Many mature, Employee Stock Ownership Plan (ESOP)-owned companies consider making an S-election, and for good reason. An S Corporation owned 100% by an ESOP generally pays no federal income taxes. An S Election instantly boosts cash flow, which the company can use to fund growth opportunities or fund its annual ESOP repurchase obligations.
But making an S Election should not be an automatic decision upon the ESOP owning 100% of the company. Below are a few issues that should be considered:
- Built-In Gains: S corporations are subject to built-in gains tax for a period of 5 years following the election on the sale of any capital asset acquired while the company was a C corporation. Built-in gains is also triggered by an equipment trade-in that would previously be exempt from taxation under Section 1031.
- Share Basis: The basis of S corporation shares are continually adjusted for flow-through items of income, expenses, and losses. Revenue Ruling 2003-27 requires ESOPs to adjust cost basis in a manner similar to any other S corporation shareholder. Cost basis must also be tracked and reported on Form 1099-R when a lump sum distribution is made to a participant in the form of employer stock.
- Distributions: Participants generally have a right to demand their distribution be made in the form of employer stock. S corporations may either eliminate this right or require any distribution of stock to be immediately sold back to the company. These changes require amendments to the plan document. Here again, tracking cost basis is important to allow participants to treat a portion of their distribution as net unrealized appreciation, which is taxed at capital gain rates.
- Allocation Limits: For a C corporation ESOP, share forfeitures and interest on ESOP loan payments are excluded from the Section 415 allocation limits. This rule does not apply to S corporation ESOPs and all forfeitures and interest must be included.
- Deduction Limits: C corporation ESOPs may deduct ESOP loan interest in addition to the deduction limits imposed by Section 404. This rule does not apply to S corporation ESOPs.
- Section 409(p) Testing: S corporation ESOPs must comply with Section 409(p). The testing rules are too complicated for this short article, but your plan TPA should be able to do the testing for you. Failure to comply with Section 409(p) results in tax penalties to participants and the employer and disqualification of the plan. A Section 409(p) violation is ESOP Armageddon and should be avoided at all costs.