How about an ESOP with that S corporation?

Most bankers are well-acquainted with the relative advantages of the S corporation tax status because either their bank or bank holding company has elected S status or they have customers utilizing S status. Generally, an S corporation is not subject to federal income tax; instead, its shareholders are subject to personal income tax on their proportionate shares of the S corporation's taxable income. Consequently, S status often affords lower overall income tax costs for a business and its owners since distributions of the corporation's profits are generally not "double-taxed" as they are with C corporations.

Reducing tax through ESOPs

Many bankers, however, are not as familiar with employee stock ownership plans, or ESOPs, and how they can be utilized to further reduce tax costs and build equity capital for an S corporation. An ESOP is a qualified retirement plan for the benefit of employees that invests primarily in employer stock. Like other qualified plans, ESOPs are generally exempt from income tax. ESOPs also provide other special benefits because of Congress' desire to encourage employee ownership, loyalty and productivity.
 

Most importantly to S corporations, tax provisions unique to ESOPs cause S corporation income allocated to an ESOP to escape current taxation. The income tax is essentially deferred until the ESOP makes distributions to employees.

Example

Assume an ESOP owns 20 percent of an S corporation and the S corporation has current year taxable income of $1 million. While the $800,000 allocated to non-ESOP shareholders will be subject to income tax, the ESOP's share of $200,000 is exempt from current tax. 
 

S corporations normally distribute "tax-free" dividends to shareholders in an amount sufficient to pay the federal and state income taxes on their respective shares of the S corporation's income. If the S corporation in this example distributes 40 percent of its earnings to help cover the shareholders' taxes, the ESOP receives cash of $80,000 that is available to buy additional stock of the S corporation on behalf of the plan participants. This provides an important potential source of liquidity for the S corporation's stock.

Complex rules to follow

The favored tax status of ESOPs carries complicated rules designed to prevent abuses by overly aggressive taxpayers. For example, strict valuation guidelines must be followed to ensure stock is purchased and sold by the ESOP at fair market value. In addition, any employee who is a "disqualified person"-generally a person who owns 10 percent or more or, collectively with other family members, owns 20 percent or more "deemed-owned" shares of the S corporation ("deemed-owned" shares take into account only the stock treated as owned through the ESOP and other shares the employee can acquire in the future under certain stock arrangements)-can't accrue any benefits under the ESOP in a year in which he or she owns 50 percent or more of the S corporation's total outstanding shares, taking into account shares directly owned, deemed-owned shares and shares allocated through tax attribution rules. This limitation can prevent some shareholder-employees from becoming ESOP participants.

Having an ESOP as a shareholder of an S corporation involves many complex fiduciary and income tax issues. S corporation banks and bank holding companies must navigate regulatory issues, as well. Still, profitable S corporations that wish to provide ownership benefits to employees should consider whether the advantages of ESOP ownership outweigh the complications.

For more information on ESOPs, contact a local Eide Bailly professional.