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S Corporation ESOPs

S corporations are those that elect to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. They are limited to 100 shareholders and a single class of stock, and instead of paying a tax on their profits, their profits and losses are passed through to their shareholders based on their proportional ownership percentages. However, to the degree an ESOP owns the company, there is no federal tax due because the ESOP trust is tax-exempt, and most states follow this rule too. This removes the need to fund shareholders' tax bills with corporate distributions and thus allows the company to retain much more of its earnings, providing a huge tax advantage that has made the S corporation ESOP structure very popular ever since it was first allowed in the late 1990s.

For example, if an ESOP owns 50% of an S corporation, no tax is due on that 50% of the company's income; if the ESOP owns 100%, there is no tax at all (at the federal and, usually, the state level as well). However, a few of the tax incentives that are available in a C corporation ESOP are not available in an S corporation ESOP:

  • The Section 1042 tax-deferred "rollover" for the selling shareholder is not available. (But an owner can sell to a C corporation ESOP and elect Section 1042, and after that the company can elect S status.)
  • S corporation distributions paid on ESOP shares are not deductible because they are not dividends for tax purposes.
  • In calculating the 25% of eligible payroll limit for deductible contributions, S corporations must include interest paid on an ESOP loan.
  • When forfeited accounts of participants who left before vesting are reallocated among the remaining participants, they always count against the "annual addition" yearly limits for each person in S corporations, unlike in C corporations.

Aside from tax incentives, there are various other issues to consider. For example, if there is both an ESOP and one or more non-ESOP shareholders, and the company pays a distribution to enable the non-ESOP shareholder(s) to pay taxes, the ESOP must receive a pro-rata distribution. This can mean that existing employees receive a disproportionate benefit compared to new employees who arrive later, or that the company is providing more in benefits than it meant to. Another example: If a C corporation is going to elect S status to take advantage of the S corporation ESOP tax shield, there are various issues to consider, such as paying built-in gains taxes on assets held at the date of conversation and sold within 10 years.

S Corporation ESOP Anti-Abuse Rules

Originally, a tax-exempt trust like an ESOP could not be an S corporation owner. When S corporation ESOPs were first allowed in the late 1990s, the tax benefits they offered led to corporate tax-avoidance schemes (e.g., setting up a ESOP-owned S corporation with one or two employees to siphon off most of the income from the real company, whose employees would not be in the ESOP), which in turn led to anti-abuse legislation and regulations. As a result, S corporations with ESOPs must ensure that they do not run afoul of the anti-abuse rules. It is very complex but boils down to this: if "disqualified persons" own 50% or more of the company's shares (including shares held directly; shares whose ownership is attributed to them; and "deemed-owned shares," meaning synthetic equity such as stock options, plus company shares that are allocated, or will be allocated, to their ESOP account), there is a "nonallocation year," the anti-abuse rules have been violated, and tax penalties will be imposed.

These and other issues are discussed in S Corporation ESOPs, 4th Ed. Also see our issue brief S Corporation ESOP Traps for the Unwary. Our research on economic impact is presented in S Corporation ESOPs and Retirement Security. And if you're an NCEO member, watch our live and replay webinars on S corporation ESOPs and related topics. If you're not a member, consider joining.

S corporation ESOPs are also discussed in general ESOP overviews like Understanding ESOPs and in specialized books like The ESOP Repurchase Obligation Handbook.