S Corp dividends paid to Profit Sharing Trust

[dmb]

I have been asked about a Profit Sharing Trust that owns part of an S Corp and the S Corp pays dividends to the Profit Sharing Trust. Does this arrangement sound kosher?? It doesn't to me.

[Mary Kay Foss]

Individuals, decendents' estates, bankruptcy estates, certain trusts and tax-exempt charitable organizations can be S corporation shareholders. A Profit Sharing Trust that is qualified under Sec. 401(a) does qualify.

I'm surprised, I was going for another answer and pulled out the rules. The change to include 401(a) qualifed plan trusts happened within the last five years.

[dmb]

Which rules did you pull out?? Where can i find this rule??

[Guest sabecker]

S corps may not be owned by qualified retirement plans, except possibly by an ESOP. So a profit sharing trust should not be owning an interest in an S corp. and no S corp. dividends would be paid to this profit sharing trust as a shareholder.

[dmb]

Thanks again.

Any support info for either argument would be greatly appreciated.

[jpod]

Any 401(a) plan can be a shareholder of an S corp. However, if the plan is something other than an ESOP, the plan must pay UBTI tax on its share of the S corp's income, whether or not the S corp pays dividends.

[Mary Kay Foss]

Section 1361©(6) says that "certain exempt organizations permitted as shareholders" -- the law change came in 1996 P.L. 104-188. I'd check for any regs (proposed or otherwise) and the committee reports before I'd draw a definite conclusion.

Good luck.

[jpod]

"Certain Exempt Organizations Permitted as Shareholders" is merely the title of Section 1361©(6). The pertinent text of Section 1361©(6) says: ". . . an organization which is . . . described in Section 401(a) . . . may be a shareholder in an S corporation."

[mbozek]

IRA cannot invest in S-Corp Stock. Rev. Rul 93-73.

[Guest sabecker]

I now agree that 401(a)'s can own S corp stock. I confess that this was news to me. IRA's have never been the same as 401(a)'s though. Although with all of the changes in EGTRRA allowing IRA rollovers to 401(a) plans, it's possible that this rule might change in the near future, too.

[BeckyMiller]

Getting back to the original question - realize that most S corporations pay dividends to allow its shareholders to pay tax on their share of the income. An ESOP is exempt from this tax (See IRC Section 512(e)(3). But, other 401(a) plans are subject to tax. You need to ask for the plan's copy of Schedule K-1, Form 1120-S. If the pass-through income is $1,000 or more, the plan must file Form 990-T and pay tax. If the income is high enough, the plan must also make estimated tax payments.

The NASTY, NASTY thing about this provision is that the unrelated business income tax rules apply to both the pass-through income AND any gain on the sale of the stock.

The instructions to Form 990-T are very helpful to guide you through this process.

[mbozek]

B: I thought that passive income such as dividends are exempt from UBIT tax. UBIT would apply if only leveraged funds are used to generate the dividends.

[BeckyMiller]

Nope, this was part of the change in the law when they allowed S corporations to have 401(a) plan shareholders. If you think about it, it makes sense. The S corporations carries on a business. That business is subject to a single layer of tax at the shareholder level. Thus, this isn't passive income. This is active income.

(They aren't taxed on the S distributions/dividends. They are taxed on their proportionate share of the corporate earnings.)

If your comment is with regards to the gain on sale of the stock, I agree that taxation of that gain is totally inconsistent with the general rules. That would be passive income and it is really weird that it is taxed. But, it is specifically included as taxable by the language of the law. In fact, the Blue Book commentary also states that if the plan distributes this stock to a participant as a normal distribution, the gain is also taxable at that point in time. I think that is going over the top, and I would tend to disagree. It is not is the actual legislative history, just the Blue Book. But, we know that the IRS gives the Blue Book tremendous deference.

[Kirk Maldonado]

BeckyMiller:

Having worked at the IRS, I can verify that the IRS has input on the content of the Blue Book.