S Corp ESOP

[Lori H]

I have read an ESOP is not favorable to an S Corp company. Was this the case years ago or does it still apply? The article did not elaborate.

[stephen]

For some companies S-Corp ESOPs are awesome! Think about this, if the company is 100% owned by an ESOP and the company is an S-Corporation the corporation pays taxes based on the tax status of it's shareholders. In this case an ESOP which is a tax free entity. pays no taxes. Taxes will be paid as shares are distributed to participants.

Also keep in mind the S Corporation ESOP “Anti-Abuse” Rules (IRC §409(p)). I have included a summary of these rules below.

1. EGTRRA imposes an income tax and/or an excise tax if the tax benefits of the S Corporation ESOP disproportionately benefits a group of shareholders that control the S Corporation either directly or indirectly.

2. Section 409(p) imposes an income tax on Disqualified Persons for the value of amounts allocated by the ESOP to such individuals if such allocations are made during a Non-allocation Year.

3. In addition, Section 4979A was amended to impose an excise tax on the S Corporation equal to 50% of a) the total prohibited allocations (includes current and prior year allocations) made to Disqualified Persons; and b) the total value of shares on which the Synthetic Equity owned by Disqualified Persons during the year is based.

4. These rules are generally effective for plan years beginning after December 31, 2004. However, for S Corporation ESOPs established after March 14, 2001 or for an ESOP established before such date by an employer who became an S Corporation after March 14, 2001 or for an ESOP that held no shares prior to March 14, 2001, these rules are effective immediately.

5. Definitions:

a. “Non-Allocation year” is defined as any plan year of an S Corporation ESOP in which disqualified persons own 50% or more of the number of shares of stock in the S Corporation, including Deemed-Owned shares.

b. Deemed-Owned shares include shares allocated to that person within the ESOP, as well as a pro-rata share of the unallocated shares held by the ESOP. Deemed-owned shares also include any synthetic equity held by the individual, but only if this treatment would result in his being a disqualified person or cause any year to be a Non-Allocation year.

c. A “disqualified person” is any individual who owns 1) at least 10% of the Deemed-Owned shares of the corporation or 2) at least 20% of the Deemed-Owned shares of the corporation, including shares owned by family members.

[Guest tmills]

409(p) is the big issue with S Corp ESOPs. If you can pass that, then they are great. If you can't, the penalties are too horrible to think about. If you have an S Corp with lots of employees (50+), 409(p) is normally not much of an issue. As the employee count shrinks, the greater the liklihood of having Disqualified Persons, etc., etc. Before you put an ESOP in an S Corp., run a 409(p) test. Don't forget to include any synthetic equity. If the results look good, then the 409(p) issue is gone and the other pros and cons can be evaluated.

Note Stephen says that the S Corporation pays taxes based on the tax status of its shareholders. That's not quite true. The S Corp. never pays taxes, earnings are passed through to shareholders who pay taxes on their share. An ESOP is a tax free entity, so the earnings it gets are not taxed. As Stephen says, taxes are paid when participants get shares or cash in lieu of shares.