Fiscal: Tax Facts on S Corporation ESOP's

[Dan Bell <dbell@kent.edu>]

I received this message from John Pimenta. Thought it might be
relevant to those interested in the COG discussion on fiscal
policy and employee ownership.
>
>T A X F A C T S 
> 
>                    Congress has taken 5 years to decide what it wanted 
> 
>                    One reason the tax code is so complicated is that when
>Congress enacts
>                    legislation to accomplish a policy goal, it may take
>several more changes to
>                    arrive at a final "product" that works to Congress's
>liking. For example, it has
>                    taken nearly five years, but it seems that Congress may
>have the rules in
>                    place that it wants regarding S corporations and
>employee stock ownership
>                    plans (ESOPs). 
> 
>                    In 1996, as part of the Small Business Job Protection
>Act of 1996 (SBJPA
>                    '96), Congress allowed certain taxexempt entities,
>including ESOP trusts, to
>                    own the stock of S corporations. Congress's reasoning
>was that prior rules
>                    that did not allow these taxexempt entities to own S
>corporation stock
>                    inhibited employee ownership of closely held
>businesses, as well as
>                    frustrating estate planning, discouraging charitable
>giving, and restricting the
>                    sources of capital for closely held businesses. 
> 
>                    As part of these new rules, the income of the S
>corporation would flow
>                    through to the tax-exempt shareholder, whether a
>pension plan or a charity,
>                    as unrelated business taxable income. UBTI is taxed at
>the regular
>                    corporate income tax rates, which range from 15% to 35%. 
> 
>                    However, the UBTI provision made S corporation ESOPs
>unattractive,
>                    because ESOP participants would now be subject to a
>double tax-first on
>                    the income of the S corporation that passes through to
>the ESOP, and then
>                    again when S corporation stock or cash is distributed
>to the ESOP
>                    participants. This double taxation would defeat one of
>the purposes of an S
>                    corporation election, which is to avoid the double
>taxation on corporate
>                    shareholders. 
> 
>                    Before these provisions of SBJPA '96 took effect,
>however, Congress
>                    enacted new rules exempting S corporation ESOPs from
>these UBTI rules. 
> 
>                    Now it seemed that Congress had what it wanted; but
>soon after these rules
>                    came into effect in 1998, Congress became aware that
>some creative
>                    taxpayers were engaging in "inappropriate deferral and
>tax avoidance in
>                    some cases." This might occur, for example, in a very
>small S corporation
>                    where the only employees, and thus the only
>participants in the ESOP, are
>                    also the historic owners of the business. 
> 
>                    Congress thought that S corporations should encourage
>employee
>                    ownership through an ESOP, but that the tax-deferral
>opportunities of an S
>                    corporation ESOP should be limited to those situations
>where there is
>                    broad-based employee coverage under the ESOP, with the
>ESOP benefiting
>                    both rank-and-file and highly compensated employees. 
> 
>                    Because of these concerns, the tax legislation that was
>recently signed by
>                    President Bush contains provisions to try to ensure
>that ESOPs of S
>                    corporations benefit a wide range of employees. 
> 
>                    The new rules provide penalties if an S corporation
>ESOP is not broadly
>                    based. An S corporation can generally avoid these
>penalties if it does not
>                    have any "disqualified persons." A disqualified person
>is generally either a
>                    member of a family that together owns more than 20%, or
>an individual who
>                    owns more than 10% of the S corporation. If
>disqualified persons, together,
>                    own 50% or more of the company (special rules apply to
>unallocated stock),
>                    these penalties may kick in. 
> 
>                    One penalty provision is that amounts allocated to
>certain owners of the S
>                    corporation will be treated as a distribution, so that
>the amount will be
>                    included in income in the year of the allocation.
>Another penalty provision is
>                    a 50% excise tax imposed on an S corporation for the
>amount it allocates to
>                    an ESOP for disqualified persons. 
> 
>                    One bright spot for those ESOPs of S corporations that
>may be too
>                    concentrated to avoid the penalty provisions is the
>effective date for these
>                    rules. For S corporation ESOPs established before March
>14, 2001, these
>                    new rules are not effective until after 2004. However,
>for ESOPs established
>                    after March 14, 2001, or for a corporation that was not
>an S corporation on
>                    March 14, 2001, the effective date is for tax years
>ending after March
>                    14,2001. 
> 
> 
> 
> 
--
Dan Bell
International Program Coordinator
Ohio Employee Ownership Center
Kent State University
Kent, OH 44242
(330) 672-0333 << Direct number!
(330) 672-3028 general office number
(330) 672-4063 fax
dbell@kent.edu
http://www.kent.edu/oeoc/
http://cog.kent.edu