Do ESOP participants have pass-through voting rights if the sponsor switches from C to S corp?

[Guest Benefits Brewster]

IRC Section 409(e) requires limited pass through voting rights for stock held by a ESOP that is not registration-type. For such stock, there need be a pass through of voting rights to the ESOP participants only if there is a "corporate matter" which includes (among other things) a "reclassification".

Does anyone have a reasonable opinion about whether a conversion from a C corp to an S corp constitutes a "reclassification" for this purpose? In other words, do the participants of an ESOP have pass-through voting rights if the sponsoring company is contemplating a switch from C to S corp?

[RLL]

Hi Benefits Brewster ---

The election to be an S corporation is not a "reclassification," as it does not involve any change in the rights, preferences and privileges of shares of stock under corporate law.

In addition, the election of S corporation status is not a "corporate matter which involves the voting of such shares" within the meaning of IRC section 409(e)(3). The "consent" of shareholders (to the S corporation election) under IRC section 1362(a)(2) does not constitute "voting" of shares under corporate law.

[Guest Benefits Brewster]

Hello RLL,

I like your analysis. Do you know of any instances in which the IRS (or anyone else) has made that distinction between voting and consent? Any authority?

Also, any authority for defining a "reclassification" as something that involes a change in the rights, preferences and privileges of shares of stock under corporate law?

I'd appreciate any feedback that you (or anyone else) could provide.

[KJohnson]

I had an associate look at this for me at one time and this is what he found:

1. Sec. 1362 requires the consent of all persons who are shareholders on the day the S election is made. The IRS regulation applying this rule in various contexts such as joint ownership of stock, ownership by trusts, etc. has not been updated since SBJPA, and thus has no provision for how organizations described in Sec. 401(a) must consent. I could not find any IRS guidance on this. However, Sec. 1361©(6) is very clear that the organization is the shareholder. The current regulations applicable to ownership of S corp. stock by trusts require consent only by the person treated as the shareholder for purposes of counting to 75 – that is the trust itself except for voting trusts and electing small business trusts (ESBTs). See Reg. 1.1362-6(b)(2). Reading these together, the logical conclusion is that the ESOP itself is the shareholder who is required to consent. The alternative rule would imply that you also had to count the participants in counting to 75, which was surely not intended.

2. On Sec. 409, I have not found anything more convincing than the arguments made by the participants in the message board discussion and others that I have thought up, but I think these are very convincing. The consent is not “a corporate matter which involves the voting of the shares.” Furthermore, an S election is not a “reclassification” – nowhere else in the Code is S corp. status considered a matter of “classification”; rather it is an election which is terminable at will and is purely an issue of tax law. “Reclassification” in 409(e)(3) appears to refer to changes in the nature of the stock, as when the corporation has several classes of stock with different rights. All of the other matters listed in 409(e)(3), such as merger, recapitalization, liquidation, etc., refer to similar changes that affect the state corporate law substance of the underlying investment, which an S election does not. Finally, the whole basis for requiring unanimous consent for an S election is because the shareholders are being taxed directly on the corporate income even though they have not necessarily received any of it, and of course ESOP participants are not taxed on the corporate income until they receive it upon distribution.

It seems a little strange that there is not specific guidance on these points, especially #1, but it may simply be that nobody thinks it’s a problem. In light of the above, let me know if you want me to try to find more. Thanks.

[KJohnson]

BTW here is the link to the prior message board discussion:

http://www.benefitslink.com/boards/index.p...t=0entry19175

[Guest Benefits Brewster]

K Johnson, Thanks for your thoughts.

[Guest eafredel]

One reason that the "pass-through" voting rights standard is a little vague is that each state has its own laws. I am not aware of any state that requires a shareholder vote for conversion to an S corporation.

[Guest eafredel]

One other point: under the Internal Revenue Code, an S corporation may only have one class of stock. If the company currently has two or more classes of stock, one step in the process of conversion of the corporation from a C corporation to an S corporation would be a change from two or more classes of stock to one class of stock. In some states, this is referred to as a reclassification, although it often is referred to as a recapitalization. Most state corporate laws require shareholder approval in this situation. As a result, a reclassification or recapitalization may be a necessary step in the conversion of a C corporation to an S corporation. As others have noted, the actual conversion from a C corporation to an S corporation requires shareholder consent (but not a shareholder vote).