Technical Issues: Update for S Corp ESOPs

Transcription

1 Technical Issues: Update for S Corp ESOPs Helen H. Morrison Principal, Deloitte Becky Hoffman Principal Group Hugh Reynolds Crowe Chizek and Company LLC 18 th Annual Ohio Employee Ownership Conference April 16, 2004 Akron, Ohio Tim Jochim Jochim Co., LPA

2 What is an S Corp? How does it differ from a C Corp? C Corporation Corporation under state law Separately taxable entity Shareholders subject to tax on dividend payments (now 15% tax for eligible dividends) S Corporation Corporation under state law Pass through entity Nature of income (for losses and expenses) retains its character in hands of shareholder)

3 What are the Advantages of S Corp over C Corp Status? No double taxation Increase in stock basis Tax free distributions Capital gain retains its character Individual use of corporate earnings or losses Sale of appreciated asset without double tax; Sale of business as asset sale Exception: built-in gain tax Sale of asset within 10 years of making the S corp election Estate planning advantages Highest corporate tax and individual tax rate are the same

4 Tax Model of Operations C Corp S Corp Tax on Corporate Earnings Net Income From Operations 50,000,000 50,000,000 Effective Corporate Tax Rate 35.00% n/a Effective Individual Tax Rate n/a 35.0% Corporate Taxes 17,500,000 17,500,000 Taxation of Discretionary Distribution Discretionary Distribution 10,000,000 10,000,000 Effective Individual Tax Rate on Distribution 15.0% n/a Tax Paid on Receipt of Distribution 1,500,000 - Total Taxes Paid 19,000,000 17,500,000

5 Stock Sale Tax Model C Corp S Corp Individual Level Taxation Cash Received For Stock 400,000, ,000,000 Less: Tax Basis From Initial Investment (1,000,000) (1,000,000) Less: Tax Basis Increases From Undistributed Earnings - (200,000,000) Equals Gain on Sale of Stock (A) 399,000, ,000,000 Individual Effective Tax Rate on Gain 15.0% 15.0% Individual Level Tax on Gain (B) 59,850,000 29,850,000 After-tax Cash Flow (A) - (B) 340,150, ,150,000 Increase in Cash From S Corp Conversion 30,000,000

6 Add the ESOP Tax Benefit ESOP is a exempt from income tax Under special rule also exempt from unrelated business tax (UBIT) Seems too good to be true - where is the catch?

7 S Corporation Requirements Limit of 75 shareholders ESOP is a single shareholder Shareholders may only be individuals, estates and certain trusts No partnerships Shareholders may not be nonresident aliens Beware of community property states

8 S Corporation Requirements (cont) Only one class of stock allowed Debt ok, provided satisfies safe harbor or general test Stock options, warrant ok, provided exercise price is at least 90% of fair market value Phantom stock, SARs, nonqualified deferred compensation ok, provided reasonable compensation Benefits allocation issue for less than 100% ESOP IRC section 409(p) issue Fringe benefit limitation for 2% or more shareholder Shareholders must file state returns in every state of operation Composite return mitigates this requirement Recognition of income regardless of distribution

9 Requirements to Convert to S Corporation Status Valid election must be filed within 2½ months of the effective date of the election Form 2553 filing 100% of the outstanding shareholders (including a spouse in a community property state) must sign a consent LIFO reserve recapture over four years Calendar year, unless 100% ESOP in which case can use ESOP plan year

10 Unique S Corporation ESOP Issues Going from C to S to C IRS permission required in first five after S termination. IRC 1362(g) Possible solution: Minnow swallows whale merger Two Classes of Stock Voting and nonvoting permitted

11 Compliance and Practical Issues Built-in Gains tax issues and planning techniques Federal and State S Election / QSub Election Requirements Tax Distributions to Outside Shareholders / Composite State Individual Returns

12 Compliance and Practical Issues State Treatment of S Corporations Varies Widely S Corporation Recognition QSub Treatment Built-in Gain Treatment Composite Individual Return Requirements Nonresident Withholding Requirements

13 The S Corp. ESOP Anti-abuse Rules The Reason Behind the Madness Preventing abusive arrangements Establish testing method to determine good ESOPs Broad-based employee ownership is crucial to being considered a good ESOP Some good ESOPs will be unfairly classified as abusive

14 Anti-Abuse Rules Effective Dates Code Section 409(p): Was effective on enactment as to S Corporation ESOPs established on or after March 14, 2001 As to S Corporation ESOPs in existence prior to March 14, 2001, effective for the first plan year beginning after December 31, 2004

15 Anti-Abuse Rules Effective Dates Temporary Regulations: Effective for plan years ending after October 20, 2003 (i.e., effective as of January 1, 2003, for a calendar year plan) NQDC distributed by July 21, 2004 will not be considered Synthetic Equity

16 Anti-Abuse Rules Defined Terms Deemed-Owned Shares Allocated ESOP shares Pro rata portion of shares in the ESOP loan suspense account Synthetic Equity

17 Anti-Abuse Rules Defined Terms Synthetic Equity Stock option, warrant, restricted stock, deferred issuance stock right, similar interest or right that gives the holder the right to acquire or receive stock Stock Appreciation Right (SAR) or similar right to a future cash payment based on the value of stock or appreciation in value Nonqualified deferred compensation Right to acquire interests in certain related entities

18 Anti-Abuse Rules Defined Terms A Disqualified Person is a person who: 1. owns 10% or more of all of the Deemed- Owned Shares of a corporation, 2. is a member of a Family that owns 20% or more of the Deemed-Owned Shares of the corporation, or 3. [has Deemed-Owned Shares and] is a Family member of an individual who is a Disqualified Person under the 20% Family rule above

19 Anti-Abuse Rules Defined Terms Family is defined broadly to include: 1. the spouse of the individual, 2. an ancestor or lineal descendant of the individual or the individual s spouse, 3. a brother or sister of the individual or the individual s spouse and any lineal descendant of the brother or sister, and 4. the spouse of any individual in two or three above Don t forget to ask about living ancestors who are not reported because they don t have any ownership themselves.

20 Anti-Abuse Rules Defined Terms Nonallocation Year Disqualified Persons own at least 50% of stock in S corporation at any time during the plan year Ownership includes Deemed-Owned Shares and direct ownership Attribution rules apply here

21 Prohibited Allocation No portion of the assets of the plan attributable to (or allocable in lieu of) the company stock may accrue for the benefit of any Disqualified Person during a Nonallocation Year.

22 Effect of Nonallocation Year If there is a Nonallocation Year, then: The value of any prohibited allocation is taxed to the Disqualified Person A 50% excise tax is imposed on the amount of the prohibited allocation A 50% excise tax is imposed on Synthetic Equity of Disqualified Persons

23 First Nonallocation Year Rule In the first Nonallocation Year the excise tax is 50% of the total value of the Deemed-Owned Shares of all Disqualified Persons

24 How is Synthetic Equity Applied in the Testing? Prior to temporary and proposed regulations we took a conservative approach, only using the Synthetic Equity of the individual or group being tested in the denominator. The temporary and proposed regulations clarified the mechanics of including Synthetic Equity in the testing. The Disqualified Person test and the Nonallocation Year test are tested by including no Synthetic Equity and again by including ALL synthetic equity.

25 How are unallocated shares attributed to participants? In the same proportions as the most recent stock allocation under the plan Same manner as the total of all share allocations under the plan (contribution, forfeitures, recycled shares, etc.) Same manner as released shares were allocated Based on total stock balance to date

26 Siblings Becky Jeff Scott Family Group - Hypothetical Example Children of each (cousins) Sean Corey Max Becky, Jeff, and Scott are independently wealthy, enjoying the good life traveling among their multiple homesites aligned with the seasons. Sean, Corey & Max start and build a company together. No other family members participate. Sean, Corey & Max each own 1/3 of the company. Each sells the same % to the ESOP, keeping 11% each outside the ESOP. After the sale, the ESOP owns 67%. Within the ESOP, each cousin is allocated 7% of the deemed owned shares. No synthetic equity. Are there any Disqualified Persons?

27 Hypothetical Testing Example for Nonallocation Year Outstanding Shares: 1,600.0 (excluding synthetic equity shares) ESOP Shares: 1,000.0 Unallocated Shares: Mock Alloc Direct ESOP of Unalloc Synthetic A B (A's brother) F (no relation) Others

28 Hypothetical Testing Example for Nonallocation Year STEP 1 - Determine DQPs w/o SYN w/o SYN FAM D-O IND D-O Mock Alloc Shares Shares Direct ESOP of Unalloc Synthetic Percent Percent A % 8.57% B (A's brother) % 4.29% F (no relation) % Others DQP = None at this point D-O = Deemed-Owned DQP = Disqualified Person IND = Individual FAM = Family SYN = Synthetic Equity

29 Hypothetical Testing Example for Nonallocation Year STEP 1 - Determine DQPs w/syn w/syn FAM D-O IND D-O Mock Alloc Shares Shares Direct ESOP of Unalloc Synthetic Percent Percent A % 18.63% B (A's brother) % 9.32% F (no relation) % Others DQP = A & B

30 Mock Alloc Direct ESOP of Unalloc Synthetic A B (A's brother) F (no relation) Others DQP = A & B Hypothetical Testing Example for Nonallocation Year STEP 2 - Test for Nonallocation Year w/o SYN (A+B) % O'ship of DQP 1,600.0 Denominator with/syn (A+B) % O'ship of DQP 1,865.0 Denominator Testing assumes attribution among DQPs already in the testing group is not required

31 Applying the S Corp. ESOP Anti-abuse Rules Questions?

32 Administration of S Corporation ESOPs

33 S v. C Distribution Differences Issues Distributions from leveraged ESOPs Distributions of Stock C Corp Distributions can be delayed until the loan is repaid Participant must generally be permitted to demand a distribution in stock S Corp It is not clear if the distribution can be delayed until the loan is repaid Stock distributions are not required. If distributions of stock are allowed, the plan must protect itself from violating the 75 shareholder limit and from distributing stock to ineligible shareholders

34 S v. C Distribution Differences Issues Determining Cost Basis of Stock C Corp Cost basis IS NOT adjusted for earnings and distributions of earnings S Corp Cost basis is(?) adjusted for earnings and distributions of earnings per an IRS revenue ruling. It is not clear if the IRS has properly interpreted the law.

35 S v. C Distribution Differences Issues Distribution timing for terminated participants C Corp Decision on timing of distributions generally not impacted by large dividends on company stock. S Corp Decision on timing of distributions can be impacted by significant S- Corp distributions. Cash-out terminees right away or allow them to keep getting S-Corp distributions.

36 S v. C: Contribution and Allocation Differences Limit Deductible Contribution Limits C Corp 25% of compensation Contribution used to pay interest on acquisition loan is not counted under this limit S Corp 25% of compensation Includes entire contribution

37 S v. C: Contribution and Allocation Differences Limit Annual Additions C Corp Lesser of 100% of compensation or $40,000 S Corp Lesser of 100% of compensation or $40,000 If One-Third Test is met, contribution used to pay interest and forfeitures of shares purchased with the acquisition loan are not Annual Additions One-Third Test does not apply, so all contributions and forfeitures are counted as Annual Additions

38 S v. C: Contribution and Allocation Differences Limit Haves and Have-nots C Corp Generally not an issue S Corp Can be a big issue in mature ESOPs: Earnings distributions allocated based on stock accounts. Very small allocations to new participants Primarily Invested in Employer Securities Generally not an issue Can be an issue in mature ESOPs

39 S v. C Dividend Differences Type/Use of Dividend Dividends (Earnings Distributions) on Allocated Shares C Corp Considered an applicable dividend under IRC Section 404(k), eligible for a tax deduction when used to pay debt S Corp Cannot be used to pay debt Dividends (Earnings Distributions) on Suspense Shares Considered an applicable dividend under IRC Section 404(k), eligible for a tax deduction when used to pay debt Can be used to pay debt, but not considered an applicable dividend, so a deduction is not permitted

40 S v. C Dividend Differences Type/Use of Dividend Dividends Passed-Through C Corp Considered an applicable dividend, eligible for a tax deduction and not considered a distribution subject to consent rules and early withdrawal penalties S Corp Not considered an applicable dividend and is therefore not deductible and is subject to the regular distribution rules, including early withdrawal penalties

41 S v. C Other Differences Issues Section 1042 Tax Deferral Available C Corp S Corp Not Available Prohibited Allocation Rules under IRC Section 409(p) Do not apply Apply Effective for ESOPs established after 3/14/01 or where the sponsoring corporation makes an S election after 3/14/01. Otherwise, the rules are effective for plan years beginning after 12/31/04