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The Twists And Turns Of S Corporation ESOPs
By Joseph Stenken
One reason the tax
code is so complicated is that when Congress enacts legislation to accomplish
a policy goal, it may take several more changes to arrive at a final
"product" that works to Congress’s liking. For example, it has
taken nearly five years, but it seems that Congress may have the rules in
place that it wants regarding S corporations and employee stock ownership
plans (ESOPs).
In 1996, as part of the Small Business Job Protection Act of 1996 (SBJPA
’96), Congress allowed certain tax-exempt entities, including ESOP trusts, to
own the stock of S corporations. Congress’s reasoning was that prior rules
that did not allow these tax-exempt entities to own S corporation stock
inhibited employee ownership of closely held businesses, as well as
frustrating estate planning, discouraging charitable giving, and restricting
the sources of capital for closely held businesses.
As part of these new rules, the income of the S corporation would flow
through to the tax-exempt shareholder, whether a pension plan or a charity,
as unrelated business taxable income. UBTI is taxed at the regular corporate
income tax rates, which range from 15% to 35%.
However, the UBTI provision made S corporation ESOPs unattractive, because
ESOP participants would now be subject to a double tax--first on the income
of the S corporation that passes through to the ESOP, and then again when S
corporation stock or cash is distributed to the ESOP participants. This
double taxation would defeat one of the purposes of an S corporation
election, which is to avoid the double taxation on corporate shareholders.
Before these provisions of SBJPA ’96 took effect, however, Congress enacted
new rules exempting S corporation ESOPs from these UBTI rules.
Now it seemed that Congress had what it wanted; but soon after these rules
came into effect in 1998, Congress became aware that some creative taxpayers
were engaging in "inappropriate deferral and tax avoidance in some
cases." This might occur, for example, in a very small S corporation
where the only employees, and thus the only participants in the ESOP, are
also the historic owners of the business.
Congress thought that S corporations should encourage employee ownership
through an ESOP, but that the tax-deferral opportunities of an S corporation
ESOP should be limited to those situations where there is broad-based
employee coverage under the ESOP, with the ESOP benefiting both rank-and-file
and highly compensated employees.
Because of these concerns, the tax legislation that was recently signed by
President Bush contains provisions to try to ensure that ESOPs of S
corporations benefit a wide range of employees.
The new rules provide penalties if an S corporation ESOP is not broadly
based. An S corporation can generally avoid these penalties if it does not
have any "disqualified persons." A disqualified person is generally
either a member of a family that together owns more than 20%, or an
individual who owns more than 10% of the S corporation. If disqualified
persons, together, own 50% or more of the company (special rules apply to
unallocated stock), these penalties may kick in.
One penalty provision is that amounts allocated to certain owners of the S
corporation will be treated as a distribution, so that the amount will be
included in income in the year of the allocation. Another penalty provision
is a 50% excise tax imposed on an S corporation for the amount it allocates
to an ESOP for disqualified persons.
One bright spot for those ESOPs of S corporations that may be too
concentrated to avoid the penalty provisions is the effective date for these
rules. For S corporation ESOPs established before March 14, 2001, these new
rules are not effective until after 2004. However, for ESOPs established
after March 14, 2001, or for a corporation that was not an S corporation on
March 14, 2001, the effective date is for tax years ending after March 14,
2001.
Joseph Stenken, JD, CLU, ChFC, is an assistant editor of Tax Facts, a
National Underwriter publication.
Reproduced from National Underwriter Life &
Health/Financial Services Edition, August 6, 2001. Copyright © 2001 by The
National Underwriter Company in the serial publication. All rights
reserved.Copyright in this article as an independent work may be held by the
author.
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