S Corp Dividends / Loan / Debt Service

[Guest EMC]

Since S Corp dividends attributable to only unallocated ESOP shares can be used to pay off an ESOP loan, how does an ESOP sponsor avoid a situation where, due to level loan payments occurring over the years of the loan, the number of allocated shares in the ESOP get higher and higher as the debt is paid, leaving fewer and fewer unallocated shares? This reduction in unallocated shares also necessarily reduces the amount of any S Corp dividend distribution that can be used to repay the ESOP loan in the later years of the loan. This is especially problematic where the S Corp's 25%-of-payroll contribution may not be high enough, when combined with dividends allocated only to the shrinking number of unallocated shares, to support the debt service at the tail end of the loan. For an S Corp, owned 100% by an ESOP, with a stable and steady income stream, would it be possible to make minimal contributions (less than the 25%-of-payroll) to the ESOP for a number of years early on in the loan until such time as the company's steady and healthy income stream has allowed the S Corp to accumulate enough earnings (tax free) within the corporation to make one huge dividend distribution to the ESOP which would allow the entire loan to be paid off? Is this a risk with the possibility of some sort of UBTI tax looming out there?

[IRC401]

There is no prohibition that I am aware of against an S Corp making contributions to an ESOP. Indeed, I believe that there is a regulatory requirment that the employer make substantial and recurring contributions. I have never seen a contribution in the range of 25% of compensation described as minimal before.

PS: Is your client certain that it wants to be owned 100% by an ESOP? There are strong business reasons why that could be a big mistake.

[RLL]

IRC401.....are you aware that an S corporation that is 100% owned by its ESOP can be totally exempt from federal income tax (and most state income taxes) under current law? I wonder about the "strong business reasons" to which you refer. Having a business which is wholly owned by its employees (through an ESOP), and which is also tax-exempt, sounds like a great arrangement!

EMC....I don't see any big problems in making low employer contributions to the ESOP in the early years of loan repayment, while paying a relatively high level of S corp. dividends which are used for loan payments. The contributions may be increased in later years.

There may be a problem in paying an extraordinarily large S corp. dividend in one year to pay off the entire loan balance. An S corp. which is 100% owned by an ESOP faces the possibility of IRS recharacterizing a very large dividend as an employer contribution (under the IRC Sec. 415 regs). The UBIT issue is not the problem under current IRC Sec. 512(e)(3).

The key is to figure out how best to pay off the loan....using employer contributions and dividends. Consider corporate cash flow, desired level of annual ESOP stock allocations, the need for cash to satisfy benefit distribution obligations (repurchase obligation), etc. Note that the dividends on allocated shares may be accumulated in the ESOP for use in paying future benefit distributions in cash.

[This message has been edited by RLL (edited 12-13-1999).]

[Dawn Hafner]

I don't have any suggestions for how to solve this problem. I would watch for changes in this area though. Some ESOP attorneys believe the IRS is wrong on this PLR interpretation of the law and that it is the regs under 4975 not 404(k) that permits dividend/distribution use. But not many clients want to or have the funds to fight that battle. Meanwhile, the only other real solution is for Congress to take action to address this problem. My understanding of why the company that requested the PLR allowed it to be issued was in hopes of getting some legislative action on the issue. Given the current administration's opinion of S corp ESOPs though I wouldn't hold my breath.

[Guest EMC]

Great points.

The S Corp's "problem" is that by making contributions and dividend distributions to the plan in the early years of the loan, more and more shares get allocated. This means that less and less of any dividend distribution in later years will go toward the loan repayment (b/c only the div. attrib. to the UNallocated shares can go to pay-off the loan).

If the loan is paid off in "level" payments, the S Corp's payroll by itself does not support a contribution high enough for the debt service; therefore a good sized dividend distribution attributable to the UNallocated shares would be required for each year. What we are trying to avoid is a situation where so many shares get allocated inside the ESOP before the debt is paid off that the dividend distribution attributable to the UNallocated shares, when added to a maximum contribution, ceases to be enough for the level payment debt service.

Because the S Corp has real strong profits and is owned 100% by the ESOP, we thought a good strategy might be to let the S Corp accumulate the profits inside the corp tax-free for a few years (making minimal ESOP contributions along the way) and then pay off the loan all at once through a combination of contributions and a distribution of the accumulated profits (although I do understand the re-characteriztion point you made).

Any suggestions on navigating this scenario for small profitable S Corps whose payroll may not support contributions sufficient to service a level payment debt, and whose UNallocated shares may not permit enough dividends to be used for debt service toward the end of the loan? Thanks.

[This message has been edited by EMC (edited 12-14-1999).]

[BeckyMiller]

Planning, Planning, Planning...

Remember, the company can borrow the debt and make a second loan to the ESOP. These loans do not need to have the same terms. Thus, the loan to the ESOP should have as long a term as possible with rights of prepayment. That way, you should not be forced to pay off the debt faster than your cash flow and benefit considerations would warrant. I admit that it is not clear how long this loan can be. However, all the regulations say is that it has to be for a fixed term. I am aware of one ESOP whose loan is for 40 years.

I am not suggesting that you rewrite existing loans. I don't want to wander into that quagmire. I am merely suggesting that for new deals planners keep an eye on the plan as an employee benefit plan for the long term.

[IRC401]

If the ESOP owns 100% of the Company, how do you get a significant ownership percentage to the next generation of senior managers without major economic and fiduciary issues? Do you want the long term employees on the assembly line owning more shares than the officers?

If the ESOP owns 100% of the business, management should start its succession planning immediately.

[RLL]

An S corporation which is 100% ESOP owned can contribute or sell additional shares to the ESOP, assuming that there are authorized but unissued shares or treasury shares available. In addition, management can be provided with stock-based incentive programs which do not require the actual issuance of shares to them....such as phantom stock or stock appreciation rights. It is also possible to issue actual shares to management employees if a decision is made by the board of directors to dilute the ESOP's 100% interest (and if permitted under the corporate charter and bylaws).

A board of directors does not violate its fiduciary responsibility by providing for appropriate compensation arrangements (including stock-based incentives) to attract and retain key employees.....so long as the arrangements provide for reasonable compensation and appropriate corporate procedures are followed.

IRC401.....it sounds like you have some kind of "ESOP-phobia." Certainly not every business is a candidate for 100% ESOP ownership. Many businesses should not have any ESOP. But it absurd to take the position that 100% ESOP ownership is bad for any business. There are hundreds of very successful 100% ESOP-owned companies...and most have very satisfied management. You might want to do some homework on the real world of ESOPs.