Should Your S Corporation Adopt An ESOP?

Should Your S Corporation Adopt An ESOP? Kevin G. Long The significant tax savings currently heralded in the tax press for S corporations that use an ESOP depend on the strategy for the use of the ESOP, as well as the strategy for using the cash that the plan might be able to accumulate in lieu of paying it into federal and state taxes. The best way to evaluate the potential tax and cash flow savings is to analyze the traditional ESOP strategies in an S corporation context. Only then do the issues and the opportunities become clear. THE REALITIES OF SUBCHAPTER S Before the Small Business and Job Protection Act of 1996 (SBJPA), subchapter S corporations only could have 35 shareholders. Now they can have 100 shareholders. According to government estimates, more than 80% of S corporations have five or fewer shareholders. Many of those S corporations distribute cash to their shareholders at least equal to the tax burden of reporting the corporate income on their individual tax returns. Furthermore, many S corporations distribute far in excess of the taxes which are due and retain cash in the corporation only to the extent necessary for operations. From a succession planning perspective, the only way out for subchapter S corporation shareholders was by redemption of the shares by the corporation, gifting the shares to family members, or by cross-purchase between the shareholders. Subchapter S corporations typically are governed by stringent shareholder agreements and buy-sell agreements. This is because it is necessary to safeguard the ownership of S corporation shares so that ineligible shareholders do not receive the shares and void the subchapter S election. Finally, since the increase in individual income tax rates between 1986 and the present, the initial attractiveness of subchapter S corporations on an operating basis has waned. Effective tax rates for individuals are now higher than for corporations. Apart from those individuals who have made the election or structured their corporation to take advantage of the long-term objective of only a single level of tax on disposition of the company, the rate of subchapter S elections has slowed dramatically. Taking each of the available ESOP planning strategies in turn, let's consider the rather dramatic effect that an ESOP may or may not have on a corporation. CONTRIBUTIONS OF NEWLY ISSUED SHARES THE STOCK BONUS PLAN APPROACH Contributing stock to an ESOP creates a tax deduction that reduces the taxes which are ultimately paid on corporate income, even if it is distributed to all shareholders of the subchapter S corporation. This, in turn, reduces the amount of cash that must be distributed to S corporation shareholders to pay the tax. Since a subchapter S corporation must treat all shareholders equally (because it must have only one class of stock), if cash is distributed to non-esop shareholders the ESOP will receive its pro rata share at the same rate of distribution. The ESOP would, therefore, receive its percentage of the cash/taxes that would otherwise be paid to the federal and state governments. To see what this means look at Chart 1. COPYRIGHT 2008 - CHANG, 1

As the ESOP grows in its ownership of the company, an increasing percentage of the taxable income and cash distributions would inure to the ESOP and its participants. The ESOP participants, therefore, would be receiving a rate of return on their stock, in the form of additional cash accruals in their accounts, equal to 47% of the taxable income of the corporation. Who would a company rather pay this money to? The federal government or its employees? If, however, the S corporation is merely one of many investments of the shareholders who are independently wealthy and S corporation cash is not being distributed, then the ESOP is truly serving to shelter taxes and improve the corporation's cash flow. This extreme, however, is not the norm for a subchapter S corporation. Chart 1. Sharing S Corporation Distributions With An ESOP Shareholder The S corporation shareholder recognizes taxable income equal to its percentage share (of stock ownership) of corporate taxable income. If the ESOP is a 30% shareholder, it likely will also receive 30% of the distribution to pay taxes. Based on this illustration, a 100% ESOP S corporation starts to look attractive. The entire $235,000 could be saved and retained in the corporation rather than be paid to Uncle Sam. If the ESOP becomes a 75-99% owner, perhaps the tax can be handled by means of salary and bonuses to the other shareholders. Shareholder % Taxable Income Cash Distribution Mr. Elder 51% $255,000 $119,850 Mr. Elder, Jr. 19% $95,000 $44,650 ESOP 30% $150,000 $70,500 Total 100% $500,000 $235,000 Note that 30% ESOP ownership is typical for many C corporation ESOPs due to this percentage requirement in tax-deferred ESOP sales. Beyond this illustration, a 100% ESOP S corporation starts to look attractive. The entire $235,000 could be saved and retained in the corporation rather than be paid to Uncle Sam. If the ESOP becomes a 75-99% owner, perhaps the tax can be handled by means of salary and bonuses to the other shareholders. The lure of tax savings in a subchapter S corporation, with less than 100% ESOP ownership, is not, strictly speaking, tax savings; rather, it is what to do with the taxes that would otherwise be paid to the government and which may accumulate in the ESOP. These cash distributions to an ESOP represent both planning opportunities and compliance issues. In this first example, the cash flow may not be significant at first. The stock and cash could simply be left in the ESOP and be used to pay benefits and help to fund distributions. Since an S corporation can only have 100 shareholders, it is anticipated that most S corporation ESOPs will distribute benefits in cash, rather than in stock, to avoid violating this rule. COPYRIGHT 2008 - CHANG, 2

SALE OF STOCK TO THE ESOP Consider the classic ESOP transaction in which initially a minority interest, say 30% - 40%, is sold to the ESOP, perhaps using bank financing, with subsequent successive transactions over time. The principle motivator in regular or "C corporations" is both the deductibility of the principal on the debt used to buy the stock and the tax deferred reinvestment strategy for the selling shareholder. This produces immediate tax "savings" for both buyer and seller. Even without the 1042 election and tax deferral for the seller though, the cost of a pre-tax purchase is significantly lower than the cost of purchasing a shareholder's interest with after-tax dollars. The reality in many S corporations, as we have stated, is that there are often family members and related parties involved in the business. In a C corporation ESOP, the one trade-off for selling shareholder's tax deferral is the exclusion of lineal descendants and other 25% or greater shareholders from allocations of that stock. (The actual exclusionary rule is more complex than this but our abbreviated explanation will suffice for this article.) In part for this reason, many S corporations have been loath to terminate their S corporation election for the sake of a sale to an ESOP, regardless of the seller's tax savings. Some S corporations, however, have terminated their S corporation elections in the past to take advantage of the tax deferred rollover transaction. In such a case, there is also the consequence of non-selling shareholders ceasing to receive distributions of cash from the S corporation. Where the distributions have exceeded the taxes due on the current income, this is a negative result. Cash distributions from S corporations can prove to be addictive. There are differences in S corporation ESOP purchase transactions, however. In addition to the cash flow for the purchase being deductible as it is for any ESOP, the ESOP will accumulate its share of whatever taxes otherwise would be paid to the federal government. At a rate of 47 cents on the dollar, the ESOP may receive cash equal to 47% of its share of the corporation's tax liability if the corporation is still paying taxes beyond the deductible contributions used to fund the transaction. If the ESOP is being used to buy out other shareholders, then this provides the first potential answer to the question, "what to do with the tax dollars distributed to the ESOP?" Those distribution dollars could be applied toward payment of ESOP loans and the purchase of additional shares by the ESOP. In some situations, this could rapidly accelerate the buyout process if there are multiple shareholders looking to sell stock, and if the company ultimately wants to be majority ESOP owned. There are fiduciary questions, however, about what other uses this cash flow could be used. Alternatively, new shares could be issued to the ESOP after cash accumulates, or while the cash is accumulating, so that the cash returns to the company in the form of capital, and is then put to use in operations as needed. This alternative use of ESOP cash raises the specter of dilution of other shareholders' interests. However, it also raises the possibility of increased growth and liquidity for the company, which should be beneficial for all shareholders' stock values. Of course, as with any ESOP company, the question of cash flow improving stock value comes down to how well management is able to put the improved cash flow to use. In short, the cash flowing through the ESOP could permit a buyout to proceed more rapidly than the Code's qualified plan deduction limits would otherwise permit; that is, in excess of 25% of compensation. COPYRIGHT 2008 - CHANG, 3

MAJORITY ESOP OR 100% ESOP? This is the most exciting example of the change in the tax law. (Sorry to make you wait.) A 100% ESOP owned S corporation could pay no federal income tax! Since it would be 100% ESOP owned, there would be no need for distributions to pay tax dollars to non ESOP shareholders. All cash, including taxes, would stay in the company. This would permit the corporation to grow at a much more rapid rate than a non ESOP company. In turn, as stock values increase, repurchase liability should also increase. But the corporation will have greater cash reserves to pay this debt. If distributions to ESOP participants are being made in cash to preserve the S corporation election, then stock may have to be redeemed by the company to provide ESOP liquidity. The corporation may also periodically make cash contributions to the ESOP, or simply distribute cash to the ESOP. Query whether a corporation that is 100% ESOP owned would ever need to make additional stock contributions to the plan? This, however, is where tax and business planning depart from employee benefits planning. As a practical matter, mature ESOPs even as a 100% shareholder of an S corporation, would need to provide stock ownership to new employees that join the company. Contributions of stock or cash, more likely than not, would need to be made to the ESOP for the employee ownership structure to be ongoing, vital and successful. Furthermore, contributions of new shares could still be made out of corporate growth so that employees continue to share in the success of the company. SHOULD YOU TERMINATE THE S ELECTION? Related to the ESOP sale transactions for an S corporation are the selling shareholder's tax considerations. A selling S corporation shareholder now has the choice of selling shares to the ESOP as an S corporation or, terminating the S election and selling shares to the ESOP to take advantage of Code section 1042 and its tax deferred rollover provisions. (There have been proposals to extend the 1042 rollover provisions to S corporation shareholders, but as of this writing they have not passed.) There are three principle factors in the decision to utilize Code section 1042 or not. They are: (i) the taxation of capital gains at federal rates as low as 20%; (ii) a shareholder's basis in his S corporation shares being higher than if it were a C corporation; and (iii) family members in the business. The reduction of capital gains rates in 1997 dramatically changed the comparison for tax deferred sales transactions. Previously, it was a fairly straight-forward analysis where tax rates for an individual's capital gain on the sale of stock were 35% (federal and California combined). In a traditional tax deferred rollover transaction, the selling shareholder benefits from investing the taxes deferred in the portfolio of replacement securities. Appreciation then provides a significantly enhanced nest egg for retirement. Current income from dividends and interest on Uncle Sam's invested taxes are a real sweetener to the deal. Furthermore, if the selling shareholder passes away prior to selling any of those reinvestment securities, they receive a "step-up" in basis upon death and the heirs never have to pay the tax on the capital gains that were deferred on the original sale. The 20% federal capital gains rate significantly narrows the calculation. It muffles the argument in favor of terminating the S election, which affects all of the all shareholders involved. It also is a much less compelling argument where distributions of cash are being made or where there is not an immediate plan to purchase the interests of the other shareholders or sell the company. Look at Chart 2. You can see that the S corporation shareholder needs the 1042 election less than his C corporation counterpart. This is especially true if they have accumulated basis in their shares (third column). Economically it may make sense for the selling shareholder to terminate COPYRIGHT 2008 - CHANG, 4

the S election to take advantage of code section 1042 if he has no basis in his S corporation shares (second column). However, the first shareholder to sell will be causing the corporation to convert to double taxation status. Subsequent sales will become dependent on the 1042 election to make economic sense. If a later sale of the company is to a third party, then it will come at a cost for the remaining shareholders and/or the company itself in the form of double taxation. This is not unusual, since few ESOPs attain 100% ownership of their company and actually make the company an attractive takeover target, even if closely held. Chart 2. C Corporation vs S Corporation - Asset Sale This illustration assumes appreciation in corporate assets or full depreciation to zero in corporate assets. C Corp. S Corp. (stock basis = 0) S Corp. (w/stock basis) Asset Value $10,000,000 $10,000,000 $10,000,000 Less Basis ($0) ($0) ($0) Gain** $10,000,000 $10,000,000 $10,000,000 Taxes 27% (State/Fed.) ($4,300,000) ($150,000)* ($150,000)* Distribution To Owner $5,700,000 $9,750,000 $9,750,000 Less Stock Basis ($0) ($0)*** ($2,650,000) Gain $5,700,000 $9,750,000 $7,100,000 Taxes 27% (State/Fed.) ($1,539,000) ($2,635,000)** ($1,917,000) Net Cash $4,161,000 $7,115,000 $7,833,000 As % Of Total Sale 41% 71% 78% * This is a California franchise tax at a reduced rate of 1-1/5% for S corporation. It is not a federal tax. ** Assumes all corporate gain is capital gain. Most cases would involve some recapture taxed at higher ordinary income rates. *** Now look ahead at charts for how "Basis" can accumulate. Shareholder basis, however, is just as powerful as the reduced capital gains rate in narrowing the issue of "to C or not to C." It is not unusual for a subchapter S shareholder's stock basis to be nearly equal to his pro rata share of the corporation's retained earnings. Look at Chart 3. It illustrates what might happen over a ten-year period after the S election is revoked. The S corporation shareholders would lose the basis accrual demonstrated in Chart 3. This, in effect, may pit the first seller's objectives against the later selling shareholders. COPYRIGHT 2008 - CHANG, 5

Chart 3. C Corporation vs S Corporation Stock Sale With S Corporation Basis Assumption Assume a 5,000,000 company that generates $500,000 in taxable income and cash flow each year. At the end of ten years, the company has doubled in value to $10,000,000. Compare 10 years of operations as both a C and S corporation on an eventual sale. Of course there are additional comparisons that can be made, including present values, and the value of savings invested over time. This is only a simple comparison of the effect of the shareholders basis adjustment. Now consider for yourself the impact of S corporation stock basis on the asset sale scenario, in column 3 of Chart 2. Annual Operating Results C Corp. S Corp. Taxable Income $500,000 $500,000 Corporate Tax $215,000 $0 Shareholder Tax $0 $235,000 Difference In Cash Flow +$20,000 $0 Addition To Stock Basis $0 $265,000 Sale In Year 10 @ Fair Market Value $10,000,000 $10,000,000 Shareholder's Basis $0 $2,650,000 Gain On Sale $10,000,000 $7,350,000 Capital Gain Tax $2,700,000 $1,984,000 Tax Savings On S Corporation $0 $715,000 Less 10 Years Higher Tax/Cash Flow Difference On Operating Income Net After Tax Savings $0 $20,000 $0 $515,000 COPYRIGHT 2008 - CHANG, 6

Of course there are additional comparisons that can be made, including present values, and the value of savings invested over time. This is only a simple comparison of the effect of the shareholders basis adjustment. Now consider for yourself the impact of S corporation stock basis on the asset sale scenario, in column 3 of Chart 2. Although conventional tax wisdom says "a dollar of tax deferred is a dollar of tax earned," the circumstances may be less dire in an S corporation setting. One must also consider that in a 1042 reinvestment portfolio, the selling shareholder must hold his investments in stocks or bonds of domestic operating corporations. The investments cannot be in government securities, public utilities, mutual funds, or other investments that do not meet the narrow definition for reinvestment securities. Some selling shareholders, depending upon age or retirement objectives, might find a more flexible reinvestment portfolio, coupled with the 27% tax rate, to be a more reasonable arrangement. It is, therefore, harder to justify revoking the subchapter S election, which arguably still benefits the remaining shareholders and the company to permit the first shareholder to sell his interest. A selling shareholder must also consider the benefits that could be allocated to his account in an S corporation ESOP. If the S corporation election is revoked to take advantage of Code section 1042, the selling shareholder (if he is still an employee of the company), would not receive an allocation of the shares that he sells to the plan. If the initial ESOP transaction is a significant but minority percentage ownership in the company, and the stock is appreciating at a reasonable rate, then the accruals to the key employees' accounts and the selling shareholders could be significant. This would be one more compelling economic factor when comparing the benefits to be accrued in a 1042 portfolio. The third key consideration is the presence of family members in the business who wish to receive a significant portion of the business, and to participate in the company's benefit plan (as well funded as most ESOPs are). Certainly, second generation "wealth" may not be lost due to the existence of the section 1042 portfolio, or insurance; but true family participation in the company is diminished. Similarly, other 25% shareholders would be excluded from a share of the sellers stock. Finally, if the S corporation were to revoke its status for the sake of accommodating a tax deferred rollover transaction of a key shareholder, then the S corporation could not re-elect subchapter S status for five years. At that later date, the tax cost of reelecting subchapter S status could be prohibitive. Bear in mind that in the midst of this ESOP participation by key individuals or selling shareholders is the planning exercise of the S corporation anti-abuse rules. Account balances and shareholder percentages must be tested to ensure no over-concentration of ownership that triggers tax penalties. WHAT TO DO ESOPs for subchapter S corporations appear to be a compelling alternative, assuming that you are engaged in long-term succession planning or capital planning for an S corporation. However, there is no substitute for "running the numbers." Due to issues such as reconciling distribution policy, profitability, the nature of the business, and whether it is capital intensive or not, employee benefits practitioners will have to work closely with CPAs in their tax planning for their S corporation clients to make an ESOP work well for any S corporation. Overall, it appears that the S corporation finally has an exit vehicle for succession planning on a tax favored basis that puts them close to par with C corporations. COPYRIGHT 2008 - CHANG, 7

Although all of the tax incentives available to ESOPs are not available to S corporation ESOPs, those that are not available may be more than offset by the realities of most S corporations and their unique shareholder planning concerns. Editor's Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government's rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or email us at contactus@seethebenefits.com. COPYRIGHT 2008 - CHANG, 8