The Twists And Turns Of S Corporation ESOPs
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One reason the tax code is so complicated is that when Congress enacts legislation to accomplish a policy goal, it may take several more changes to arrive at a final "product" that works to Congresss liking. For example, it has taken nearly five years, but it seems that Congress may have the rules in place that it wants regarding S corporations and employee stock ownership plans (ESOPs).
In 1996, as part of the Small Business Job Protection Act of 1996 (SBJPA 96), Congress allowed certain tax-exempt entities, including ESOP trusts, to own the stock of S corporations. Congresss reasoning was that prior rules that did not allow these tax-exempt entities to own S corporation stock inhibited employee ownership of closely held businesses, as well as frustrating estate planning, discouraging charitable giving, and restricting the sources of capital for closely held businesses.
As part of these new rules, the income of the S corporation would flow through to the tax-exempt shareholder, whether a pension plan or a charity, as unrelated business taxable income. UBTI is taxed at the regular corporate income tax rates, which range from 15% to 35%.
However, the UBTI provision made S corporation ESOPs unattractive, because ESOP participants would now be subject to a double tax–first on the income of the S corporation that passes through to the ESOP, and then again when S corporation stock or cash is distributed to the ESOP participants. This double taxation would defeat one of the purposes of an S corporation election, which is to avoid the double taxation on corporate shareholders.
Before these provisions of SBJPA 96 took effect, however, Congress enacted new rules exempting S corporation ESOPs from these UBTI rules.
Now it seemed that Congress had what it wanted; but soon after these rules came into effect in 1998, Congress became aware that some creative taxpayers were engaging in "inappropriate deferral and tax avoidance in some cases." This might occur, for example, in a very small S corporation where the only employees, and thus the only participants in the ESOP, are also the historic owners of the business.
