Hello and thank you for your interesting (really!) question.
Although IRAs and SEPs are not permitted as S corp shareholders, ESOPs
do qualify, and that would be the route to follow if you want to
achieve tax deferral for your S corp income. However, if too many of
the would-be beneficiaries of this plan are 'disqualified persons' the
ESOP solution will not be practical.
Here's why:
As you may know, only certain types of persons can own S corporation
stock, and there are limits on the total number of shareholders
allowed.
Again, SEPs and IRAs are not permitted to own S stock, but trusts
described in Code section 401(a) are allowed. And an ESOP fits within
the Code section 401(a) definition.
The number of S corp shareholders is currently limited to 75.
"Astute tax consultants recognized the value of coupling an S
corporation with an employee stock ownership plan (ESOP) in 1998 when
Congress changed Section 512(e) of the Internal Revenue Code to allow
ESOPs to become eligible S corporation stockholders without being
required to pay an unrelated business income tax (UBIT). This change
in the law caused all of the income attributable to S corporation
stock owned by the ESOP to be, in effect, tax-free. Accordingly, an S
corporation wholly owned by its ESOP pays no federal income tax on an
ongoing basis. Because of this tax advantage, Congress added IRC
§409(p) to the Internal Revenue Code, and the IRS and Treasury have
continued to focus on S corporation ESOPs to assure that this
advantage inures to the benefit of rank and file employees and not
just the primary shareholders of the business."
New Regulations Stop S Corp ESOP Abuse, But Cause Ancillary Problems
http://www.bipc.com/news.cfm?mode=article&article_id=855
As a practical matter this means that disqualified persons, in the
aggregate, cannot own 50 percent or more of an S corporation's stock
(a disqualified person is any person whose deemed-owned ESOP shares
are at least 10 percent of the number of deemed-owned ESOP shares of
the S corporation or for whom the aggregate number of deemed-owned
ESOP shares of such person and the members of such person's family is
at least 20 percent of the number of deemed-owned ESOP shares).
Id.
See also, Scam Alert ? Watch out for S corp ESOP Scheme
http://www.beysterinstitute.org/onlinemag/dec02/ask.htm
You will also note that because of the broad anti-abuse rules set
forth in the regulations, the company's other deferred compensation
schemes may have the result of disqualifying the ESOP (that's one of
the 'ancillary problems' described more fully in the article first
cited above).
And here's an interesting technical problem--a favorable IRS private
letter ruling that does allow an IRA to have momentary ownership of S
stock as part of the ESOP arrangement (private letter rulings cannot
officially be relied on by anybody other than the person who obtained
the ruling, but they are usually a good indication of what the IRS is
likely to tolerate):
IRS PERMITS MOMENTARY OWNERSHIP OF S CORPORATION STOCK BY AN IRA
http://www.mwe.com/index.cfm/fuseaction/publications.nldetail/object_id/974C1E9F-0478-4FCD-8424-5EEF28123AFF.cfm
You also asked how they go about valuing the the shares and what is
the mechanism to exchange the shares for the cash. There is a small
industry devoted to valuing closely held business shares for ESOP
purposes, and the mechanism by which the ESOP gets funded with the
shares is also well established.
For exammple,
Dynasty Capital
http://www.dynastycapital.net/sys-tmpl/esopservices/
Whole books have been written on the subject
Selling to an ESOP
http://www.nceo.org/pubs/selling.html
As to valuing the company shares (and there's a whole book here too)
"If you want to have an employee stock ownership plan (ESOP) in a
closely held company, an independent, outside valuation is not just a
good idea, it's the law. You must have an appraiser figure out what a
willing buyer would pay a willing seller, assuming both have all the
relevant information they need to make the transaction."
Understanding ESOPs
http://www.nceo.org/pubs/understanding.html
Here's a brief summary of how the typical ESOP works
"When a company adopts an ESOP it creates a trust for the employees,
also referred to as the "ESOP Trust." The company could contribute
stock to the ESOP; however, if the owner of the company wants to
create liquidity, the owner may sell shares of his or her company?s
stock to the ESOP Trust. In a leveraged transaction, the ESOP Trust
usually obtains its funds through a loan either from a financial
institution or from the seller or a combination of institutional and
seller financing. The amount of the loan is based on the cash flow and
financial strength of the corporation. The ESOP then gives cash to the
shareholders in exchange for their stock.
In practice, it is quite common for ESOP financing structures to use
two loans. The first loan or "external" loan is from a third party
lender to the corporation. The second loan or "internal loan" is from
the corporation to the ESOP. There is no requirement that the terms of
these two loans be identical. If, for example, the terms of the
external loan are longer, the corporation may be accelerating its tax
deduction faster than the loan payoff of the principal to the bank. On
the other hand, if the terms of the internal loan are longer, stock
will be allocated to employees at a slower pace. Generally, lenders
prefer to lend to the corporation, thereby avoiding compliance with
the exempt loan requirements of ERISA."
ESOPs: The Private Business Owner's Secret Planning Device
http://www.gtlaw.com/pub/alerts/2003/kahnj_03.asp
And note the following from the same article:
"Since 1998, S corporations have also been permitted to adopt ESOPs;
however, different rules apply. Rollover treatment under Section 1042
is not allowed and dividends are not deductible. It is not uncommon,
therefore, for an S corporation to convert to a C corporation prior to
an ESOP transaction. On the other hand, if all the stock is sold to an
S corporation ESOP, the future earnings of the company will be exempt
from income tax."
Id.
So to conclude, your employer can potentially achieve the savings
alluded to in your question by forming an ESOP to own the company
shares. But as you can probably tell from the foregoing, it's a
costly and complicated process, and it's unlikely to be practical
unless 'disqualified persons' are kept in the minority. And even if
the decision is made to proceed, your employer will need some
sophisticated advisors to make the thing work.
Search terms used:
sep "401(a)" "s corp"
esop "closely held" valuation
"s corporation" "401(a)" "1.1377
Thank you again for letting us help. If you find any of the above to
be unclear (or, let's say, more unclear than you'd expect in an area
like this), please request clarification. I would appreciate it if
you would hold off on rating my answer until I have a chance to reply.
Sincerely,
Google Answers Researcher
Richard-ga |
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