Article by Judy Kornfeld
(Page 2 of 2)

Effect of S Corporation Distributions on Participant Account Balances

The choice between S corporation distributions and regular contributions as ways to get cash into the ESOP has significant implications for individual account balances. Cash contributions to an ESOP are allocated pro rata to compensation (unless the plan document provides a different allocation method.) This results in higher allocations to people with higher compensation, irrespective of their length of service. But when an S corporation makes a distribution to shareholders, or when a C corporation pays a dividend, the distribution or dividend is allocated to the ESOP participants pro rata to the number of shares allocated to their accounts. The result is that the accounts of participants who have accumulated more shares receive more cash and grow much more rapidly than those with fewer shares. This is not necessarily bad, but it is an issue of which the company needs to be aware when it is deciding how to get cash into the ESOP.

The cash that accumulates in the ESOP from S corporation distributions can be used to meet repurchase obligations, but will tend to exacerbate the differences between the "haves and have-nots" with respect to company stock. If cash balances are used to fund repurchases, they will come out of individual accounts pro rata to the cash balances and be replaced with shares. The result is that those who had the largest cash balances because they had the most shares end up with even more shares. In ESOPs with relatively small numbers of participants, the result is a concentration of shares in the accounts of longer term, higher paid employees. These participants tend to be older and have low turnover, and as they exercise diversification rights and retire, repurchase obligations will tend to be accelerated.

There are some situations where there isn't any choice about S corporation distributions. These include distributions to shareholders to cover taxes (in the less-than-100% ESOP), where the distribution has to be made to all of the shareholders, including the ESOP, even though the ESOP doesn't have to pay any taxes. There are also situations where S corporation distributions, in addition to regular cash contributions, are needed to meet payments on ESOP loans. The distributions attributable to the allocated shares in the ESOP can't be used toward the loan payment, so the S corporation distributions may have to be pretty high to get enough cash into the trust to meet the loan payments from the distributions on the unallocated shares. (This restriction does not apply to C corporations.) The same distributions will also have to go to any non-ESOP shareholders, which can make this an expensive way to meet the payments on ESOP debt.

Funding Choices for Repurchase Obligations in S Corporations

The development of a funding strategy must take into consideration many different factors, and for S corporations, it is particularly important to be aware how the tax treatment of the ESOP affects the relative cost of different funding methods and investment vehicles.

In particular, it is more attractive for an S than for a C corporation to accumulate a "sinking fund" in the corporation to fund repurchase obligations. The reduction or elimination of tax at the corporate level for S corporation ESOPs means that income can be retained in the corporation without being taxed. This allows an S corporation ESOP to create a corporate "sinking fund" to fund repurchase obligations with before tax dollars and to avoid taxation on the investment earnings. By comparison, a C corporation uses after tax dollars to create such a fund and pays tax on the investment earnings unless they are invested in some sort of tax-advantaged vehicle.

A sinking fund in the corporation allows the corporation to remain flexible about whether it will contribute the funds to the ESOP to recirculate shares, or whether it will use the funds to redeem shares. It also strengthens the balance sheet, but this can be a double-edged sword because it may increase the value of the stock. Many appraisers treat non-productive assets (such as a sinking fund) as an add-on to the operating value of the business.

Life insurance will generally not be attractive as a funding vehicle for repurchase obligation in S corporations. Insurance can sometimes work as a cash accumulation vehicle for repurchase obligations in C corporations because of its tax advantages: tax-free (or tax-deferred, depending how the policy matures) growth of cash value, tax-free withdrawals and loans, and tax free death benefits. However, these tax advantages are reduced by the administrative and mortality charges associated with the life insurance product. The economics of insurance funding work if the tax advantages exceed these charges. In an environment where there is no tax, the economics typically don't work. There are circumstances, of course, where it is desirable to have death benefit coverage, but in general, insurance designed for cash accumulation does not seem to offer any advantage for S corporation ESOP companies.

Summary and Conclusions

Repurchase obligations are an important issue in all ESOP companies, but particularly so in S corporations because of the high percentage of stock that is usually owned by the ESOP. The elimination of tax on the income attributable to the ESOP can create a large financial advantage, but it also affects the relative cost of different ways of handling repurchases and different funding methods. ESOP companies that have elected S status need to understand these issues, and they need to formulate a strategy for managing and funding the repurchase obligations that takes their tax status into account. ESOP companies that were previously taxed as C corporations may need to review and adjust their prior strategies. Particular attention should be paid to the consequences of S corporation distributions as an alternative to regular cash contributions to the ESOP. The corporation's tax status also affects the choice of funding methods and investment vehicles for repurchase obligations.

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