Article by Judy Kornfeld

Introduction

The passage of the Small Business Job Protection Act of 1996 allowed ESOPs to be shareholders in S corporations. In the past several years, many companies that sponsor ESOPs have elected to be taxed as S corporations because of the tax advantages associated with this combination. Additionally, many S corporations that did not previously have ESOPs have established them.

S corporation status does not directly affect the amount of a company's ESOP repurchase obligations, but most ESOPs in S corporations hold large percentages of company stock. This is because the tax advantages associated with S corporation status vary directly with the percentage of the company's stock owned by the ESOP. Since ESOP repurchase obligations also vary directly with the amount of stock owned by the ESOP, S corporations with ESOPs tend to have high repurchase obligations. Planning for the repurchase obligations is therefore more important and more challenging. This article will focus on several ESOP repurchase obligation issues as they relate to S corporations:

• Method of handling repurchases
  
• Effect of S corporation distributions on participant account balances
  
• Choice of funding methods

Tax Advantages for an ESOP As an S Corporation Shareholder

When a company has elected to be taxed as an S corporation, taxation of income at the corporate level is eliminated. Instead, the shareholders are taxed on their proportionate share of the corporation's income. Usually, the corporation will distribute enough of its earnings to the shareholders to cover the taxes they will owe on their share of the corporation's income.

When an ESOP trust is one of the shareholders, the income attributable to its share of the corporation's income is not subject to income tax, but if other shareholders are receiving a distribution, so must the ESOP, because an S corporation can have only one class of stock. The cash that the ESOP trust receives from S corporation distributions provides liquidity for the trust that can potentially be used to fund ESOP distributions to participants.

If the ESOP owns 100% of the company, taxes on corporate income are completely eliminated. This gives companies that are entirely or mostly owned by an ESOP a big advantage, and explains why so many ESOP companies have elected S status.

Method of Handling Repurchases

ESOP repurchase obligations can be handled in two different ways. The first is redemptions: Distributions are made in stock, and the recipient can "put" those shares back to the corporation, which redeems them. The second way is by recirculating stock in the ESOP: The ESOP trustee makes distributions in cash, and the stock remains in the trust and is reallocated to the remaining participants. The cash can come from prior accumulations in the ESOP, from a current contribution, or from S corporation distributions to the trust.

In a C corporation ESOP, the contributions that the company makes to the ESOP are tax deductible, the tax savings reduce the cost of handling repurchases by recirculating shares. Although more shares will have to be repurchased over time, the higher cost is offset wholly or in part by the tax savings. In an S corporation ESOP, the tax savings associated with recirculating are eliminated or reduced. Since more shares will be repurchased over time when recirculating, the cost will be higher than handling repurchases through redemptions. The higher cost may be partially offset if redemptions have an antidilutive effect on the value of the stock by reducing the number of shares outstanding.

Cost is not the only consideration in the redeem versus recirculate decision. There are effects on individual account balances and the balance of ownership between the ESOP and non-ESOP shareholders that also need to be considered. Recirculating stock will result in larger numbers of shares in participants' accounts, and provides a way for new participants to receive allocations of company stock when no new shares are available. It also leaves the ESOP's percentage of ownership of the company unchanged, while redeeming stock will cause the ESOP's relative ownership to decline (except if the ESOP owns 100% of the company.)

In an S corporation, the limitations on the number and type of shareholders also introduce some additional complexity into the planning for distributions. Because the number of shareholders in an S corporation is limited to 75, distributions of stock to participants followed by a redemption of the shares must be carefully planned. Distributions of stock to a participant's IRA are also a problem, since an IRA cannot hold shares in an S corporation. While it may be possible to obtain a favorable private letter ruling on some methods for circumventing these issues, in many situations it may simply be more practical to recirculate shares.

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