ESOPs and S Corporations

By The AICPA Tax Divisions S Corporation Taxation Technical Resource Panel (TRP)

Authors note: The S Corporation Taxation TRP (Kenneth N. Orbach, Chair) thanks Stewart Karlinsky, Graduate Tax Director, San Jos State University, San Jos, CA, and TRP Member, for his work on this item.

Sen. Russell Long (D-LA), the long-time tax dean of the Senate Finance Committee, believed that if labor were allowed to share in the rewards of capital, productivity would increase, making the U.S. economy stronger. He thus promulgated the concept of employee stock ownership plans (ESOPs). Eventually, the idea made its way into the tax law, primarily benefiting C corporations and their owners, banks and (maybe) employees.

The original version of ESOPs was not available to S corporations; as discussed below, employee trusts were finally deemed qualified shareholders in 1996 legislation. Even if they had been qualified, the Secs. 511514 unrelated business income tax (UBIT) rules would have defeated a major goaldeferral.

The main tax benefits of ESOPs were threefold: (1) a bank could lend to an ESOP with a guarantee by the corporation and report only half the interest income (a provision since repealed); (2) the corporations founder could use Sec. 1042 to sell his or her interest to the ESOP for cash (usually borrowed from a bank), reinvest the proceeds in publicly traded stocks or securities, hold them until death and pay no income tax on the built-in gain; (3) under Sec. 404(k), the corporation could deduct dividends paid to the ESOP on its stock ownership. None of these provisions are currently available to S corporations.

Law Changes

In 1996, Congress believed that encouraging S corporation funding and ownership would be accomplished by allowing charitable organizations and pension trusts (except IRAs) to be eligible S corporation ESOP (SESOP) shareholders. This change, enacted by Section 1316 of the Small Business Job Protection Act of 1996, allowed an ESOP to be an S shareholder. In addition, the enactment of Sec. 512(e)(3) by Taxpayer Relief Act of 1997 Section 1523 exempted SESOPs from UBIT on S earnings.

IRAs and S stock: When a SESOP owns an S corporation, what happens when an employee retires and rolls over recently distributed S stock into an IRA? Normally, this would terminate S status, because an IRA is not an eligible S shareholder.¹ To correct this problem, Rev. Procs. 2004-14² and 2003-23³ held that a SESOP or S corporation could buy back the stock from the IRA, without loss of S status. Also, none of the income or loss would be allocated to the IRA.

Related taxpayers: Another issue is the potential application of Sec. 267(e) to postpone the deduction of compensation between an accrual-basis S corporation and its cash-basis employee/ deemed-owner. The IRS has informally stated that it will apply Sec. 267(e)(1)(B) to postpone the deduction until the employee includes the amount in income under Sec. 267(a)(2), rather than applying Sec. 404s 2-month rule to allow the deduction in the earlier year. 

Abuse

As often happens, taxpayers take advantage of a good thing and abuses seep into the system. In the last year or two, this has happened with SESOPs.

Mainly, an S corporations controlling owners would cause most (or all) of the corporations income to be allocated to the SESOP (essentially, tax free), while retaining control and ultimate enjoyment of the S corporations benefits and wealth. Several recent pronouncements highlight the increased use of SESOPs by some aggressive promoters.

Temp. Regs. Sec. 1.409(p)-1T(g)⁴ provided application of the rules and an example of an S corporation and its shareholders and SESOP dealing with a nonallocation year, including the effect of synthetic equity schemes, and discussed the new constructive ownership rules.⁵ Temp. Regs. Sec. 1.409(p)-1T is generally effective for all SESOPs beginning in 2005 (in some cases, earlier).⁶

The presence of disqualified persons owning (actually or constructively) 50% or more of the S stock could trigger, at the corporate level, a 50% excise tax under Sec. 4979A. Also, the portion of the income and plan assets allocated to the SESOP and accruing to a disqualified person in a nonallocation year is deemed distributed by the SESOP to the disqualified person (and, thus, is taxable to the recipient).

Definitions

A disqualified person is measured under Temp. Regs. Sec. 1.409(p)-1T(d)(1) by looking to deemed or allocated SESOP ownership (including a very broad family attribution rule in Temp. Regs. Sec. 1.409(p)-1T(d)(2)) and any synthetic equity he or she is deemed to own.

An integral element of the prohibited transaction rules involves synthetic equity. This term, explained more fully in Temp. Regs. Sec. 1.409(p)-1T(f), includes many of the instruments used in the context of a closely held company, such as phantom stock or stock appreciation rights (SARs) (whether receivable in cash or company stock), warrants and stock options, certain nonqualified deferred compensation and potentially, convertible debt. Unfortunately, the synthetic equity rules are a one-way street. If synthetic equity causes a person to be disqualified, it will be counted. If it results in a person not being disqualified, it will be ignored. The same is also true in determining a nonallocation year.

Family attribution rules: Under Temp. Regs. Sec. 1.409(p)-1T(d)(2), the Sec. 318(a)(1) family constructive ownership rules are expanded to include not only a spouse, ancestors and lineal descendants (and those of the spouse), but also brothers and sisters of the taxpayer or spouse and their lineal descendants. Thus, possibly for the first time in income tax history, in-law ownership (and that of in-laws lineal descendants) is attributable.

Under Temp. Regs. Sec. 1.409(p)-1T(d), a disqualified person must own a moderate concentration of SESOP shares (at least 10% without family attribution or at least 20% with), including synthetic equity; under Temp. Regs. Sec. 1.409(p)-1T(a), a nonallocation year is one in which disqualified persons, in the aggregate, control 50% or more of the stock (including ownership that is direct, deemed through a SESOP, expanded Sec. 318 constructive or synthetic equity (if it causes disqualification)). Besides the 50% excise tax mentioned above, a nonallocation year results in a disqualified shareholder recognizing income on his or her return as a deemed distribution from the SESOP.

Planning Problems

From a planning perspective, these rules make the deemed ownership of S stock through the synthetic equity rules less advantageous than owning it outright. Under Temp. Regs. Sec. 1.409(p)-1T(d), direct ownership counts only for the 50% (nonallocation year) test, while synthetic equity must be considered for both the disqualified person and the 50%  tests. Thus, if an S shareholder had 30% direct ownership, 5% ownership through a SESOP⁷ and no synthetic equity, he or she would not be a disqualified shareholder (less than 10% deemed ownership of the SESOP); thus, none of the stock ownership would count toward the 50% control requirement.

If, however, the shareholder owned 6% through the synthetic equity rules and 24% directly (instead of 30% directly), he or she would be a disqualified shareholder (5% deemed-owned SESOP shares + 6% synthetic equity ownership exceeds the 10% threshold in Temp. Regs. Sec. 1.409(p)-1T(d)(1) (ii)); all of his or her actual and deemed ownership, 35% (24% direct + 5% SESOP allocation + 6% synthetic equity) would count toward the 50% requirement for a nonallocation year in Temp. Regs. Sec. 1.409(p)-1T(c)(1)(ii). 

In addition, Rev. Rul. 2004-4⁸ (discussed below) was issued to deter tax shelter promoters.

Tax Shelter Rules 

Unfortunately, S corporations are on Treasurys radar screen, as well as investment bankers, accounting and law firms and corporate tax shelter promoters. Now that Treasury is starting to develop strategies that challenge potentially abusive arrangements using S corporations, tax advisers need to be aware of the listed transaction, disclosure and reporting provisions of Secs. 6011, 6111 and 6112.⁹ This is an area that many small business tax advisers were happy to ignore; in the past, these rules just did not apply to their clients.

Rev. Rul. 2004-4 elaborated on one scheme involving SESOPs and qualified subchapter S subsidiaries (QSubs). It basically held that if an S corporation enters into this type of transaction, Secs. 6011, 6111 and 6112 apply. Essentially, the strategy is to use a SESOP to avoid taxation of S income, while having key employees (who are, by means of stock options, the companys or QSubs true owners) keep the value, by eventually exercising nonqualified stock options, SARs, etc.

In the three situations discussed in the ruling, an S corporation created multiple QSubs, ostensibly owned by the parent S corporation. Key service provider A transferred As clients to QSub A and was an employee of QSub A. Service provider B did the same with QSub B, etc. The QSubs issued a stock option or similar instrument to the key service provider to buy substantially all the stock. Little, if any, cash would be distributed, so that the QSubs value was increasing by the profits hypothetically earned by the SESOP, the parents sole owner. The Service held that the corporations rank-and-file employees were not really the trust beneficiaries as to the QSubs earnings; thus, Sec. 409(p) applied to make the year a nonallocation year and the service providers disqualified persons. The ruling also discussed the meaning of synthetic equity.

To add fuel to the listed-property-transaction fire, Notice 2004-30¹⁰ and IR 2004-44¹¹ described an S corporation transaction that is a reportable listed transaction and, for the first time, included tax-exempt organizations as participants required to disclose. In these pronouncements, the S shareholder issued nonvoting common stock and warrants to acquire a supermajority ownership of nonvoting common. The shareholders then gave the nonvoting stock to an exempt organization (either with UBIT losses or UBIT-exempt), taking a deduction for the gift. The gifted stock had a put option or other arrangement attached. Ninety percent of the S income was then allocated to the nonvoting shares the nonprofit owned, even though the economic benefit inured in the warrants and voting stock. Also, distributions were suspended while this strategy was in effect.

Conclusion

SESOPs have pros and cons, not the least of which is a potential 50% excise tax; further, the IRS will not tolerate certain arrangements in which income is allocated to one party, but beneficial ownership remains with others. However, an understanding of the tax planning aspects of direct versus synthetic equity ownership may help avoid disqualified-person status and a nonallocation year. It may make sense to examine the SESOP trust document and ascertain whether there is a nonallocation provision. Finally, the interplay of Secs. 267(e) and 404 is crucial to consider for accrual-basis S corporations with SESOP shareholders.