By Brian Khorsand
Corporations in the U.S. are generally taxed at the corporate level unless they make an election with the IRS to be taxed at the shareholder level, known as an S Corporation. Corporations that do not make this election are by default taxed as a C Corporation. S Corporations only can issue one class of stock and can have no more than 100 shareholders. In addition, only individuals, certain trusts (ESOPs included), and estates can be shareholders of S Corporations (partnerships or corporations cannot be shareholders).
S Corporations are considered pass-through entities for federal income tax purposes, meaning that the taxable earnings of the entity are attributed on a pro-rata basis and taxed at the shareholder level. Companies with this structure often distribute enough of the earnings for the shareholders to cover their tax liability. Since each shareholder may have a different personal tax situation, a distribution level near the top marginal federal and state income tax rates is typical. For example, if a shareholder owns 80 percent of an S-Corporation with taxable income of $1.0 million, they will receive a form (Schedule K-1) after the end of the year showing $800,000 of income in their name. Assuming the board of directors of the company decides to distribute 40 percent of earnings, the shareholder would receive a cash distribution of $320,000 (also reported on the K-1).
Where an employee stock ownership plan (ESOP) is an owner of a corporation, the plan assets are held in trust for the benefit of the plan participants. As a shareholder of an S Corporation, the ESOP trust (considered one shareholder) is attributed its proportionate amount of the taxable income of the company. In the example above, if the ESOP trust were to own the remaining 20 percent of the shares, it would receive a schedule showing income of $200,000 and would receive a cash distribution of $80,000. Under U.S. tax law, the income attributed to the ESOP trust is exempt from federal income tax (most states follow the same rule). Since it does not owe any tax on its earnings, the trust can use the $80,000 it receives for other purposes such as benefit payments or to purchase additional stock in the sponsor company.
Like any ESOP company, these firms must properly plan for the benefit payments (also known as the repurchase liability) that need to be made when employees leave or retire from the company. Depending on the circumstances, the cash flow savings may in fact outweigh the repurchase liability over time. S Corporations with ESOPs also face additional regulatory guidelines (Section 409(p) designed to ensure that the bulk of the benefit is not going to just a few employees. There are many other considerations and each issue may involve seeking the advice of legal and tax professionals.
There are some S Corporations seeking to attain 100 percent ESOP status, either through a one-time sale or incrementally, in order to take advantage of the tremendous benefit it affords. With all the stock of the company owned by the ESOP, the company no longer needs to make tax distributions and the additional cash flow can enable greater capital investment in new products or facilities. It can allow a company to become more competitive on price in order to gain market share in their industry or perhaps be used for acquisitions. The possibilities are endless. When structured and maintained properly, the 100 percent ESOP-owned S Corporation can be a powerful force of employee ownership.Go Back