Plan Distributions from SESOPs

Rev. Proc. 2003-23 addresses the practical problem of employee stock ownership plan (ESOP) participants seeking to roll over distributions of S corporation stock into an individual retirement account (IRA), when the trustee or custodian of such an account is not a permissible S shareholder.

Background

In 1996, Congress amended the Code to make ESOPs, along with other qualified retirement plans, eligible S shareholders. Since then, hundreds of ESOP sponsors have examined whether they would qualify for an S election and potentially benefit from becoming an S corporation. Among those electing S status, many have also increased the percentage of S stock held to 100%.

An ESOP is unique because, in addition to functioning as a qualified retirement plan, it also provides participants with equity ownership in the corporation. This equity-ownership arrangement applies to both C and S corporations that sponsor ESOPs.

Distribution Problems

Generally, ESOP plans have to allow participants to receive distributions as employer securities when they become entitled to a distribution under the plans terms. However, an S corporation ESOP (SESOP) can distribute only cash or employer securities subject to a repurchase requirement (also known as a put option).

Qualified plans (including ESOPs) permit participants receiving an eligible rollover distribution to roll it over directly to an eligible retirement plan, including an IRA. Thus, a problem arises; the IRA trustee or custodian is not a permissible S shareholder.

Under Sec. 409(h)(2)(B), a SESOP plan providing for distributions of SESOP securities can require the S corporation to immediately repurchase the S stock included in such a distribution, on a direct rollover of the stock to an IRA.

Rev. Proc. 2003-23

Under this procedure, if a SESOP meets certain distribution requirements when participants elect a direct rollover to an IRA, the transaction will not effect the sponsors S election.

The IRS will not treat an S election as terminated when a SESOP distributes stock if:

1. The SESOPs terms require the S corporation to repurchase its stock immediately on the SESOPs stock distribution to an IRA;

2. The S corporation repurchases the stock contemporaneously with, and effective on the same day as, the distribution; and

3. No income (including tax-exempt income), loss, deduction or credit attributable to the distributed stock is allocated to the participants IRA.

Conclusion

SESOP sponsors would be well advised to review their plan documents and administrative procedures in light of the Rev. Proc. 2003-23 requirements. If the plan document is written to comply with the repurchase requirement and the stock repurchase from the IRA is handled properly, SESOP participants can benefit from the potential advantages of a direct rollover to an IRA.

From David S. Horvath, CPA, Oak Brook, IL