New Tax Law Addresses S Corporation ESOP Abuses
June 2001
The Economic Growth and Tax Relief Reconciliation Act of 2001, signed by President Bush on June 7, 2001, contains a long-sought provision that cracks down on perceived abuses in the S corporation Employee Stock Ownership Plan (ESOP) area.
Background
For the past three years, the ESOP community has been lobbying in favor of these new restrictions in an effort to head off pressure to repeal the entire S corporation ESOP concept. This pressure emanated from a concern over perceived abuses, such as the one-person S corporation and the "tax holiday" achievable by concentrating a S corporation's equity in the form of stock options that are not treated as outstanding stock. By eliminating these abuses, the ESOP community hopes and expects that the laws governing legitimate S corporation ESOPs will remain intact indefinitely.
The new anti-abuse law, however, is quite complex and may result in severe penalties for some S corporations that would not think of themselves as being "abusive." Every S corporation with an ESOP should understand the new rules to avoid being caught in a trap. The good news, though, is that for S corporation ESOPs in existence prior to March 14, 2001, the effective date of the new restrictions is deferred until the first plan year beginning after December 31, 2004. So plans that are not now in compliance will have time to take the necessary steps to avoid future penalties.
There are two ways to get in trouble under the new law, either by allocating too much stock to the accounts of a small number of ESOP participants, or by having too many outstanding options, warrants, stock appreciation rights or other forms of "synthetic equity."
Prohibited Allocations
The first step in determining whether there is a violation of the prohibited allocation rule is to identify which ESOP participants are "disqualified persons." A disqualified person is a person who has "deemed owned shares" constituting more than 10 percent of all of the deemed owned shares of the corporation's stock or is a member of a family that in the aggregate has more than 20 percent of the deemed owned share" of the corporation. "Family" is defined broadly to include spouses, ancestors, descendants, siblings and siblings' descendants.
For this purpose, deemed owned shares include the following:
- shares allocated to a participant's ESOP account (or that would be allocated to the account, in the case of ESOPs that allocate by cash rather than by shares); or
- the participant's proportion of the shares in any unallocated account, such as a loan suspense account or a section 4980(d) suspense account, assuming that all such shares become allocated in the same proportion as the most recent annual stock allocation under the plan; or
- any "synthetic equity" owned by the participant, which includes warrants, stock options, stock appreciation rights, etc. (discussed in more detail below).
However, deemed owned shares do not include shares held outright by an individual outside the plan.
For example, corporation X has 1,000 shares outstanding, 800 of which are held by the ESOP. Henry has 70 shares allocated to his ESOP account. Henry's niece Alice has 30 shares allocated to her ESOP account, plus 200 shares outside of the ESOP. There are 400 shares remaining in the ESOP loan suspense account. Last year, Henry received 5 percent of the total shares allocated from the suspense account for the year, and Alice received 3 percent of the total. Henry's deemed owned shares, therefore, are the 70 shares already allocated to his account, plus 5 percent of the 400 unallocated shares (20 shares) for a total of 90 deemed owned shares. Henry is a disqualified person, because his 90 deemed owned shares are more than 10 percent of the total of 800 deemed owned shares. Alice, however, has only 42 deemed owned shares (30 in her account, plus 12 more as her 3 percent portion of the unallocated shares), which is less than 10 percent of the total. She is also not caught up by the family aggregation rules since the total family deemed owned shares of Henry's 90 plus her 42 is less than 20 percent of the 800 total. Her 200 shares outside the ESOP are irrelevant. Therefore, Henry is a disqualified person, but Alice is not.
The treatment of synthetic equity as deemed owned shares is likely to cause confusion. "Synthetic equity" is defined as any stock option, warrant, restricted stock, stock appreciation right, phantom stock unit or similar right. That part is fairly straightforward. What is more difficult is the treatment of synthetic equity in the denominator of the various percentage tests. Synthetic equity is treated as outstanding if doing so results in treating a person as a disqualified person or in imposing taxes when disqualified persons own too many deemed owned shares but not otherwise.
For example, corporation Y has 800 shares of stock outstanding, all of which are held by the ESOP and allocated to participant accounts. Martin has 50 shares in his ESOP account, and Ned has 85 shares. Martin also has an option to acquire 100 shares. The disqualified person computation for Martin would put his 50 ESOP shares plus his 100 option shares in the numerator, and the 800 outstanding shares plus the 100 option shares in the denominator. This yields a percentage of 16.67 percent, which makes Martin a disqualified person. For Ned, the key question is whether Martin's 100 option shares are counted in the denominator. It would appear that they are not counted, making Ned a disqualified person with 85 shares in the numerator and only 800 in the denominator for a percentage of 10.625 percent.
Note that the definition of synthetic equity includes any option or right to acquire shares, not just a right to acquire newly issued shares from a corporation. It would appear, therefore, that if a person has the right to purchase outstanding shares from a stockholder, such as on the death of the stockholder, that person will be treated as having Synthetic Equity in the number of shares he can acquire. This could easily be a trap for the unwary, because there is no abuse in having a right to acquire already outstanding shares. It might be possible to argue that interpreting the statutory language in accordance with its intent would exclude rights to acquire existing shares from the definition of synthetic equity; however, in the absence of clear guidance, the penalties are so severe that it is unwise to take any chances.
Once the disqualified persons have been identified, the next step is to determine how much stock they own in the aggregate. If disqualified persons own at least 50 percent of the total number of shares of the S corporation at any time during an ESOP's plan year, then that year is treated as a "nonallocation year" and severe penalties begin to apply. For purposes of testing for a nonallocation year, stock that is held outright does count (unlike for purposes of determining deemed owned shares), along with all of the person's deemed owned shares. The attribution rules of Code § 318(a) also apply, except that the broader family attribution rules (including nieces, nephews, great-grandchildren, etc.) of the deemed owned share definition are used in place of the regular § 318 rules. Synthetic equity is treated as outstanding only where it results in treatment as a nonallocation year and not otherwise.
For example, Corporation Z has 1,000 shares outstanding, 900 of which are held by the ESOP and allocated to three participants who are not related to one another. Laura has 300 shares allocated to her account inside the ESOP, plus 100 shares in her own name outside of the ESOP. Justin has 75 shares in his ESOP account and an option to acquire 100 shares from the corporation. Meredith has 20 shares in her ESOP account and an option to acquire 75 shares from the corporation. The following chart shows how the testing works:
| Outright | ESOP | Option | Disqualified Person test | Total | Nonallocation test |
|||
| Laura | 100 | 300 | 0 | 33.3% | 400 | 34.0% | 400 | 36.4% |
| Justin | 0 | 75 | 100 | 17.5% | 175 | 14.9% | 175 | 15.9% |
| Meredith | 0 | 20 | 75 | 9.7% | 95 | 8.1% | 20 | 1.8% |
| Other | 0 | 505 | 0 | 505 | 43.0% | 505 | 45.9% | |
| Total | 100 | 900 | 175 | 1175 | 1100 |
Laura is clearly a disqualified person. So is Justin, because he will be considered to have 175 deemed owned shares out of a total of 1,000 deemed owned shares (the ESOP shares plus his option shares). Meredith just misses being a disqualified person. If all option shares were treated as outstanding, then Laura and Justin as the two disqualified persons would have just under 50 percent of the total, so there would not be a nonallocation year. However, Meredith's option shares would not be counted in the denominator of the test because they do not result in treatment of the year as a nonallocation year. Therefore, the disqualified persons taken together have more than 50 percent of the total outstanding shares and nonallocation year results.
Penalties
In some areas of employee benefits law, the penalties are light enough that employers may be willing to take aggressive positions, knowing that even if they fail the results will not be devastating. However, that will not be the case with violation of the S corporation ESOP prohibited allocation rules.
All S corporation ESOP documents will have to be amended to prohibit allocation of employer securities (or other assets in lieu of employer securities) to a disqualified person during a nonallocation year. If a plan actually does allocate employer securities (or other assets in lieu thereof) to a disqualified person during a nonallocation year, then the amount so allocated will be deemed to have been distributed to the disqualified person and, therefore, will be currently taxable to him or her. The employer is also obligated to pay a 50 percent excise tax on the amount allocated to the disqualified persons in the nonallocation year. A special rule also provides that in a corporation's first nonallocation year, all deemed owned shares are treated as having been allocated (and, therefore, subject to penalties) during that year.
Using the Laura-Justin-Meredith example above, Laura would be treated as having a taxable distribution of 300 shares in the first nonallocation year, and Justin would have a taxable distribution of 75 shares. The corporation would also be obligated for the first nonallocation year to pay an excise tax on 50 percent of the value of 300 shares for Laura and 175 shares for Justin. Any future allocations to Laura's and Justin's ESOP accounts will also be treated as having been distributed to them immediately, as well as being subject to the 50 percent excise tax so long as Laura and Justin remain disqualified persons. However, if Meredith becomes a disqualified person in a future year, her initial 95 deemed owned shares apparently will escape these taxes because the special rule applies only in a corporation's first nonallocation year.
It is not clear under the statute how the value of these shares will be computed for tax purposes. For example, even though Meredith's option shares are ignored for purposes of determining whether there is a nonallocation year, are they also ignored for purposes of determining the value of Laura's and Justin's deemed owned shares? Do minority discounts apply? Do nonmarketability discounts apply? We believe it may be a long time before these questions are ever answered because no matter how they are answered, the penalties are so onerous that no well-informed S corporation will be willing to risk them. It does appear to be clear that with regard to synthetic equity, it is the value of the shares to which the synthetic equity relates and not the value of the synthetic equity itself that is important. If Justin's options were at a strike price equal to (or higher than) the fair market value of the company stock, they would have little or no economic value; but they would be taxed at the full fair market value of the stock to which they relate anyway.
It is completely unclear under the statute how shares that are deemed to have been distributed are treated thereafter. If they are treated as continuing to be held by the persons to whom they were deemed to have been distributed, then those persons will be personally liable for their proportionate share of the future income of the S corporation.
It is also possible (although the statute does not specifically indicate) that the ESOP itself would be disqualified if a prohibited allocation occurs. The law now provides that the plan document must prohibit allocation to disqualified persons, so any such allocation would itself be a violation of the plan document. The IRS takes the position that violation of a plan document provision results in disqualification of the plan. If an S corporation ESOP is disqualified, then it would no longer be a permitted holder of S corporation stock and the S corporation would automatically become a C corporation. A footnote in the Conference Committee report on this legislation states that this result is not the Congressional intent; it is not at all clear, however, whether the IRS will go along with this.
Planning Tip
If an S corporation ESOP is or expects to be "close to the edge" on violating the nonallocation rules, it should be possible to build in fail-safe language to assure that the rule is not violated. This can be done by changing the asset mix in participant accounts to prevent participants who are disqualified persons from exceeding the 50 percent % test for a nonallocation year. For example, in the aforementioned Laura-Justin-Meredith example, a plan provision to prevent disqualified persons from owning more than 50 percent of the corporation's stock would have the effect of forcing an exchange of approximately 7 percent of the shares in Laura's and Justin's ESOP accounts for cash (e.g., that the ESOP had received from dividend distributions). The shares taken from Laura and Justin would be reallocated to the accounts of the other ESOP employees from whom the cash had been taken. Laura and Justin would then have just under 50 percent of the total stock of the corporation and no nonallocation year would result. (If the reallocation to other participants forced Meredith into a disqualified person status, then some of her shares would have to be exchanged for cash as well.)
This technique will only work in cases that are close to the edge, however. In some cases, it will not be possible to prevent a nonallocation year from occurring and the company would be best advised to terminate either its ESOP or its S election. As a matter of arithmetic, it is not possible to avoid a nonallocation year if there are six or fewer participants in an ESOP that owns 100 percent of an S corporation's stock.
Synthetic Equity
A separate excise tax is also imposed on the mere ownership of synthetic equity during a nonallocation year. This tax is also set at 50 percent of the amount involved, which is defined as the value of the shares to which the synthetic equity relates (instead of just the value of the synthetic equity itself). This tax appears to be especially onerous because it is imposed on the same synthetic equity every year. There may also be a double tax. Although the statutory language is not totally clear, in the example above it appears that there might be two separate 50 percent taxes imposed on the corporation in the first nonallocation year with respect to Justin's 100 option shares. Thereafter, there would be a single 50 percent tax imposed on these option shares each year. Clearly, this is so confiscatory that it cannot be allowed to happen and will only happen in cases where companies are unaware of the law. Note that the synthetic equity rules can apply to persons who are not even ESOP participants, such as mezzanine financing warrant holders, in any case where there is a nonallocation year.
Note that for this purpose synthetic equity may be interpreted to include the right to acquire outstanding shares from another stockholder. Suppose that an ESOP, Bill and Margaret each own one-third of a company, and Bill and Margaret are parties to a stockholders agreement giving each of them the right to purchase the other's shares at death. This corporation would appear to have two-thirds of its stock in the form of synthetic equity and be liable for a confiscatory tax payable every year.
The vast majority of S corporation ESOPs will have no difficulties under the new rules. A few S corporation ESOPs that have been established to benefit a single individual, such as a high-earning professional, will have to be terminated before 2005. The real danger lies for companies that are close to the edge, without realizing it, or who slip past the edge over time. For this reason, every S corporation ESOP should determine who its disqualified persons are and how many shares they own in order to avoid some extremely serious consequences. McDermott, Will & Emery has developed a computer spreadsheet to aid in identifying disqualified persons and nonallocation years to assist its clients in complying with these complex rules.
