technical issues: update for s corp esops 18 th annual ohio employee ownership conference april 16,...

Technical Issues: Update for S Corp ESOPs

18th Annual Ohio Employee Ownership Conference

April 16, 2004 Akron, Ohio

Helen H. MorrisonPrincipal, Deloitte

Becky HoffmanPrincipal Group

Hugh ReynoldsCrowe Chizek and Company LLC

Tim Jochim Jochim Co., LPA

What is an “S Corp”?How does it differ from a “C Corp”? C Corporation

Corporation under state law

Separately taxable entity

Shareholders subject to tax on dividend payments (now 15% tax for eligible dividends)

S Corporation Corporation under

state law “Pass through”

entity Nature of income

(for losses and expenses) retains its character in hands of shareholder)

What are the Advantages of S Corp over C Corp Status?

No double taxation Increase in stock basis Tax free distributions Capital gain retains its character Individual use of corporate earnings or losses Sale of appreciated asset without double tax;

Sale of business as asset sale Exception: built-in gain tax Sale of asset within 10 years of making the S corp

election Estate planning advantages Highest corporate tax and individual tax rate are the

same

Tax Model of Operations

C Corp S Corp

Tax on Corporate Earnings

Net Income From Operations 50,000,000 50,000,000Effective Corporate Tax Rate 35.00% n/aEffective Individual Tax Rate n/a 35.0%

Corporate Taxes 17,500,000 17,500,000

Taxation of Discretionary Distribution

Discretionary Distribution 10,000,000 10,000,000 Effective Individual Tax Rate on Distribution 15.0% n/aTax Paid on Receipt of Distribution 1,500,000 -

Total Taxes Paid 19,000,000 17,500,000

Stock Sale Tax Model

C Corp S Corp

Individual Level Taxation

Cash Received For Stock 400,000,000 400,000,000 Less: Tax Basis From Initial Investment (1,000,000) (1,000,000) Less: Tax Basis Increases From Undistributed Earnings - (200,000,000) Equals Gain on Sale of Stock (A) 399,000,000 199,000,000

Individual Effective Tax Rate on Gain 15.0% 15.0%Individual Level Tax on Gain (B) 59,850,000 29,850,000

After-tax Cash Flow (A) - (B) 340,150,000 370,150,000

Increase in Cash From S Corp Conversion 30,000,000

Add the ESOP Tax Benefit

ESOP is a exempt from income tax Under special rule also exempt from

unrelated business tax (UBIT) Seems too good to be true - where is

the catch?

S Corporation Requirements

Limit of 75 shareholders ESOP is a single shareholder

Shareholders may only be individuals, estates and certain trusts No partnerships

Shareholders may not be nonresident aliens Beware of community property states

S Corporation Requirements (cont) Only one class of stock allowed

Debt ok, provided satisfies “safe harbor” or general test Stock options, warrant ok, provided exercise price is at least

90% of fair market value Phantom stock, SARs, nonqualified deferred compensation ok,

provided reasonable compensation Benefits allocation issue for less than 100% ESOP IRC section 409(p) issue

Fringe benefit limitation for 2% or more shareholder

Shareholders must file state returns in every state of operation

Composite return mitigates this requirement Recognition of income regardless of distribution

Requirements to Convert to S Corporation Status

Valid election must be filed within 2½ months of the effective date of the election

Form 2553 filing 100% of the outstanding shareholders (including a

spouse in a community property state) must sign a consent

LIFO reserve recapture over four years Calendar year, unless 100% ESOP in which

case can use ESOP plan year

Unique S Corporation ESOP Issues

Going from C to S to C IRS permission required in first five

after S termination. IRC §1362(g) Possible solution: Minnow swallows

whale merger Two Classes of Stock

Voting and nonvoting permitted

Compliance and Practical Issues

Built-in Gains tax issues and planning techniques

Federal and State S Election / QSub Election Requirements

Tax Distributions to Outside Shareholders / Composite State Individual Returns

Compliance and Practical Issues

State Treatment of S Corporations Varies Widely S Corporation Recognition QSub Treatment Built-in Gain Treatment Composite Individual Return

Requirements Nonresident Withholding Requirements

The S Corp. ESOP Anti-abuse Rules

The Reason Behind the Madness Preventing abusive arrangements Establish testing method to

determine “good” ESOPs Broad-based employee ownership

is crucial to being considered a “good” ESOP

Some “good” ESOPs will be unfairly classified as abusive

Anti-Abuse Rules Effective Dates

Code Section 409(p):

Was effective on enactment as to S Corporation ESOPs established on or after March 14, 2001

As to S Corporation ESOPs in existence prior to March 14, 2001, effective for the first plan year beginning after December 31, 2004

Anti-Abuse Rules Effective Dates

Temporary Regulations:

Effective for plan years ending after October 20, 2003 (i.e., effective as of January 1, 2003, for a calendar year plan)

NQDC distributed by July 21, 2004 will not be considered Synthetic Equity

Anti-Abuse Rules – Defined Terms

Deemed-Owned Shares Allocated ESOP shares Pro rata portion of shares in

the ESOP loan suspense account

Synthetic Equity


Synthetic Equity Stock option, warrant, restricted stock,

deferred issuance stock right, “similar” interest or right that gives the holder the right to acquire or receive stock

Stock Appreciation Right (SAR) or “similar” right to a future cash payment based on the value of stock or appreciation in value

Nonqualified deferred compensation Right to acquire interests in certain

related entities


A “Disqualified Person” is a person who:1. owns 10% or more of all of the Deemed-

Owned Shares of a corporation, 2. is a member of a Family that owns 20%

or more of the Deemed-Owned Shares of the corporation, or

3. [has Deemed-Owned Shares and] is a Family member of an individual who is a “Disqualified Person” under the 20% Family rule above


“Family” is defined broadly to include:1. the spouse of the individual, 2. an ancestor or lineal descendant of the

individual or the individual’s spouse,3. a brother or sister of the individual or the

individual’s spouse and any lineal descendant of the brother or sister, and

4. the spouse of any individual in two or three above

Don’t forget to ask about living ancestors who are not reported because they don’t have any ownership themselves.


Nonallocation Year Disqualified Persons own at least

50% of stock in S corporation at any time during the plan year

Ownership includes Deemed-Owned Shares and direct ownership

Attribution rules apply here

Prohibited Allocation

No portion of the assets of the plan attributable to (or allocable in lieu of) the company stock may accrue for the benefit of any Disqualified Person during a Nonallocation Year.

Effect of Nonallocation Year

If there is a Nonallocation Year, then:

The value of any prohibited allocation is taxed to the Disqualified Person

A 50% excise tax is imposed on the amount of the prohibited allocation

A 50% excise tax is imposed on Synthetic Equity of Disqualified Persons

First Nonallocation Year Rule

In the first Nonallocation Year the excise tax is 50% of the total value of the Deemed-Owned Shares of all Disqualified Persons

How is Synthetic Equity Applied in the Testing? Prior to temporary and proposed regulations

we took a conservative approach, only using the Synthetic Equity of the individual or group being tested in the denominator.

The temporary and proposed regulations clarified the mechanics of including Synthetic Equity in the testing. The Disqualified Person test and the Nonallocation Year test are tested by including no Synthetic Equity and again by including ALL synthetic equity.

How are unallocated shares attributed to participants?

In the same proportions as the most recent stock allocation under the plan Same manner as the total of all share

allocations under the plan (contribution, forfeitures, recycled shares, etc.)

Same manner as released shares were allocated

Based on total stock balance to date

Siblings Becky Jeff Scott

Children of each (cousins) Sean Corey Max

No synthetic equity.

After the sale, the ESOP owns 67%.

Within the ESOP, each cousin is allocated 7% of the deemed owned shares.

Are there any Disqualified Persons?

Family Group - Hypothetical Example

Sean, Corey & Max start and build a company together. No other family members participate.

Becky, Jeff, and Scott are independently wealthy, enjoying the good life traveling among their multiple homesites aligned with the seasons.

Sean, Corey & Max each own 1/3 of the company.Each sells the same % to the ESOP, keeping 11% each outside the ESOP.

Outstanding Shares: 1,600.0 (excluding synthetic equity shares)ESOP Shares: 1,000.0Unallocated Shares: 300.0

Mock AllocDirect ESOP of Unalloc Synthetic

A 500.0 60.0 25.7 150.0B (A's brother) 100.0 30.0 12.9 75.0F (no relation) 0.0 0.0 0.0 40.0Others 0.0 610.0 261.4 0.0

600.0 700.0 300.0 265.0

Hypothetical Testing Example for Nonallocation Year

STEP 1 - Determine DQPsw/o SYN w/o SYNFAM D-O IND D-O

Mock Alloc Shares SharesDirect ESOP of Unalloc Synthetic Percent Percent

A 500.0 60.0 25.7 150.0 12.86% 8.57%B (A's brother) 100.0 30.0 12.9 75.0 12.86% 4.29%F (no relation) 0.0 0.0 0.0 40.0 0.00%Others 0.0 610.0 261.4 0.0

600.0 700.0 300.0 265.0

DQP = None at this point


IND = Individual

D-O = Deemed-Owned FAM = FamilyDQP = Disqualified Person SYN = Synthetic Equity

STEP 1 - Determine DQPsw/SYN w/SYNFAM D-O IND D-O

Mock Alloc Shares SharesDirect ESOP of Unalloc Synthetic Percent Percent

A 500.0 60.0 25.7 150.0 27.95% 18.63%B (A's brother) 100.0 30.0 12.9 75.0 27.95% 9.32%F (no relation) 0.0 0.0 0.0 40.0 3.16%Others 0.0 610.0 261.4 0.0

600.0 700.0 300.0 265.0

DQP = A & B


Mock AllocDirect ESOP of Unalloc Synthetic

A 500.0 60.0 25.7 150.0B (A's brother) 100.0 30.0 12.9 75.0F (no relation) 0.0 0.0 0.0 40.0Others 0.0 610.0 261.4 0.0

600.0 700.0 300.0 265.0

DQP = A & B

STEP 2 - Test for Nonallocation Yearw/o SYN(A+B) 728.6 45.54% O'ship of DQP

1,600.0 Denominator

with/SYN(A+B) 953.6 51.13% O'ship of DQP

1,865.0 Denominator

Testing assumes attribution among DQPs already in the testing group is not required


Applying the S Corp. ESOP Anti-abuse Rules

Questions?

Administration of S Corporation ESOPs

S v. C Distribution Differences

Issues C Corp S CorpDistributions from leveraged ESOPs

Distributions can be delayed until the loan is repaid

It is not clear if the distribution can be delayed until the loan is repaid

Distributions of Stock Participant must generally be permitted to demand a distribution in stock

Stock distributions are not required. If distributions of stock are allowed, the plan must protect itself from violating the 75 shareholder limit and from distributing stock to ineligible shareholders

S v. C Distribution Differences

Issues C Corp S Corp

Determining Cost Basis of Stock

Cost basis IS NOT adjusted for earnings and distributions of earnings

Cost basis is(?) adjusted for earnings and distributions of earnings per an IRS revenue ruling.

It is not clear if the IRS has properly interpreted the law.

S v. C Distribution DifferencesIssues C Corp S Corp

Distribution timing for terminated participants

Decision on timing of distributions generally not impacted by large dividends on company stock.

Decision on timing of distributions can be impacted by significant S-Corp distributions.

Cash-out terminees right away or allow them to keep getting S-Corp distributions.

S v. C: Contribution and Allocation Differences

Limit C Corp S CorpDeductible Contribution Limits

25% of compensation

Contribution used to pay interest on acquisition loan is not counted under this limit

25% of compensation

Includes entire contribution


Limit C Corp S CorpAnnual Additions Lesser of 100% of

compensation or $40,000

If One-Third Test is met, contribution used to pay interest and forfeitures of shares purchased with the acquisition loan are not Annual Additions

Lesser of 100% of compensation or $40,000

One-Third Test does not apply, so all contributions and forfeitures are counted as Annual Additions


Limit C Corp S CorpHaves and Have-nots Generally not an issue Can be a big issue in

mature ESOPs: Earnings distributions allocated based on stock accounts.

Very small allocations to new participants

Primarily Invested in Employer Securities

Generally not an issue Can be an issue in mature ESOPs

S v. C Dividend Differences

Type/Use of Dividend

C Corp S Corp

Dividends (Earnings Distributions) on Allocated Shares

Considered an “applicable dividend” under IRC Section 404(k), eligible for a tax deduction when used to pay debt

Cannot be used to pay debt

Dividends (Earnings Distributions) on Suspense Shares

Considered an “applicable dividend” under IRC Section 404(k), eligible for a tax deduction when used to pay debt

Can be used to pay debt, but not considered an “applicable dividend,” so a deduction is not permitted

S v. C Dividend Differences

Type/Use of Dividend

C Corp S Corp

Dividends Passed-Through

Considered an “applicable dividend,” eligible for a tax deduction and not considered a distribution subject to consent rules and early withdrawal penalties

Not considered an “applicable dividend” and is therefore not deductible and is subject to the regular distribution rules, including early withdrawal penalties

S v. C Other Differences

Issues C Corp S CorpSection 1042 Tax Deferral

Available Not Available

Prohibited Allocation Rules under IRC Section 409(p)

Do not apply Apply – Effective for ESOPs established after 3/14/01 or where the sponsoring corporation makes an S election after 3/14/01.

Otherwise, the rules are effective for plan years beginning after 12/31/04

technical issues: update for s corp esops 18 th annual ohio employee ownership conference april 16,...

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