In light of the changes arising from the recent Tax Cuts and Jobs Act, businesses have spent significant time and resources evaluating whether their current organization structure is the right one from a tax perspective. Whether a company is considering an employee stock ownership plan (ESOP) transaction or is already owned by an ESOP, the choice between a C corporation and S corporation runs deeper than currently enacted tax rates.
The differences between the two entity types arise as early as the initial sale to an ESOP. C corp stockholders who sell their stock to an ESOP can defer (or potentially eliminate) the gain on the sale of their stock under Section 1042 of the Internal Revenue Code (IRC). There are several requirements to qualify for this treatment. For example, the ESOP must own at least 30 percent of the company post transaction, and the selling stockholder must reinvest the proceeds in qualified replacement property within 12 months of the date of sale.
This tax deferral strategy has lost some of its popularity due to the current low capital gain rates and is not an option for S corp shareholders who sell their stock to an ESOP. S corp shareholders can terminate their S status to qualify. If a company chooses to terminate its S election, it must wait five tax periods before choosing to re-elect S corp status. As we’ll explore below, this decision shouldn’t be taken lightly, as other factors of the C corp vs S corp decision could outweigh the benefit of a current tax-deferral strategy.
Current Earnings of the Company
The most widely known advantage of a 100 percent S corp ESOP is that it generally doesn’t pay federal income tax and most state income taxes. This results from the flow-through structure of S corps, which are generally not taxable at the entity level regardless of whether they’re owned by an ESOP. Income flows through to the owner who pays the tax. Since the owner in this case is a tax-exempt retirement plan trust, it’s not subject to income tax. However, a C corp doesn’t have the same flow-through status, meaning that the earnings from the company are subject to income tax at the entity level.
There are times an S corp ESOP may pay federal taxes. For example, if an existing C corp elects to become an S corp, it can be subject to a built-in gains tax in the first five years after converting. This tax is triggered when the company recognizes a gain during that five-year window on an asset it held at the time of its S conversion. The asset’s fair market value must have exceeded its net tax basis on the day of the S corp conversion.
In addition, an S corp cannot use the last in, first out (LIFO) method to value its inventory. If a C corp is using LIFO when it elects S status, a one-time tax is calculated and paid in four installments, three of which fall during the time the company is an S corp.
Dividends & Distributions Paid from Company
Applicable dividends paid from a C corp to its ESOP shareholder can be tax deductible if the funds are used to repay an ESOP acquisition loan or paid to participants (either directly to the participants or paid to the ESOP and distributed in cash to participants within 90 days after the end of the plan year). In contrast, distributions from S corps are not tax deductible by the company. Often a 100 percent ESOP-owned S corp will not make distributions, but if an S corp company is only partially owned by an ESOP, non-ESOP owners expect to receive distributions to pay their tax liabilities related to the taxable income of the company. Special care should be taken when making these tax distributions, since distributions to S owners must be pro-rata.
Contributions to the Plan
Contributions to the ESOP are deductible by the company, subject to compliance with IRC §404 limitations. Generally, contributions cannot exceed 25 percent of total compensation paid to all eligible participants. For C corps, ESOP contributions to repay the principal portion of any exempt loan are limited to 25 percent of compensation. Contributions by a C corp to repay the interest portion of the exempt loan do not count against the 25 percent limitation. For S corps, contributions used to repay principal and interest are considered in the 25 percent limit. For C corps, if the employer is sponsoring another qualified plan, i.e., a 401(k) or profit-sharing plan, the total maximum contributions may not exceed 25 percent. In addition, the employer may contribute an additional 25 percent to the ESOP, provided the contribution is used solely to repay principal on the exempt loan, plus interest. For S corps, contributions to other qualified plans, plus contribution to the ESOP (including contributions used to repay principal and interest on the exempt loan), may not exceed 25 percent of eligible compensation on a combined basis.
Allocations to Participants
The IRC places limits on benefit amounts that may be allocated to any individual participant in a defined contribution plan under §415. Similar to other retirement plans, the “annual additions,” or amount that can be allocated to each participant account, is limited to certain thresholds set by the IRS. Plans sponsored by both types of corporations must comply with these limitations, but a special rule exists for C corps. This rule allows contributions used to pay the interest portion of an exempt loan as well as the current market value of shares forfeited, which were purchased with the proceeds of an exempt loan, to be excluded from the annual additions amount if the plan does not favor highly compensated employees. The plan must meet the requirement that no more than one-third of the contributions used to repay interest and principal on the exempt loan be allocated to highly compensated employees. This special rule may allow a larger accrual of annual benefits for C corp ESOP participants.
IRC §409(p) Anti-Abuse Rules
Tax law includes anti-abuse provisions (Abuse Laws) for S corp ESOPs under IRC §409(p). The Abuse Laws are complex but should be carefully considered. To simplify, if a group of individual shareholders, each owning more than 10 percent of a company—including ownership through the ESOP, deferred compensation arrangements, incentive stock options, etc.—exceed in total 50 percent of company ownership, severe penalties apply, negating the benefit of the company’s S corp status and potentially jeopardizing the company’s ability to continue. It’s important the company closely monitors compliance with the Abuse Laws to avoid potential issues.
C corp ESOPs do not have similar anti-abuse provisions.
Distributions to Participants
To be eligible for S corp status, a company may have no more than 100 shareholders. The ESOP trust is counted as a single shareholder. In addition, eligible shareholder types are limited. For example, S corp stock may not be held in an IRA. To maintain S status, an S corp ESOP can include in its plan documents a provision requiring that distributions must be paid in cash. C corp participants have the option to take distributions in the form of stock.
While not an inherent difference between S and C corp-sponsored ESOPs, a participant’s taxation differs when stock is distributed from the plan versus cash. When a participant takes a cash distribution from the plan, the distributions are taxed to the participant as ordinary income. However, there is an exception when a distribution is made in stock and includes “net unrealized appreciation.” Under this exception, part of the ESOP distribution may be eligible for capital gain treatment. The difference between the fair market value and the cost basis at the time of distribution is taxed at long-term capital gains rates. The ESOP’s basis in the stock is taxed as ordinary income. When the participant sells the stock, the difference between the fair market value at the time of sale, less the ESOP’s cost basis, is taxed capital gain. The portion of the appreciation attributable to the period the shares were held by the ESOP is taxed as long-term capital gains (or loss), regardless of how long the ESOP actually held the shares before distributing them. The portion of the appreciation attributable to the period the shares were held by the participant is taxed as short-term or long-term capital gains (or loss), depending on the length of the period between the ESOP distribution date and the date the shares are sold.
As you can see, differences abound between ESOPs sponsored by the two entity types—and this is merely a summary. To learn more, reach out to your BKD trusted advisor or use the Contact Us form below.