3,000 to buy those shares. Now there are 9,500 shares outstanding the the ESOP has 2,500 of them and only owns 26.3% of the shares. In effect the 70% owner wants to use the ESOP's money to increase his/her percentage owned of the company. That can't be done.

Now you can allocate the $3,000 per the plan document and recycle the shares within the plan. My guess is the money related to the unallocated share will have to be used to pay the loan per the plan document. The Plan Administrator might have more flexibility to on how the allocated shares money is used. For example that cash might be allowed to pay plan expenses.

I guess let me know if you think I don't understand your questions.

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I'll have to think this through for a bit, because maybe I didn't pose the question properly -- or more likely, I don't know what I should be asking. I've been reading articles that seem to say that that the earnings distributions CAN be used for other plan purposes (other than paying down the loan), such as "repurchase obligations and plan expenses." However, I could certainly be misinterpreting what I'm reading, and there are no citations mentioned to help me out. But I see your point about increasing the owner's percentage and decreasing the plan's. So the part about "recycling the shares within the plan" is probably what I should focus on. It sounds like I must be confusing allocated vs. unallocated shares. I very much appreciate your input.

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I think the "paydown the loan or allocated to participants" stuff is coming from the Code and Reg for 404(k) which defines when a dividend paid to an ESOP is deductible for the employer. I know enough to find the cite; I don't know enough to guess the implication of making a dividend that is not deductible under 404(k).

EDIT: take a look at 1.404(k)-3 http://www.ecfr.gov/cgi-bin/text-idx?SID=0113444e058db10b6a025fa9a983938b&node=26:5.0.1.1.1.0.3.151&rgn=div8

Kurt Vonnegut: 'To be is to do'-Socrates 'To do is to be'-Jean-Paul Sartre 'Do be do be do'-Frank Sinatra

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ESOP Guy: In your example, why couldn't the ESOP use its $3,000 to fund the purchase of shares of accounts of participants entitled to a distribution (or entitled to diversify), and then allocate the shares so purchased to participants' accounts as earnings in lieu of the $3,000 cash? That is, of course, assuming there is no language in the plan document throwing up a roadblock.

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ESOP Guy: In your example, why couldn't the ESOP use its $3,000 to fund the purchase of shares of accounts of participants entitled to a distribution (or entitled to diversify), and then allocate the shares so purchased to participants' accounts as earnings in lieu of the $3,000 cash? That is, of course, assuming there is no language in the plan document throwing up a roadblock.

I think they can do that. That is not how I understood the question nor is it how my example reads. Based on follow up comments from the original post I might not understand the question correctly. However, what I read the question as saying is the shares are DISTRIBUTED OUT OF the plan as shares and the $3,000 is used to buy the shares and making them treasury stock.

What you are talking about is typical recycling of shares. You allocate the $3,000 to people's accounts based on their share balance in the ESOP. You then use the cash in their account to fund the distributions. You will note the shares are staying in the plan in your example.

You will note I mentioned recycling in my first comment as being doable.

I think I was thrown off by the use of the word liquidate the shares in the original question. Or maybe I just got it wrong. But I got it in my head when I read that the shares were leaving the ESOP and becoming treasury stock.

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The Original Post stated "Instead, the company would rather use the distribution for other plan obligations". The OP may have misdirected slightly by offering some specific examples but I take those as being possibilities, not as exclusive options.

So... if a dividend is not used to repay the loan nor allocated to participants, what other uses are permissible and what are the ramifications (such as the dividend not being tax-deductible to the company)? Can they use it to make distributions in cash in lieu of shares? Can they pay plan expenses from the plan with it? What else could the plan do with the cash for purposes that are related to the plan and plan's obligations?

Kurt Vonnegut: 'To be is to do'-Socrates 'To do is to be'-Jean-Paul Sartre 'Do be do be do'-Frank Sinatra

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