Legal Issues for S Corporation ESOPs Presented by Mark R. Kossow mkossow@esopplus

1. Legal Issues for S Corporation ESOPs Presented by Mark R. Kossow mkossow@esopplus.com

2. Overview of Topics to be Covered • S qualification, election and other issues • Planning for stock sales to ESOPs • S Corporations partially owned by ESOPs (part-ESOP S corporations) • Miscellaneous

3. S Qualification, Election and Other Issues • Limitations on eligible shareholders and 100 shareholder limit • IRAs, nonresident aliens, corporations, LLCs, partnerships, and many trusts may not own shares • ESOP only counts as one shareholder • ISSUE: Part-ESOP S corporations need to protect eligibility through shareholder agreements.

4. S Qualification, Election and Other Issues • Single class of stock requirement • S corporations may have only one class of stock outstanding • Under the corporation’s governing provisions all outstanding shares must confer identical rights to distributions and liquidation proceeds • Governing provisions include the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements that affect distribution / liquidation proceeds • Differences in voting rights are permissible

5. S Qualification, Election and Other Issues • Single class of stock requirement (cont’d) • ISSUE: Options, warrants, shareholder agreements, etc. can inadvertently create second classes of stock, and must be carefully structured. • Nominal exercise prices on warrants to lenders / selling shareholders may cause warrant to be treated as a disqualifying second class of stock • TEST: Taking into account all facts and circumstances • (A) is the warrant/option substantially certain to be exercised; and • (B) does it have a strike price substantially below fmv of the underlying stock on the issue date.

6. S Qualification, Election and Other Issues • Election Issues • Election may be made any time prior to beginning of tax year • Election may be made within 2 ½ months after start of tax year to be retroactive so long as the corporation is eligible during entire retroactive period • ISSUE: With a retroactive election S status starts as of the beginning of tax year, so it is critical to coordinate the time of any 1042 transaction.

7. S Qualification, Election and Other Issues • Election Issues (cont’d) • The election is not valid unless all shareholders of the corporation at the time of the election consent to the election. • However, once a valid election is made, new shareholders need not consent to that election. • If an election is retroactive to the beginning of the tax year, each person who was a shareholder at ANY time during the portion of that year which occurs before the time the election is made (and who is not a shareholder at the time the election is made) must also consent to the election. • Trustee of the ESOP can consent on behalf of the ESOP • Shareholder consent is binding and may not be wtihdrawn after a valid election is made by the corporation

8. S Qualification, Election and Other Issues • Tax Year Issues • Issue: The S corporation’s tax year must be a calendar year unless: • The corporation establishes a business purpose for a year other than the calendar year • The corporation agrees to make a refundable interest-free deposit with the IRS to eliminate the benefit of any tax deferral • If the ESOP owns 100% of the company and it operates on a fiscal year, the S corporation can adopt the tax year of its principal shareholder.

9. S Qualification, Election and Other Issues • Qualified Subchapter S Subsidiaries (Q Subs) • Must be 100% owned subsidiary • Must elect S status for QSUB • QSUB treated as a disregarded entity (tax treatment of the QSUB is ultimately passed through to the shareholders of the parent S corporation)

10. S Qualification, Election and Other Issues • Distributions • S corporations having no earnings and profits • The distribution is first applied against basis • If amount of distribution exceeds the adjusted basis of the stock, excess shall be treated as a capital gain

11. S Qualification, Election and Other Issues • Distributions (cont’d) • S corporation having E&P • Portion of distribution that does not exceed AAA is tax free • Portion of distribution that exceeds AAA shall be treated as a dividend to the extent it does not exceed E&P • Remainder shall be treated as return on basis and any excess over basis shall receive capital gains treatment. • NOTE: company can make an election to distribute E&P first. • Requires the consent of all affected shareholders

12. S Qualification, Election and Other Issues • Termination of S status • Revocation – an election may be revoked only if shareholders holding more than ½ of the shares of stock on the day on which the revocation is made consent to the revocation. • Revocation made during the taxable year and on or before the 15th day of the 3rd month shall be effective retroactively to beginning of the tax year • If revocation does not specify a prospective revocation date and the revocation is made after the 15th day of the 3rd month, the revocation shall be effective on the 1st day of the following tax year. If revocation specifies a prospective revocation date, the revocation is effective on such date.

13. S Qualification, Election and Other Issues • Termination of S status • By corporation ceasing to be a small business corporation • Such termination shall be effective as of the date in which the event occurs. • Termination by reason of excess passive investment income • Termination occurs if the company has for 3 consecutive years passive investment income in excess of 25% of gross receipts. • Termination is effective on the first day of the first taxable year following the third consecutive year in which the company had excess passive investment income. • Only applies to S corporations that used to be C corporations.

14. C Corporations that Become S Corporations • ISSUE: Built-In Gains (BIG) Tax • Exposure to corporate level tax on net realized built in gains for 5 years after S election • Appraising assets at the time of election helps manage this tax • Accounts Receivable – (accrual method rule) cash basis corporation subject to BIG tax on collections after conversion.

15. C Corporations that Become S Corporations • Presence of C corporation E&P raises issues • ISSUE: potential taxable dividends if distributions exceed AAA • AAA generally reflects the aggregate, undistributed taxable income or loss of the S corporation for the continuous period during which its S election has been in effect. • (i.e. previously taxed S corporation earnings) • Must monitor distributions to ensure that taxable dividends are not inadvertently paid.

16. C Corporations that Become S Corporations • ISSUE: LIFO recapture tax – a C corporation that uses LIFO inventory accounting and makes an S election is taxed on its LIFO recapture amount • LIFO recapture amount is the amount by which inventory computed on the FIFO method exceeds inventory computed on the LIFO method • Tax is computed on last C return and is paid in four equal installments, which are due on or before the due dates for the tax returns for that year and the next three years.

17. Planning for Stock Sales to ESOPs • Income Tax Deferral • 100% ESOP owned S corporation has significant tax saving opportunities. • If corporation makes an S election there will be no federal tax on its annual income (most states mirror this provision). • Although income will be passed through to the shareholder (the ESOP), no shareholder level tax will be imposed because the ESOP is a tax-exempt entity. • The income tax liability will effectively be deferred until the participants in the ESOP receive their benefits.

18. Planning for Stock Sales to ESOPs • Income Tax Deferral (cont’d) • Company has shareholders in addition to ESOP • Tax savings will still be available by making S election, but S election may have a neutral impact on the corporation’s cash flow. • Reason, in most cases, S corporation shareholders must withdraw sufficient funds to cover payment of their taxes on the passed through corporate income. • Example, S corp. sponsors ESOP that owns only 30% of company and taxable income for 2010 was $1 million. Non ESOP shareholder will have income allocation of $700,000 which will impose federal tax liability of $245,000. The corporation will also be required to distribute $105,000 to the ESOP. After distributions, the company will have $650,000 in retained earning. However, if the corporation was a C corporation, its tax liability would be $350,000 and would also have retained earnings of $650,000. • Companies that are expanding and have a need for cash to fund future expansion may not benefit from a partially ESOP owned company.

19. Planning for Stock Sales to ESOPs • ISSUE: Capacity of a leveraged ESOP to carry purchase debt • With a C corporation 404 limits contributions for principal payments on ESOP debt, but deductions for contributions used to pay interest are not limited • The provision for unlimited contributions to pay interest does not apply to S corporations, and, because contributions for both principal and interest payments count toward the 404 limitation, the amount of debt service an S corporation’s payroll can support will be less than if it were a C corporation

20. Planning for Stock Sales to ESOPs • 415 annual addition limits issue • Generally, 415 limit is the lesser of (a) 100% of participants compensation and (b) $49,000. Includes employer contributions, employee contributions and forfeitures. • For C corporations only – if no more than 1/3 of the employer contributions to the ESOP which are used to pay down an ESOP loan are allocated to the accounts of HCEs, then the general 415 rules do not apply with respect to annual additions attributable to forfeitures of shares and interest payments on an exempt loan. • This rule does not apply to S corporations and therefore may limit the capacity of an ESOP to carry debt.

21. Planning for Stock Sales to ESOPs • Stock Redemption Transactions in S corporation ESOP companies • Helps obtain capital gain / installment sale treatment for owners of non-1042 transactions • ISSUE: Need to ensure that the redemption qualifies under 302 as a sale of exchange and not a 301 dividend • Reduces value of corporation and stock for sale to ESOP • Seller Financing (with warrants attached) permit sellers to participate in future growth

22. Planning for Stock Sales to ESOPs • S corporation becomes C corporation because owners want 1042 treatment (intending to eventually convert back to S status) • ISSUE: Will 1042 transaction qualify? • Shares sold to ESOP must be qualified employer securities • 3 year holding period • 30% rule – immediately after the sale, ESOP must own at least 30% of each class of outstanding stock or at least 30% of the total value of all outstanding stock • Conversion to C corporation my block S status for 5 years • Built-In Gains (BIG) tax exposure upon later S election

23. Part ESOP S Corporations • ISSUE: Tax funding needs of non ESOP shareholders may require distributions, which also must be made to the ESOP, potentially skewing allocations between younger and older employees and former participants.

24. Part ESOP S Corporations • Use of S corporation distributions to make loan payments • Allocated Shares – participant shall receive an allocation of Company Stock for the Plan Year from the Company Stock released from the Unallocated Stock Suspense Account as a result of all S Corporation Distributions for the Plan Year having a fair market value at least equal to the value of the S Corporation Distribution credited to the Participant’s Account. • Unallocated Shares - Company Stock to be allocated as a consequence of repayment of an outstanding Acquisition Loan by S Corporation Distributions on unallocated shares shall be allocated in the same manner as Company Contributions. • ESOP loan documents and / or ESOP plan document may prohibit using S corporation distributions on allocated shares to make loan payments.

25. Miscellaneous • ESOP Distribution Rules • Generally, participants in an ESOP are entitled to demand their benefits be distributed in the form of stock. • This general rule raises issue of involuntary termination of S election (e.g. rollover to IRA would terminate S election and exceeding 100 shareholder rule) • The 1997 Tax Act resolved this problem. This act permits an S corporation to require the participants to take their benefits in cash (or in the form of stock, subject to a mandatory put).

26. Miscellaneous • Anti abuse rule for S corporation ESOPs • The economic growth and tax reconciliation act of 2001 (EGTRRA) contained some changes in tax law that were designed to eliminate two perceived abuses of S corporation ESOPs • First abuse arises when ESOP has only one or a few employees (example, a highly paid professional might defer taxes indefinitely by forming an S corp and transferring all of his stock to an ESOP). This use of an ESOP is against public policy of promoting broad based employee ownership. • Second abuse involves a “tax holiday” for newly formed enterprises in which executives and outside investors hold stock options (and other forms of equity interests) that over time will substantially dilute the ESOP’s ownership. The equity interests of the executives could be designed to defer their recognition of income over a period of years, during which time all of the corporate earnings would be reported by the ESOP and thereby escape taxation during this period (the tax holiday). If the ESOP will be substantially diluted after the stock options are exercised, the ESOP will have served only to avoid taxes and not to promote broad based employee ownership.

27. Miscellaneous • Anti abuse rule for S corporation ESOPs (cont’d) • The anti abuse rules under EGTRRA (as set forth in Code Section 409(p)) are designed to eliminate these two abuses described earlier. • Under 409(p), an ESOP that holds shares of an S corporation is prohibited from allocating or accruing employer securities to disqualified persons during any nonallocation year (which is defined as a year in which disqualified persons own at least 50% of the outstanding shares of the company). • Violation of this rule has devastating effects

28. Questions ? Mark R. Kossow Schatz Brown Glassman Kossow LLP 250 Mill Street; Suite 309-311 Rochester, New York 14614 585-512-3414 x 8121 mkossow@esopplus.com