DEBORAH GROBAN OLSON
ATTORNEY AT LAW
1021 Nottingham Road
Grosse Pointe Park, Michigan 48230
Telephone (313) 331 7821
Fax (313) 331 2567
Email dgo@esoplaw.com
A Sub-Chapter S company sponsoring an ESOP may distribute a participant's account in cash, not stock. Thus, a Sub-S company need not be concerned that it may be dissolved upon distribution to ESOP participants.
A Sub-Chapter S company sponsoring an ESOP has exemptions from ERISA and IRS prohibited transaction rules similar to those for a C corporation sponsoring an ESOP.
Taxable income of a Sub-Chapter S company sponsoring an ESOP, pro rated to the ESOP's share of ownership will not be subject to federal income tax, except when distributed to participants of the ESOP. Unrelated business income tax (UBIT) shall not be applied to the ESOP. This UBIT exemption applies only to ESOPs and not to profit sharing, stock bonus or 401(k) plans. Thus, ESOP participants have a tax benefit arguably better than other Sub S shareholders due to the deferral aspect of qualified plans. While the individual S shareholder owes taxes annually on the S company's earnings, the ESOP participant owes no taxes on the earnings of his S company stock until he receives his ultimate taxable distribution from the ESOP.
* The contents of this memorandum constitute only summaries of law. They should not be relied upon as conclusive legal advice, which can be secured only through consultation with a qualified attorney reviewing a concrete factual situation. This is especially true because in addition to being mere summaries, various of the provisions noted herein take effect on different dates. @ 1997 Attorney Deborah Groban Olson
Under very special circumstances, which may only apply to one company, an ESOP may act as a charitable remainder trust for an estate, provided the plan was in existence August 1, 1996, the decedent and members of the decedent's family own not more than n 10% of the value of the company, and the ESOP owns at least 6O% of the stock after the transfer, the employees have full voting rights and there is an independent trustee.
A C corporation which uses a leveraged ESOP to pay off principal on a stock purchase loan may take a deduction for as much as 25% of covered employee compensation for contributions to the ESOP used for principal repayment. An unlimited deduction is allowed for contributions used to repay interest on a stock purchase loan. (If a stock purchase loan is not involved, the allowed deduction for contributions for an ESOP is equal to 15% of covered employee compensation.)
A "rollover" provision under which a seller of stock to an ESOP of a C corporation or an Eligible Worker Owned Cooperative (EWOC) can delay taxation on the proceeds of the sale, by reinvesting the proceeds in stock of a U.S. company provided the ESOP or EWOC owns at least 30% of the Company's stock after the transactions.
A deduction for dividends paid on ESOP stock, if the dividends are paid in cash (which the IRS has interpreted to include in addition to direct payment, payment to an agent or trustee for the participant's benefit) to ESOP participants or used to pay off ESOP debt.
Sub-Chapter S corporations can create ESOPs and Stock Bonus Plans -Before the Small Business Job Protection Act (SBJPA) of 1996, a tax-exempt organization, such as an ESOP trust, could not be a Sub S shareholder and a trust could not hold Sub S stock. An S corporation can now have an ESOP. The S corporation ESOP will count as one shareholder for purposes of determining the number of shareholders in an S corporation. (Holders of the majority of shares may elect to end the Sub S status.) The effective date of this provision is taxable years beginning after December 31, 1997. A Sub S corporation, which used to be limited to no more than 35 shareholders, can now have up to 75 shareholders and may have Sub S or Sub C subsidiaries.
Sub-S ESOP benefits are more limited than those for Sub-C Corporations -Although ESOPs will soon be allowed in S corporations, many of the tax benefits ordinarily available to ESOPs will not be available to S corporation ESOPs. S corporation shareholders in company's with ESOPs will not be eligible for the tax free rollover under IRC §1042 on sales of their stock to an ESOP. The S corporation ESOP cannot deduct dividends paid to employees, and will have to count interest on a loan when calculating the contribution amount for annual limitations on contributions. The contribution limit for an S corporation ESOP is 15% of covered employee compensation, and in combination with another defined contribution plan cannot exceed 25% of covered compensation. However, under TRA 97, unlike other types of qualified plans now permitted in S companies as of SBJPA of 1996, , only the ESOP is exempt from payment of unrelated business income tax (UBIT), while profit sharing plans, stock bonus plans and 401(k) plans must pay UBIT.
Small Business 401(k) Plans are Available Making 401(k) ESOPs and Stock Bonus Plans Viable Structures for Sub-S Companies - A 401(k) ESOP in a Sub S company provides several benefits for owners who would like eventually to sell their stock through a "rollover ESOP", but plan to work in the business for a number of years before retiring, and desire the current benefits of Sub S status. These benefits include: a) reduce current cash outlay for employee benefits; b) preserve Sub S status for the period it is useful to the company; c) seed a future rollover ESOP so that the 30% ownership threshold is easier to meet when the time comes; d) begin creating an ownership perspective amongst employees; and e) availability of all Sub C corporation ESOP benefits upon election of Sub C status. The new non-discrimination safe harbor rules (effective for years after 1998) for 401(k) plans allow employers to avoid expensive testing by giving a notice and making non-elective contributions for all non-highly compensated employees. This, combined with the provisions allowing Sub-S corporations to have ESOPs, may cause many to consider creating Sub-S 401(k) ESOPs. Under securities law, when an employee has an opportunity to purchase company stock through a profit sharing or 401(k) plan, s/he is considered to be purchasing securities. If the company is not publicly traded, then the securities must be registered if they are to be sold to employees. However, if the company is contributing stock on a non-elective basis, where no employee decision is being made, there is no employee securities purchase. Thus, if a Sub S company has a combined 401(k) ESOP plan, and gives employees the traditional choices (excluding company stock) for investment of employee deferred or contributed funds, but makes the employer match in company stock (based on a proper independent valuation and following ERISA fiduciary standards) no securities registration should be required. The new Sub S 401(k) ESOP will have the Sub S tax advantages available to the individual stockholders (including the deductibility of company losses off personal income tax and the ability to pay out dividends to non-working shareholders), while providing an employee benefit which puts less drain on immediate cash flow, and gives employees an ownership stake. Although the Sub S company will not receive the ESOP tax benefits a C corporation would receive, if and when the S corporation later elects to becomes a C corporation, as many do, it will be eligible for the C corporation ESOP benefits.
Similarly, stock bonus plans may also be attractive to Sub-S companies.
Except for ESOP/401(k) Combination Plans - 401(k) Plans Limit the Ability of an Employer to Require Employees to Invest their Contributions in Company Stock - If the employee deferral part of a 401(k) plan is 10% or more invested in company stock, the company cannot require that its employees' contributions be invested in company stock. ESOP/401(k) plans are specifically excluded from this TRA 97 rule and may require employees to invest their deferrals in company stock. However, few companies make such a requirement and most advisors find it is not a wise policy.
.
Dividend Deduction - A deduction is allowed for cash dividends paid on ESOP stock in C corporations and those used to repay a loan incurred to purchase that stock. Such dividends are not treated as prohibited involuntary cash outs.
Dividends on ESOP stock are deductible to the Corporation in addition to the other ESOP deduction limits provided the dividends are:
1) paid in cash to the participants or beneficiaries;
2) paid to the plan and distributed in cash to plan participants or beneficiaries within 90 days after the end of the Plan Year in which contributed, or
3) used to make payments on loans the proceeds of which were used to buy the employers' stock (whether or not allocated to participants).
Any dividend used to pay off an ESOP debt, which is attri-butable to stock allocated to a participants' account shall not be eligible for an employer tax deduction unless the Plan provides that the parti-cipant shall have allocated to his account stock with a fair market value not less than the dividend he would otherwise have had allocated to his account.
The Treasury Secretary may, however, disallow dividend de-ductions deemed to constitute tax avoidance. Thus, in addition to the 25% of covered compensation which was previously allowed as deductible annually by an employer for repayment of loan principal used to pur-chase employer securities for an ESOP, dividends (within reason) used to pay such principal payments are also deductible, as are all ESOP con-tributions used to pay interest on such securities acquisitions loans.
Maximum Annual Limit for Contribution to Accounts - Was lowered from $60,000 to $30,000 for years beginning after July 12, 1989.
Tax-Free Rollover Rules for C Corporations and Cooperatives - TRA 86 and RRA 89 clarified and changed the tax-free rollover provisions regarding ESOPs and Eligible Worker Owned Cooperatives (EWOCs) in a number of ways. The 1996 SBJPA limits these ESOP benefits to C Corporation ESOPs.
What the Tax Free Rollover Is - The rollover allows a taxpayer (other than a "C" corporation) or estate executor to postpone tax payment on capital gains from the sale of stock in a closely-held domestic corporation (which seller did not receive from the distribu-tion of a pension, profit-sharing or stock bonus plan) by selling the stock to an eligible ESOP or EWOC, provided: (1) the ESOP or EWOC files a written statement agreeing to an excise tax on any prohibited alloca-tions; (2) the seller uses the proceeds to purchase within the qualify-ing period (of no more than 3 months before or 12 months after the sale) "qualified replacement property;" and (3) the seller files the necessary forms with the IRS designating the specific "qualified replacement property".
Declaration of Rollover Election and Replacement Property - The taxpayer seeking rollover treatment must file with the IRS forms for the required declarations including: (1) for the taxpayer to elect the rollover by the time he must file his taxes; and (2) the "statement of purchase" describing the qualified replacement property which must take place within 90 days after the later of the sale of the securities to the ESOP or EWOC or the purchase of the qualified replacement property.
Qualified Replacement Property Rules - Qualified replacement property generally means securities of a domestic operating corpora-tion, with not more than 25% passive income. It cannot include stock of the same company whose stock is being sold to the ESOP or EWOC, a mem-ber of its controlled group, or a municipal bond. When the qualified re-placement property is subsequently sold, the gain is realized and becomes taxable with the basis being the basis the seller had in the stock originally sold to the ESOP or EWOC, unless the basis is altered by some other provision of the Code, such as the stepped up basis caused by death.
30% Ownership Test - For the seller to obtain tax deferral for sales after May 6, 1986, the plan must hold after the sale at least 30% of each class of outstanding stock (by number) or 30% of the total value of all outstanding stock of the corporation.
Exemptions from Recapture of Gain - TRA 86 clarified that there will not be a recapture of the deferred gain from disposition of replacement property caused by (1) death; (2) gift; (3) certain ex-changes required in the event of a reorganization provided the corpora-tion involved in the reorganization is not controlled by the taxpayer holding qualified replacement property; and (4) subsequent rollover transactions by the electing taxpayer. General Rollover Allocation Rules - An ESOP or EWOC receiving securities in a rollover transaction must not allocate stock re-ceived from the seller to the seller, family members and 25% shareholders. Rollover Allocation Rules Defining 25% Ownership - For purposes of determining whether a person owns more than 25% of the value of employer securities, all allocated employer securities held by an ESOP are treated as outstanding securities owned by the participant to whom the securities are allocated. Individuals are treated as 25% shareholders if they are 25% sharehold-ers (1) at any time during the one-year period ending on the date of the sale of rollover securi-ties to the ESOP (and they continue to be treated as 25% shareholders until such securities are allocated) or (2) on the date on which the rollover securities are allocated. Holding Period - RRA 89 requires that the selling taxpayer must have owned the stock for three years prior to its sale to the ESOP in order to qualify for the capital gains deferral. The ESOP must hold the stock for three years thereafter or be subject to an excise tax on proceeds of the sale of such stock. Rollover Allocations Family Member Exception - Family members of a seller are now eligible for rollover allocations if they are lineal des-cendants of a seller and would not, absent the family rela-tionship, be ineligible for such allocations, provided the total amount allocated to all such lineal descendants of all sellers is no more than 5 percent of rollover securities attributable to such sellers. Rollover Allocations Time Limit - TRA 86 provides that these allocation rules apply for 10 years beginning after the later of (1) the sale or (2) the allocation attributable to the final payment of acquisition debt. Rollover Allocation Rules-Sanctions - If the allocation rules are violated, the plan is disqualified in regard to the affected par-ticipants, the prohibited allocations to their accounts become treated as income, and a tax in the amount of 50% of the offending allocation shall be assessed against the ESOP company or the EWOC. Diversification of Investments - ESOP participants who reach age 55 and complete 10 years of service may diversify up to 25% of their account balances. Participants who reach age 60 may diversify 50%. The ESOP must offer three different diversification options or a partial distri-bution of the account balance. This rule is applicable to distributions attributable to securities acquired by the ESOP after December 31, 1986. If, under this rule, stock is distributed in satisfaction of the diver-sification requirement, the put option rules apply. Amounts which are distributed in satisfaction of the diversification requirement may be rolled over to an IRA or to another qualified plan. Although the direct cash flow impact of diversification may not be felt for 10 years, it greatly increases the need for doing careful repurchase liability analysis in the planning stages of ESOP development. Participant Voting Rights Defined - ESOP plan participants vote non-readily tradable stock allocated to their accounts on "major issues" as defined by federal law including: "merger or consolidation, re-cap-italization, reclassification, liquidation, dissolution, or sale of substantially all assets of the trade or business or such similar transactions as the Secretary may prescribe by regulations". Formerly, voting pass-through was required on non-readily tradable stock only for supermajority issues, as defined by state law. For publicly traded stock, voting pass through to plan participants is required on all voting stock allocated to the parti-cipant's account. One vote per participant or per share is now specifically provided for in the law. Distribution Must Begin Within Five Years of Employment Termination - For ESOP distributions attributable to employer securities acquired by the ESOP after December 31, 1986, unless the par-ticipant otherwise elects, his distribution must begin in the year fol-lowing the plan year in which he retires, dies or is totally disabled. Participants whose employment ends before retirement must begin receiv-ing distributions of their account balances 5 years after termination of employment. (Formerly, distributions were not re-quired until a par-ticipant died, became disabled, or retired). If stock held in a partic-ipant's account is purchased with the proceeds of a loan, however, commencement of dis-tribution of that stock may be delayed until one year after the loan is fully repaid. Also, distributions, in most cases, must be completed within five years of the time they begin to be paid. For participants whose benefits exceed $500,000 in value, the distribution period may be extended (up to an additional five years) by one year for each $100,000 (or fraction thereof) by which the value of his benefits ex-ceeds $500,000. Subject to these requirements, an ESOP may deter-mine the timing and form of distributions in a non-discriminatory manner without violating the rules on amendments to accrued benefits. ESOPs Exempt From Early Withdrawal Tax - A 10% additional income tax is levied on pension plan distributions received before a partici-pant reaches age 59 1/2 unless he is disabled or over 55 upon separation from service. Cash dividends on employer stock passed through to ESOP participants are exempt from this tax. Put Option Requirements - TRA 86 clarified the ESOP put option re-quirement which enables participants to sell their ESOP stock back to the employer if there is no public market for it. For distributions attributable to stock ac-quired after 1986, if a total distribution is put to the employer, the option price may be paid in substantially equal payments over a period not exceeding 5 years and beginning not more than 30 days after the put option is exercised. Where payment of the option price is paid in in-stallments, the employer must provide adequate security and must credit a reasonable rate of interest on the outstanding balance. In the case of a put option exercised as part of an installment distribution, the employer is required to pay the option price within 30 days after the exercise of the option. Independent Appraisal Required - The value of ESOP stock must be determined by an independent appraiser.
Involuntary Cash Out Limit Increased - When an employee's participation in a plan terminates, if the account balance does not exceed $5,000, the plan may pay out the account balance to the participant without his or his spouse's consent. Previously such payments were limited to accounts no greater than $3,500.
Fewer Required Filings with Department of Labor - Summary Plan Descriptions (SPDs) and Summaries of Material Modification (SMM's) need no longer be filed with the Department of Labor effective as of August 5, 1997. However, the Department may require an employer to furnish it such documents upon request.
Repeal of Excess Distribution Tax - For the 15% excise tax applicable to certain large benefit distributions from retirement plans, which was suspended for the three-year period 1997-99, has now been repealed entirely for distributions received after 1996.
Rollover Rules Protect Receiving Plans - A qualified retirement plan will not risk disqualification under the Code if it accepts a rollover contribution from another qualified retirement plan merely because the other plan has not received a favorable determination letter from the IRS.
Increase in Excise Tax on Prohibited Transactions - The excise tax on prohibited transactions increased from 10% to 15% per year for transactions occurring after 8/5/97.
End of Tax Deduction for COLI premiums may affect repurchase liability planning - Employer tax deductions are disallowed under TRA 97 for certain life insurance contracts, issued after 6/8/97, where the employer is directly or indirectly the beneficiary of the policy. These new restrictions will reduce the attractiveness of broad based leveraged corporate owned life insurance (COLI) to fund ESOP repurchase liability. However, other forms of COLI are still viable for repurchase liability planning.
New Definition for Highly Compensated Employees -A highly compensated employee is now defined as one who (1) was a 5% owner of the employer during the year or the preceding year or (2) had compensation for the preceding year of more than $80,000 (indexed for inflation) and, if the employer so elects, was in the top 20% of the most highly paid employees, effective for years beginning after 1996.
Required Distributions - For years beginning after December 31, 1996, employees who continue to work after age 70 1/2 are not required to begin receiving benefit distributions until after actual retirement (unless the employee is a 5% owner).
Family Aggregation Rule Repealed -The family aggregation rule that treats an employee who is a family member of a highly compensated employee and the highly compensated employee as a single employee for the purposes of non-discrimination testing has been repealed for years beginning after 1996.
Expanded Definition of Compensation for §415 - The definition of compensation for purposes of the §415(c) limits on contributions and benefits for defined contribution plans has been expanded to include certain deferrals, such as employee contributions to 401(k) plans, elective contributions to §457 non-qualified deferred compensation plans, and salary reduction contributions to cafeteria plans, for years beginning after 1997.
Repeal of Combined Plan Limit after 1999 - Defined contribution plans, such as ESOPs, need not count defined benefit plan contributions when determining if they have exceeded § 415 limits; for limitation years beginning after 1999. Five Year Averaging of Lump Sum Repealed after 1999 - Ten Year Forward Averaging Reduced to Five Years - Five year forward averaging for taxable years beginning after December 31, 1986, with a phase out of capital gains treatment over 6 years, will be repealed for lump-sum distributions for tax years beginning after 1999.
Sample Language - The IRS is required to develop sample language for spousal consent forms and for QDRO's by January 1, 1997.
Amendments Deadline - Any plan amendments required by the provisions of the 1996 Small Business Job Protection Act need not be adopted until the first plan year beginning after December 31, 1997, so long as the amendment applies retroactively.
Compensation Ceiling - No compensation in excess of $150,000 is considered in determining deductible contributions to plans.
Vesting Schedule Required - All benefit plans, including ESOPs, must vest at least as quickly as one of two alternative schedules: a) 100% vesting at the end of five years, or b) beginning at three years of service, 20% vesting each year until participants are 100% vested (at the end of seven years). These vesting rules are applicable for plan years beginning after December 31, 1988, or later for some collectively bargained plans. Capital Gains Treatment of Some Lump-Sum Distributions - Although TRA 86 eliminated special treatment for capital gains income generally, two exceptions exist for some participants who receive lump sum distributions. Taxpayers over age 50 on January 1, 1986, retain the right to apply pre-TRA 86 capital gains provisions to their lump sum distributions and may do so even before reaching age 59 1/2. Additionally, any lump sum distribution received after December 31, 1986, and before January 1, 1992, is covered by a phase out of capital gain treatment. Net Unrealized Appreciation - "Net unrealized appreciation" in value of employer stock in the plan may also receive the special lump sum treatment. Some exchanges of employer securities in the plan for other employer securities by the plan trustee, if replaced within 90 days, will not change the net unrealized appreciation.
Minimum Coverage and Participation Rules - All pension plans must meet one of these coverage tests: (1) (the "percentage test") 70% of all non-highly compensated employees must be covered; or (2) (the "ratio test") the percentage of non-highly compen-sated employees covered must be at least 70% of the percentage of high-ly compensated employees covered; or (3) the "average benefits test" based on the pre-1989 "fair cross section" test must be met, and the benefits given to non-highly compen-sated employees must be at least 70% of the benefit given to highly compensated employees. This coverage rule became effective January 1, 1989. But, under all these rules the employer may exclude from the count of "all employees" those who do not meet minimum age and service requirements and those covered by collec-tive bargaining agreements where retirement benefits have been negotiated, non-resident aliens and certain airline employees.
The Minimum Participation 50-40 Rule Does Not Apply to ESOPs - The 50-40 rule (requiring participation by 50 employees or the greater of 40% or 2 employees) applies only to defined benefit plans, and thus does not apply to ESOPs effective for plan years beginning after December 31, 1996. Leased Employees - Under some circumstances leased employees must be counted for minimum participation and other purposes. Put Option for Stock Bonus Plans - The ESOP put option requirements apply to stock bonus plans. No Floor Offset Plans Allowed - Floor Offset Plans, which used an ESOP in combination with a defined benefit plan to provide some pension benefits security without being limited in the amount of employer stock they held, could not legally be created after December 17, 1987, as they then became one plan and subject to the defined benefit plan 10% limits on owning company stock. Earlier created plans were grandfathered.
Under UCA 92 a participant can avoid a 20% withholding tax by electing to roll over all or a portion of his ESOP distribution in a trustee to trustee transfer to an IRA or other qualified plan, provided the entire distribution is to be paid over a period of less than ten years. However, if the participant takes the distribution himself, and then decides to make the rollover in the allowed period, the 20% will be withheld and he must find his own cash to make up for that 20% if he wishes to make a total rollover.
Increased Unified Credit for "Family-Owned Business Interests" creates a new generation who benefit from IRC § 1042 - Heirs who receive family-owned business interest stock, but are not interested in running the business, can use the §1042 tax free rollover to liquidate their family owned business interest stock and defer the payment of capital gains tax on it.
c:\msofc\wwrd\speech\esop997.rev\092297; esop1289.htm; 121897