S Corp ESOP w/ Non-Voting Stock

[Alf]

Assuming no 409(p) problems with the S Corporation ESOP, it literally looks like an S Corp ESOP with only non-voting shares would be subject to UBIT on all of its earnings because the shares are not QES under 409(l) because it can't meet the exception in 512(e)(3).

Is it really that clear? Anyway else to interpret the 512 exception?

If that is true, you could never really use nonvoting stock in an S Corp ESOP, correct?

[RLL]

Hi Alf ---

It is very clear.

Your interpretation of IRC section 512(e)(3) is correct. Only the voting common stock held by an S corp ESOP is exempt from taxation. In addition, an "ESOP" with only non-voting stock does not constitute an "employee stock ownership plan" under section 512(e)(3).

It is possible for an S corp ESOP to own some non-voting common stock, so long as the ESOP is invested "primarily" in voting common stock. However, such an ESOP would be subject to taxation with respect to the non-voting stock's share of the S corp taxable income.

[Kirk Maldonado]

Alf:

I assume that the ESOP did not purchase the stock in a leveraged transaction, right?

[Alf]

Yes. We know that leveraging is out b/c the stock does not meet 409(l). The UBIT problem was apparently not that obvious though, so I wanted to see if we were missing some way around it.

It sounds to me like there is no way economically (b/c of UBIT) that a non-leveraged S corp ESOP shoud be designed to be primarily invested in non-voting stock, correct?

[BeckyMiller]

It depends on the economics. If your economics only work with the exclusion from income tax, then there is an issue. But, if the stock is a good investment to a taxable shareholder, it could still be a good investment to the ESOP. BUT, you have to manage the ESOP to both aspects of the UBIT tax - on the pass-through income and on any disposition of the stock. Such ESOPs really need to be designed to make sure that the stock stays in the ESOP and is not distributed to participants.

RLL - if the ESOP acquired the non-voting shares before 1978, aren't they still qualifying employer securities for purposes of the plan's status as an ESOP? Not for purposes of the UBIT exclusion or other tax incentives. I am thinking this is true just for IRC Section 4975.

[Alf]

BeckyMiller - If we go ahead with it, the securities will not have been acquired before '78. We assume it is still a 4975 ESOP, just not a 409 ESOP eligible for leveraging and UBIT exemption. I read RLL's statement to be referring to 409 and not 4975. Is this consistent?

[RLL]

Alf ---

Under IRC section 4975(e)(7), an ESOP must be designed to invest primarily in employer stock which meets the requirements of section 409(l). Non-voting common stock (which is not publicly traded) does not satisfy such requirements. Section 512(e)(3) includes the same requirements for purposes of the exemption from taxation for employer stock in an S corp ESOP.

If the S corp "ESOP" to which you are referring holds only non-voting common stock acquired after 1979, it would not be an ESOP under section 4975(e)(7). It still could be a non-ESOP stock bonus plan qualified under section 401(a) and could be a shareholder (subject to UBIT) in an S corporation under section 1361©(6).

Becky ---

Good question!

I now recall that the change in the definition of "qualifying employer securities" for an ESOP under section 4975(e)(7), to require compliance with section 409(l), applied to stock acquired after 1979. But that was a long time ago, and retired minds are sometimes a bit cloudy on such technical issues (some day you may know what I mean).

So, non-voting common stock acquired by an ESOP before 1978 (or before 1980) would still be "qualifying employer securities" for purposes of ESOP status under section 4975(e)(7). You are also correct that section 512(e)(3) specifies that only section 409(l) stock qualifies for the UBIT exclusion (the 1978 Act "grandfather" provision is not available to an ESOP for this purpose).