Restricted Stock Loan by omg11669

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									Technical Issues:
Update for S Corp
ESOPs

Helen H. Morrison               18th Annual Ohio
Principal, Deloitte
                               Employee Ownership
Becky Hoffman
Principal Group
                                   Conference
                                   April 16, 2004
Hugh Reynolds
Crowe Chizek and Company LLC
                                    Akron, Ohio

Tim Jochim
Jochim Co., LPA
What is an “S Corp”?
How does it differ from a “C Corp”?
   C Corporation                 S Corporation
       Corporation under             Corporation under
        state law                      state law
       Separately taxable            “Pass through” entity
        entity                             Nature of income (for
       Shareholders subject                losses and expenses)
                                            retains its character
        to tax on dividend                  in hands of
        payments (now 15%                   shareholder)
        tax for eligible
        dividends)
    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
Tax Model of Operations
Stock Sale Tax Model
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?
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
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
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
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
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
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
 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
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
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
Anti-Abuse Rules – Defined
Terms
    Deemed-Owned Shares
      Allocated ESOP shares
      Pro rata portion of shares in
       the ESOP loan suspense
       account
      Synthetic Equity
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
    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
    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.
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
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.
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
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
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.
        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
Applying the S Corp. ESOP
Anti-abuse Rules
    Questions?
Administration of S
Corporation ESOPs
           S v. C Distribution Differences
        Issues                  C Corp                      S Corp
Distributions from       Distributions can be        It is not clear if the
leveraged ESOPs          delayed until the loan is   distribution can be
                         repaid                      delayed until the loan is
                                                     repaid
Distributions of Stock   Participant must generally Stock distributions are
                         be permitted to demand     not required. If
                         a distribution in stock    distributions of stock are
                                                    allowed, the plan must
                                                    protect itself from
                                                    violating the 75
                                                    shareholder limit and
                                                    from distributing stock to
                                                    ineligible shareholders
          S v. C Distribution Differences
       Issues                      C Corp                     S Corp
Determining Cost Basis of   Cost basis IS NOT         Cost basis is(?) adjusted
Stock                       adjusted for earnings and for earnings and
                            distributions of earnings distributions of earnings
                                                      per an IRS revenue
                                                      ruling.

                                                       It is not clear if the IRS
                                                       has properly interpreted
                                                       the law.
        S v. C Distribution Differences
        Issues                   C Corp                        S Corp
Distribution timing for   Decision on timing of         Decision on timing of
terminated participants   distributions generally not   distributions can be
                          impacted by large             impacted by significant S-
                          dividends on company          Corp distributions.
                          stock.
                                                        Cash-out terminees right
                                                        away or allow them to
                                                        keep getting S-Corp
                                                        distributions.
        S v. C: Contribution and Allocation
        Differences
         Limit                   C Corp                      S Corp
Deductible Contribution   25% of compensation         25% of compensation
Limits
                          Contribution used to pay    Includes entire
                          interest on acquisition     contribution
                          loan is not counted under
                          this limit
        S v. C: Contribution and Allocation
        Differences
        Limit             C Corp                        S Corp
Annual Additions   Lesser of 100% of             Lesser of 100% of
                   compensation or $40,000       compensation or $40,000

                   If One-Third Test is met,     One-Third Test does not
                   contribution used to pay      apply, so all contributions
                   interest and forfeitures of   and forfeitures are
                   shares purchased with         counted as Annual
                   the acquisition loan are      Additions
                   not Annual Additions
        S v. C: Contribution and Allocation
        Differences
         Limit                 C Corp                   S Corp
Haves and Have-nots     Generally not an issue   Can be a big issue in
                                                 mature ESOPs: Earnings
                                                 distributions allocated
                                                 based on stock accounts.

                                                 Very small allocations to
                                                 new participants


Primarily Invested in   Generally not an issue   Can be an issue in
Employer Securities                              mature ESOPs
        S v. C Dividend Differences
   Type/Use of                       C Corp                      S Corp
    Dividend
Dividends (Earnings           Considered an “applicable Cannot be used to pay
Distributions) on Allocated   dividend” under IRC       debt
Shares                        Section 404(k), eligible
                              for a tax deduction when
                              used to pay debt


Dividends (Earnings           Considered an “applicable   Can be used to pay debt,
Distributions) on Suspense    dividend” under IRC         but not considered an
Shares                        Section 404(k), eligible    “applicable dividend,” so
                              for a tax deduction when    a deduction is not
                              used to pay debt            permitted
         S v. C Dividend Differences
  Type/Use of                     C Corp                      S Corp
   Dividend
Dividends Passed-Through   Considered an “applicable   Not considered an
                           dividend,” eligible for a   “applicable dividend” and
                           tax deduction and not       is therefore not
                           considered a distribution   deductible and is subject
                           subject to consent rules    to the regular distribution
                           and early withdrawal        rules, including early
                           penalties                   withdrawal penalties
        S v. C Other Differences
        Issues                       C Corp          S Corp
Section 1042 Tax Deferral     Available       Not Available




Prohibited Allocation Rules   Do not apply    Apply – Effective for
under IRC Section 409(p)                      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

								
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