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    ESOP Companies: Should You Elect S Corporation Status?

    This question is largely part a mirror question to our companion article, "Should Your S Corporation Adopt An ESOP?" (Please see link right). As far as the impact on employee benefit planning, cash flow planning and ESOP planning goes, the considerations are the same as stated in that article. The larger the percentage of company stock that is owned by the ESOP, the more compelling it is to consider S corporation status. However, there are a number of issues that are outside of the employee benefits arena which affect this consideration. This article briefly covers those concerns. They fall into two categories:

    • S corporation tax rules.
    • Corporate/structural issues. 

    Subchapter S Details

    The first subchapter S conversion issue relates to "built in gain" on corporate assets. The appreciation of corporate assets and the depreciation taken on corporate assets is what makes up built in gain. At the date of an S corporation election, the built in gain must be quantified. A corporate level tax is imposed on this built in gain measured at the date of conversion from C to S status, if the gain is "recognized" due to sale of the company's assets, within ten years of the conversion to subchapter S status. Therefore, corporations considering a complete sale to a third party, or a disposition of certain assets of the corporation which make up the built in gain, would not benefit from the subchapter S election to that extent if the event occurs within ten years of the conversion.

    Corporations that earn more than 25% of their gross receipts from "passive investment income" may be subject to an additional S corporation tax after conversion. If an S corporation has earnings and profits from when it was a C corporation, a tax will be imposed on the corporation's excess net passive investment income. Also, if the 25% limit on net passive investment income continues for three consecutive years, and the corporation still had earnings and profits left over from being a C corporation at the end of those three years, the corporation's S status will be terminated.

    Any corporations that are accounting for inventory on the last-in-first-out (LIFO) method must include in income for its last year as a C corporation on the difference between the inventory on a LIFO basis and on a FIFO (first-in-first-out) basis. The resulting additional tax for this LIFO-FIFO adjustment must be paid in equal installments over a four-year period.

    Certain tax attributes from being a C corporation, such as net operating losses, capital loss carryovers, and minimum tax credits are not permitted to be carried over from C corporation status by an S corporation. If a company is just becoming profitable, any net operating loss will be lost if the corporation elects subchapter S status. Also, alternative minimum tax credit carryforwards, which may be due, for example, from dividends deducted under Code section 404(k) on payments on ESOP shares, would also be lost. Therefore, it is better to use up the operating losses and credit carryforwards as a C corporation before converting to subchapter S status.

    One attractive aspect of S corporation status is that the S corporation can avoid what is called "accumulated earnings tax" problems because it is not subject to the accumulated earnings tax. Therefore, if the corporation is, for example, a 100% ESOP owned company, it may accumulate cash in the corporation without being subject to this C corporation penalty tax. However, a C corporation that elects S corporation status may wish to distribute any C corporation earnings and profits during the first two-and-one-half months of its initial S corporation tax year to obtain a dividends paid deduction and thus limit or avoid the accumulated earnings tax for its final year as a C corporation.

    The Corporate Structure

    ESOP companies who want to convert to subchapter S status must also take care of corporate structural issues on or before the conversion date. For example, if the ESOP was capitalized with more than one class of stock, the second class of stock must be eliminated to elect subchapter S status. It was not uncommon for corporations to use preferred classes of stock in ESOP transactions for the sake of deductible dividends used to fund those transactions. An S corporation must have only one class of stock. In these situations, ESOP fiduciaries will face two fiduciary issues:

    • First, the issue of whether to convert the preferred shares to common stock under the terms of the agreements in place and the value of the relative classes of stock; and
    • Second, whether to consent to the subchapter S election. It may be the case that under ERISA, the ESOP fiduciaries should bargain for special consideration to make the conversion most advantageous for the participants, where the difference in value between the classes of preferred and common have not worked themselves out at the date of the conversion.

    In short, ESOP fiduciaries should not assume that they should necessarily convert the shares or elect subchapter S status. Financial due diligence is required to support such a decision. This financial due diligence might also include commitments from the corporation on how it is going to manage cash flows and the purported tax advantages of being an S corporation.

    A corporation should also consider the effect of the increase of individual income tax rates on corporate cash flow prior to electing subchapter S status. For example, if a corporation is paying federal income taxes at the rate of 34% and the shareholder's individual tax rate is 40%, the conversion to subchapter S status would require an additional 6% cash flow cost to the corporation to make distributions to permit shareholders to pay their share of income taxes on S corporation income. If the S corporation is in a high tax rate state like California, there would be a deduction for state taxes paid, but the additional cash flow cost still would be in the 5% to 6% range. This has to be balanced against the cash flow strategies regarding those funds distributed to the ESOP that it does not use to pay taxes. 

    On the positive side, conversion to S corporation status will permit those shareholders who do not sell their shares to the ESOP immediately, to start accumulating basis in their shares as S corporation shareholders, due to the tax treatment of earnings each year. This would reduce or contain their future taxable gain if and when they sell their stock, (please see Chart 1). As you can imagine, the most compelling situation for S corporation conversion exists where an ESOP is approaching total ownership of the corporation and a selling shareholder can sell the remainder of his shares, using Code section 1042 to defer the gain, and permit the ESOP to elect subchapter S status once it owns 100% of the company. 


    Chart 1. 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 10 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.

    Annual Operating Results

    C Corporation

    S Corporation

    Taxable Income



    Corporate Tax



    Shareholder Tax



    Difference In Cash Flow



    Addition To Stock Basis



    Sale In Year 10 @ Fair Market Value



    Shareholder's Basis



    Gain On Sale



    Capital Gain Tax



    Tax Savings On S Corporation



    Less 10 Years Higher Tax/Cash Flow


    Difference On Operating Income



    Net After Tax Savings




    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. 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.