ESOP with no cash

[jsample]

I have a company who has never funded their ESOP with cash (non leveraged, S Corporation, all company shares are held in the ESOP, 9 active employees, 8 terminated employees).  When employees are entitled to distributions, they fund the trust account with the distribution amount(s) and payout the employee.  I allocate the amount(s) contributed during the year as contributions to eligible employees who then repurchase the terminated shares.

The employer now has a problem as the distributions are becoming much greater than 25% of compensation of the eligible employees.  Their accountant told me that the company is not deducting any of the "distribution contributions" on their corporate return.  I have to allocate the contributions based on compensation and I believe that they have nondeductable contributions and need to pay an excise tax of 10% on the amount greater than 25% of eligible wages. CPA disagrees.

Has anyone ever come across this situation?

Thank you.

[CuseFan]

I don't know if company being an S-corp makes this impossible, but can't the company distribute the shares and then repurchase them directly from participants? I know there is an ESOP guy on this forum, so hoping he'll chime in with a definitive answer for you.

[JRN]

CuseFan is correct. Also, the Employer can make an S corp distribution of earnings to the ESOP (akin to a dividend). The distribution of earnings is not a contribution nor a Sec 415 annual addition, The distribution of earnings is generally allocated to participants based on shares, not compensation. Based on the accountant's explanation that the company is not treating the "contribution" as a "contribution'", this may in fact be what is happening.

[Dare Johnson]

Since all company shares are held by the ESOP, the deduction is not an issue since there is no income tax.  I would find out how the company (and accountant) are treating the funding.

Most ESOPs with S-corp stock only allow cash distributions as the company would not want a lot of ex-employees owning and receiving a K-1 for their share of earnings.  In addition, S-corps cannot have more than 100 shareholders but that is not an issue with this S-corp.

[Bri]

(Just wondering - is the 100 shareholder limit done with treating the plan as one investor, or as whatever number of participants are IN the plan?)

[CuseFan]

On 6/30/2022 at 5:14 PM, Bri said:

is the 100 shareholder limit done with treating the plan as one

yes.

[ESOP Guy]

On 6/30/2022 at 3:51 PM, JRN said:

CuseFan is correct. Also, the Employer can make an S corp distribution of earnings to the ESOP (akin to a dividend). The distribution of earnings is not a contribution nor a Sec 415 annual addition, The distribution of earnings is generally allocated to participants based on shares, not compensation. Based on the accountant's explanation that the company is not treating the "contribution" as a "contribution'", this may in fact be what is happening.

They can do all of this.   They can distribute the shares and have the company repurchase them.   They can in effect put in dividends/S corp earnings distributions.

 

The hard part with a plan with small with both of those ideas is making sure you don't run into 409(p) testing issues.  Remember 409(p) testing is an every day of the year test.  You have to pass this test every day of the year.  So if you distribute shares and months later they contribute some of them back you have to show you passed on the test on the day the shares were distributed and when the new shares were put into the plan.

 

In fact with a plan that small 409(p) tends to be a problem.   With only 17 people with balances 409(p) testing has to be a bear with that ESOP.  

 

To answer the original question if I understand it correctly "yes" they have a deductability problem.  Even though an S Corp ESOP doesn't deduct they have to stay under that limit and not deducting the contribution does NOT solve the issue has been my understanding.  So I believe they owe the excise tax on the excess contribution.   We never allow your clients go over that limit if they are asking us how much they can put in based on that understanding at the firm I am working at. 

[Degrand]

I would run 409p testing prior to making any distributions in either cash or stock.  You may have to convert to a C-corporation prior to distribution in order to pass testing.  I have worked a few ESOP companies that have failed to run the test and failed 409p.   

[ESOP Guy]

14 hours ago, Degrand said:

I would run 409p testing prior to making any distributions in either cash or stock.  You may have to convert to a C-corporation prior to distribution in order to pass testing.  I have worked a few ESOP companies that have failed to run the test and failed 409p.   

I 2nd this.   We do it for any client that is small or even kind of close to failing this test.   This fact pattern is a set up to fail at some point in the future without good planning and even then it might still do it.