ESOP and S-Corporations

[Guest AllanB]

Has anyone worked with 100% ESOP owned S-corporations? I would like to get thoughts on uses and misuses.

[Guest Larry Goldberg]

Since January 1, 1998, many C corporations owned 100% by an ESOP have made the election to be taxed as an S corporation. An S corporation is a "pass-through" entity for income tax purposes. It generally does not pay income tax; the taxable income passes through to its shareholders. Since the ESOP is the only shareholder, and it is exempt from income tax, the S corporation and its shareholder may avoid income tax on the corporate earnings.

In addition, many C corporations in which an ESOP owned a majority interest (but less than 100%) have elected S corporation status. In fact, several of these companies arranged a buy out of all of their non-ESOP shareholders immediately prior to making the S election and therefore became 100% ESOP-owned. However, since the S corporation may need to pay cash dividends each year in order for its non-ESOP shareholders to pay their income taxes on the "flow- through" phantom income, the ESOP will also need to be paid its pro-rata share of these dividends. A significant planning issue arises as to how the ESOP can effectively use these cash dividends.

With respect to misuses of ESOPs, this Summer Congress considered repealing the exemption from UBIT which makes this tax benefit possible by repealing Section 512(e)(3) of the Internal Revenue Code. ESOP proponents offered remedial, anti-abuse legislation as an alternative to repeal of the exemption. Neither proposal made it into law in 1999. Expect more developments on this legislative front in 2000. Also, see The ESOP Association website (www.esopassocation.org) for additional information on the legislation, and on the ESOP/S Corporation Conference being held in Tampa, Fl on March 2, 2000.

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[Guest Rich Urda]

The Winter 2000 issue of the Journal of Pension Planning and Compliance contains a discussion of the advantages and disadvantages of an ESOP which owns S Corporation stock. See 25 J. Pens. Pl. & Comp. 1, 29-31.

[BeckyMiller]

We have several clients that are S corporations and 100 percent ESOP owned. What issues are you interested in discussing? There is a relatively new association formed specifically for employee owned S corporations. They might be of some help to you.

See Employee-Owned S Corporations of America at 1501 M Street Suite 700, Washington D.C. 20005. The number given is 1-800-228-9290.