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.
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.
* 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
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.
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.
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.
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\spch\tra97sum.doc